5 October 1990 Internal T.I. 9023477 F - Interest Distinguished from Discount

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.

SUBJECT:  24(1) or "the taxpayer"

We are writing in response to your memorandum of September 5, 1990 in which you requested our opinion on a number of outstanding questions. These questions relate to the tax treatment under the Income Tax Act ("the Act") of 24(1) A brief history of the relevant facts relating to this matter is set outs below.

History

1.     24(1)

     Your position was that the discount of 24(1) was not in the nature of interest but rather was deductible only in accordance with the provisions of paragraph 20(1)(f). One of your reasons for this conclusion was that the interest rate on 24(1) was not substantially lower than the market rate at the time of issue. This of course is one of the tests stated in paragraph 3 of Interpretation Bulletin IT-114. In making this comparison, you contrasted the effective rate of interest on the 24(1) with the market interest rate. You did not state a special figure for the assumed market rate of interest you relied upon.

2.     In our memorandum of June 28, 1989 we responded to the questions you raised in your April 5, 1989 memorandum and stated that, in our opinion, 24(1)  This conclusion was based on the assumption that there was no evidence available to support the taxpayer's contention that the rate of interest on 24(1) was substantially lower than the market rate at the time of issue. We did point out, however, that in the event 24(1) presented additional evidence which resulted in you accepting that the discounts were the equivalent of interest, the discounts must be deducted using the simple-compound interest method.

3.     In our April 10, 1990 memorandum, we responded to your office's round trip memoranda of September 6, 1989 and February 22, 1990 with which you had include written submission from 24(1). In our response we confirmed our view that the discounts were not interest. This conclusion was still conditional on our understanding regarding the market rate of interest. On page 3 of our memorandum we stated:

     We understand that 24(1) is not submitted any additional evidence which would allow you to conclude that in fact the rate of interest on 24(1) was substantially lower than the market rate at the time of their issue.

Your Questions

In your September 5, 1990 memorandum you have asked us the following questions:

1.     "Is there a legal possibility that the taxpayer is incorrect in allocating issue price between debt and warrants for tax that there is on discount on the issue, considering that 24(1)

2.     In the context of paragraph 3 of IT-114, "what are the criteria used to determine what is an interest rate substantially lower than market... if any".

Our Opinion

1.     As stated in paragraph 1 of Interpretation Bulletin IT-96R4, whenever an option is issued concurrently with another security of the corporation, the Department considers that an allocation of the issue price must be made between the option and the security. We would emphasize that the determination of a correct allocation is a question of fact. In the present case 24(1) In is submission, the taxpayer stated that its allocation was done on the advice of a professional valuator. In the absence of any new evidence, it would not seem reasonable, especially at this late stage, to challenge the taxpayer's allocation. The fact that the taxpayer may have treated the transaction differently for book purposes is not relevant in determining the income tax treatment.

2.     As you are aware, under paragraph 3 of IT-114, a discount will be considered to be interest if:

a)     the discount arose on the original issue of the obligation, and

b)        the debt was either a non-interest bearing obligation or carried an interest rate substantially lower than the market rate.

There appears to be no dispute that the discount arose on the original issue of the debentures. The issue that still remains, as noted in our previous memoranda, is the determination of whether the debentures carried an interest rate substantially lower than the market rate.

We are unable to provide you with any firm guidelines as to what is meant by the term "substantially" in the context of paragraph 3 of IT-114. As mentioned in our April 10, 1990 memorandum, the true nature of a discount is to be ascertained from all the circumstances of the case and is to be determined in view of all the relevant facts. In the present case we still have not been provided with any information as to what the relevant market rate of interest was at the time the debentures were issued other than the taxpayer's submission that it was in 24(1). Once the market rate of interest can be determined to your satisfaction, it should be compared with 24(1) (In this regard, we would note that it is the actual rate of interest on 24(1) and not the effective interest rate. 24(1) at should be compared with the market rate). If the taxpayer can establish to your satisfaction that the market rate of interest on comparable debt instruments at the time of issue was 24(1)  Accordingly, the entire amount of the discount would be considered to be interest pursuant to the criteria in IT-114.

J.C. ClarkSection ChiefLeasing & Financing SectionFinancial Industries Division