27 October 1989 Income Tax Severed Letter

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.

MEMORANDUM

October 27, 1989

TO Special Audits Division E.H. Gauthier Director

Attention: Saif T. Abdulhusein Industry Specialist Section

FROM Financial Industries Div. Blair P. Dwyer 957-3500

SUBJECT: XXXX

This is in reply to your memo dated May 9, 1988, forwarding to us a referral from the Mississauga District Office regarding the above-named taxpayer. We apologize for the extremely lengthy time we have taken to reply.

You have asked us to comment on the taxation treatment of the following:

a) the discounts;

b) the related financing costs incurred in connection with the commercial paper zero coupon bonds;

c) the related selling concessions incurred in connection with the Eurodollar Bonds; and,

d) the responsibility for withholding and remitting Part XIII taxes.

PART I - ISSUES

Whether XXXX carrying on a Business

The deductibility of several amounts depends on whether XXXX is carrying on a business and, if so, whether that business includes moneylending. Since XXXX sole purpose is to raise money and relend that money to its subsidiaries, it is carrying on a moneylending activity. The issue is whether that moneylending activity constitutes a business.

In a telephone conversation, XXXX informed us that he took the view that XXXXdid not carry on a money-lending business.. Nevertheless, we note that page 57 of the T20 report attached as Appendix 2 to the District Office submission states that commercial paper hedge contracts entered into by XXXX "clearly form part of the business operations" of XXXX. XXXX is engaged in a business operation, it is difficult to see what the business would consist of if not moneylending. For purposes of this reply, we will disregard the statement suggesting that XXXX is in fact carrying on a business.

Our understanding of the facts pertinent to this issue are as follows:

XXXXXXXX is a corporation. For a corporation whose corporate objects are expressly set out in its constitutional documents, a rebuttable presumption exists that income has a business character if it is earned by the corporation in the pursuit of one of its corporate objects [see Canadian Marconi Company v. The Queen, 86 DTC 6526 (S.C.C.)]. It is an open question whether the presumption applies in the case of a corporation that does not have stated objects. Nevertheless, the Supreme Court of Canada has indicated that a broader form of presumption may apply to all corporations on the basis that corporations are "incorporated to earn income by doing business" (Canadian Marconi, at p. 6529). While we should examine the constating documents of XXXX to determine whether they include lending money as a corporate object, this memo will presume that the presumption applies and must be rebutted.

A number of factors can be used to rebut the presumption:

- the number, volume and frequency of transactions engaged in; - the nature of the investments; - the rate of turnover of investments; and - the number of employees and amount of staff time involved in the operation.

XXXX has no employees and consequently no staff time is taken up by its lending activities. This factor is of comparatively little weight by itself, however, and can be rendered insignificant by daily involvement of officers and directors in directing the alleged business activity. For example, refer to M.R.T. Investments Ltd. et al. v. The Queen, 75 D.T.C. 5224 (F.C.T.D.), affirmed sub nom The Queen v. M.R.T. Investments Ltd., 76 D.T.C. 6158 (F.C.A.) and approved of on this point in Marconi at p. 6530-1. In M.R.T., the corporation carried on a small-scale activity of lending money on mortgages. This constituted a business activity even though the corporation had no employees and no office of its own. Its activities were conducted by an unpaid director and officer, assisted by office staff and office equipment owned by related corporations. No charge was made by the related corporations for the services of the office staff and equipment. All advertising for prospective borrowers was handled by one of the related corporations (see the F.C.T.D. decision, at p. 5227).

The employment and office situation in M.R.T. is consequently analagous to the XXXX situation, with XXXX parent corporation fulfilling the role of the related corporations in M.R.T..

The M.R.T. case is distinguishable, however, in terms of the nature of the activity undertaken. M.R.T. advertised for potential borrowers (without disclosing the M.R.T. name) both through a related corporation and through several independent agents. It solicited high risk loans from the public in general and accepted only one of every two or three proposals submitted to them. M.R.T. engaged in considerable negotiation concerning the terms of each mortgage loan and examined the property given as security (F.C.T.D. level, at pp. 5228-9).

While considerable effort may be expended in XXXX borrowing activities, borrowing is separate from lending. XXXX lending operation appears to be quite unlike that in M.R.T.. We assume that XXXX engages in virtually no real negotiation with its subsidiaries as to terms (indeed, XXXX makes a habit of retroactively reducing interest in order to reduce taxes for the group as a whole). Loans are made exclusively to the subsidiaries and no other persons. In contrast, a money-lending business requires that the moneylender be "ready and willing to lend to all and sundry." (M.R.T., at p. 5236, quoting from Lichtfield v. Dreyfus, [1906] 1 K.B. 584).

In Charles Chaffey v. M.N.R., [1974] C.T.C. 598 (F.C.T.D.), affirmed [1978] C.T.C. 253 (F.C.A.), a partnership held shares in a corporation operating a tourist resort. Members of the partnership extended loans to the corporation and suffered losses. The partnership had previously made advances to several other corporations, in which the partners held shares, several of which corporations carried on the business of granting mortgage loans. Neither the partnership nor the partners loaned money otherwise or advertised that they had money to lend to the public. The partners did testify that they had loaned money prior to the taxation years in issue (see pages 602-6 of the trial judgement).

