Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Would a shallow original-issue discount in respect of a debenture issued be subject to the application of 18(1)(f) and 20(1)(f) or would it be viewed as interest and subject to 20(1)(c)?

Position TAKEN:

It would be subject to the application of 18(1)(f) and 20(1)(f).

Reasons FOR POSITION TAKEN:

The legislation clearly provides this result.

			September 9, 1994

North York District Office Head Office
Industry Specialist Services Rulings Directorate
Allan Nelson
Attention: Doug Mitchell (613) 957-8953
Banking Specialist
942195

XXXXXXXXXX
Original Issue Discount

This is in reply to your memorandum to us dated August 25, 1994, wherein you asked for our comments concerning the application of Interpretation Bulletin IT-114 and the deductibility of XXXXXXXXXX original-issue discount.

Background and Facts

XXXXXXXXXX

QUESTIONS AND RESPONSES

1.It is my understanding that the Department will not consider any requests for an advance ruling on whether a discount is the equivalent of interest. This is so notwithstanding that the special release to IT-114, dated June 10, 1994, states "The Department will continue to consider requests for opinions on specific provisions in the law relating to the taxation of discounts...and will provide advance income tax rulings on specific proposed transactions." Is our understanding correct?

In applying IT-114 to the matter of discounts, and in particular paragraph 3, where it states "As a general rule the amount of a discount is regarded as the equivalent of interest..." (underlining added), we look at the particular supporting documentation to see if it demonstrates that the apparent discount has all the legal attributes of interest. If so, we will provide rulings that it is interest and that paragraph 20(1)(c) would apply and paragraphs 18(1)(f) and 20(1)(f) would not apply. To the best of our knowledge, we have not looked at something that was not interest and given a ruling that it was interest. It is always a question of fact whether what is termed a discount is in fact interest. The problem in this regard relates to unsettled jurisprudence on this point and the requirement that there be a "day-to-day accrual" for an amount to be considered interest.

2.Are there specific paragraphs in the original bulletin which have been identified as no longer reflecting the policy of the Department and what are those specific paragraphs?

IT-114 was issued in 1973 and was never intended to cover the wide array of financial products currently available in the marketplace. With this in mind the Bulletin was cancelled on June 10, 1994. Some of the main concerns with the Bulletin relate to paragraph 3, and whether a discount is in fact interest, and paragraph 29, where it states "...in any other case the amount of a premium is not regarded as income". In addition, the Bulletin does not address the prescribed debt obligation interest accrual rules in Regulation 7000.

3.When was the tax community first advised that the bulletin no longer reflected the policy of the Department?

At the 1983 Canadian Tax Foundation Conference, John Calderwood, Director, Tax Avoidance and Foreign Operations Division, Revenue Canada, Taxation, Ottawa presented a paper entitled "A Revenue Canada Perspective on Offshore Funds, Commodity Straddles, and Offshore Deep Discount Bonds and Treasury Bills". Therein, as reported at pages 261 and 262 of the 1983 Conference Report, he stated "The reporting requirements of discounts and whether the discounts are interest or capital are both concerns of ours...the problem in these instances rests with the issuer: can this person deduct interest as an expense?...Whether a deep discount is a current or a capital item is a question of fact, and thus a factual determination must be made in each case."

Other public statements include the 1987 (CTF) Round Table Question 51 (we said the IT is currently under review and amendments will be made as necessary), the 1988 Conference Report, at page 53:15 (where we discussed our concern over the different legal meanings for the words "discount" and "interest"), the 1991 Round Table, Q.53, and at the 1992 and 1993 Tax Executive Institute meetings (where we referred to Finance's interest study and proposed legislation in the context of revisions to the IT).

4.With reference to paragraph 3 of IT-114, what in your view would be a "substantially lower than the market rate at the time of issue"?

As you have identified, it is a question of fact whether a particular interest rate would constitute an interest rate substantially lower than the market rate at the time of issue. Examples of factors to consider would be what the market rate was at the time the debenture was issued, XXXXXXXXXX credit worthiness at the time, what rates and products competitors were offering in the marketplace at that time, the quality and amount of the underlying security, etc. Based on the facts presented to us, we doubt that XXXXXXXXXX, with a stated interest rate of 7 3/4% would constitute a debenture issued carrying an "interest rate substantially lower than the market rate at the time of issue".

5.In the latter part of paragraph 3 of IT-114, concerning what we will call "deep discounts", the Department states

As a general rule the amount of a discount is regarded as the equivalent of interest where it is reasonable to regard it as such and (a) the discount arose on the original issue of the obligation, and (b) the debt...carried an interest rate substantially lower than the market rate at the time of issue.

XXXXXXXXXX may argue that the Department is being inconsistent in its application of paragraph 20(1)(f) of the Act. Since the Department accepts that paragraph 20(1)(f) of the Act does not apply to limit the deductibility of deep discounts (because the discount is treated as the equivalent of interest), in order to be consistent in XXXXXXXXXX case, the Department should also treat the 1% discount (presumably a "shallow discount") on the issuance of their debenture as being the equivalent of interest. Could we have your comments?

We do not believe that the Department is being inconsistent in its application of paragraph 20(1)(f). As noted above in response to query #1, we accept that paragraph 20(1)(f) does not apply to limit the deductibility of deep discounts only if the documentation supports the contention that the discount is in fact interest. That response applies equally to original-issue deep discount debt obligations on which no interest was stipulated to be payable and on those carrying an interest rate substantially lower than the market rate at the time of issue.

Based on your comments that there are no facts to substantiate that the 7 3/4% interest rate attached to XXXXXXXXXX debenture at the time of its issuance was a substantially lower than market interest rate, and given that we have nothing to support the argument that the 1% discount was in fact interest, it is our view that the law is clear and paragraphs 18(1)(f) and 20(1)(f) of the Act would apply to restrict the amount of the discount deducted by XXXXXXXXXX

Concerning any perceived inconsistencies between the law and IT-114, we note the recent case of 74712 Alberta Ltd. (Formerly Cal-Gas and Equipment Ltd.) v. The Queen, 94 DTC 6392. At page 6405, Justice Muldoon stated that the judicial branch of the state is the interpreter of the law and that it is not subordinate to departmental Interpretation Bulletins. In that case, the court did not find itself bound by the Department's positions outlined in IT-445. Instead the case was decided on the facts and based on the comments of the Supreme court in Bronfman Trust (87 DTC 5059)...(i.e. direct use...).

6.Paragraph 4 of IT-114, as it previously read, states

Where it is found that the amount of a discount...is in the nature of interest, the normal rules concerning the...deduction of interest expense in computing the income of the borrower are applied.

When a discount is paid, it may seem to be equivalent to interest, but it is not paid pursuant to a legal obligation to pay interest and it does not fit within the normal case law definition of interest (i.e. a daily accrual and referrable to a principal sum). It would appear that the Department made a policy decision to accept these amounts under paragraph 20(1)(c). Is this correct?

By referring to the February, 1977, memorandums from R.N. Godwin, Rulings Division to D.L.H. Davidson, Assistant Deputy Minister, Legislation Branch, which you provided to us (in particular the February 28 memorandum), it can be seen that the view at the time was that there was legal justification for the position to give interest treatment to discounts in certain limited circumstances. It does not appear to have been an administrative policy decision. In addition, as noted in response to queries #1 and #5, above, we would not rule that a discount would be deductible under paragraph 20(1)(c), unless the underlying documentation supported that the discount was in fact interest.

7.Considering the taxpayer follows the accrual method of accounting, would not the decision in the case of Hassan v. MNR (62 DTC 451) support the deduction of the discount on an accrual basis, once the decision is made to allow the discount as being equivalent to interest?

The Department's position concerning the deductibility of discounts, where the obligation was issued without a stated interest rate and with a deep discount, was expressed publicly by John Calderwood at the 1983 Canadian Tax Foundation Conference, as follows (see pages 260 - 262 of the 1983 CTF Conference Report):

If factually, the discount is an interest expense to the borrower, the effective rate of interest on the issue price can be determined on a compound interest basis. This rate times the issue price will be allowed annually as simple interest under paragraph 20(1)(c). The balance of the deep discount is compound interest and is allowable under paragraph 20(1)(d) only when paid, usually on redemption.

We acknowledge that this position modified the view expressed in the February 28, 1977, memorandum from Godwin to Davidson (referred to above in query #6), in which it was stated that once the decision was made to accept a discount as being the equivalent of interest, the full amount of the discount could be deducted by the issuer, pursuant to paragraph 20(1)(c), but only at the termination of the debt.

Our position is not inconsistent with the decision in the Hassan case, where the court determined that the interest was deductible in the year it was paid (i.e. it was paid and payable in the same year), not in the year that the litigation between the brothers was finally settled.

We hope the above information is of assistance to you. If you have further queries, please contact the writer.

Director
Financial Industries Division
Rulings Directorate
Policy and Legislation Branch