The court rejected the argument that the partnership was carrying on a moneylending business. At page 610 of the trial judgement the court summarized the evidence as follows:

The evidence shows that certain companies in which (the partners) were officers and shareholders carried on a large mortgage business under their corporate powers and that [the partners] provided shareholders' advances to them for that purpose, that they also provided shareholders' advances to other companies and their share of advances as participating purchasers of real estate or other assets, but I do not think that the making of such advances proves that the lending of money was part of their ordinary business, or that the evidence as a whole proves that it was.

The Federal Court of Appeal specifically agreed with this passage (at p. 257-8) and added the following comment:

In my opinion shareholders' advances do not constitute the business of lending money; they are simply a particular form by which capital is put into a company. The loans made by the partnership did not have as their principal object the accommodation of persons in return for income in the form of interest; they were merely a device for the financing of projects through which profit was to be made by other means.

Consequently, the fact that the XXXX subsidiaries are themselves in a moneylending business does not give rise to any presumption that XXXX advances to those subsidiaries form part of a moneylending business engaged in by XXXX.

The following cases also involve persons advancing loans to subsidiaries or controlled corporations:

The Queen v. Terence Malone, (19821 C.T.C. 145 (F.C.T.D.)

Western Wood Products Limited v. M.N.R., 60 D.T.C. 638 (T.A.B.), affirmed 63 D.T.C. 1053 (Exch.)

Consolidated Bowling Limited v. M.N.R., 68 D.T.C. 357 (T.A.B.)

Industrial Investments Ltd. V. M.N.R., 73 D.T.C. 118 (T.R.B.)

Alfred Kotelko v. M.N.R., (1977) C.T.C. 2274 (T.R.B.)

Leslie C. Kandos v. M.N.R., 66 D.T.C. 271 (T.A.B.)

Gordon Rosenberg v. M.N.R., 68 D.T.C. 830 (T.A.B.)

In each case, the court rejected the taxpayer's argument that it advanced the loans as part of a money-lending business.

In conclusion, it appears that XXXX does not carry on a moneylending business.

Zero Coupon Bonds

We understand the facts concerning the Zero Coupon Bonds as follows:

XXXX does not carry on a money-lending business, as discussed in the previous portion of this memorandum. Nevertheless, XXXX does extend loans periodically to several subsidiaries. In order to raise funds to lend to its subsidiaries, XXXX issues unsecured promissory notes guaranteed by its USA parent. Some of these notes take the form of original issue zero coupon discounted bearer bonds. These bonds carry no stipulated interest rate but are issued at a discount. The loans made to the subsidiaries yield interest income which incrementally exceeds XXXX cost of borrowing.

You have asked whether XXXX may deduct the discount on the zero-coupon bonds.

If XXXX carried on a financing business, the discounts would represent its cost of borrowed funds and consequently would be deductible on income account whether or not the discounts represented interest. Such a deduction would be taken under section 9 of the Act in accordance with generally-accepted accounting principles. Since XXXX does not carry on a financing business, however, deductibility of the discount depends on whether it can be classified as interest.

Discounts

Whether discount on a zero-coupon bond represents interest is unclear under the current state of the law. Several judicial decisions in England give rise to a strong argument that a discount cannot be interest because it does not accrue on a day-to-day basis. No Canadian court has considered the matter in depth; nevertheless, some Canadian cases contain comments suggesting that discounts do accrue on a daily basis. All the Canadian cases deal with the issue in merely a peripheral manner and may be of doubtful value as binding precedents.

For an amount to be considered interest, it must meet all three of the following criteria.

a) it must represent compensation for the use of money belonging to or owed to another [see Reference re Saskatchewan Farm Security Act, [1947] 3 D.L.R. 689, at 703 (S.C.C.), affirmed sub nom A.-G. Sask. v. A.-G. Canada, [1949] 2 D.L.R. 145 (J.C.P.C.)];

b) it must be calculated by reference to an ascertainable principal amount (ibid.); and

c) it must accrue on a daily basis [Attorney-General for Ontario v. Barfried Enterprises Ltd. (1963), 42 D.L.R. (3d) 137, at 145 (S.C.C.)].

Some commentators have suggested that the third criterion is not an essential element of the definition because it was not mentioned by the Supreme Court of Canada in The Queen v. Melford Developments Inc., 82 D.T.C. 6281. This case concerned whether a guarantee fee was interest in the common law sense. The court concluded that it was not because the guarantee fee did not represent rent for the use of borrowed money. While the court did not refer to the principle that interest accrues on a day-to-day basis, there was no need for it to do so: the guarantee fee failed under the first criterion. The court's silence, therefore, cannot be taken as a denial of the accrual requirement.

Subject to a discounting transaction being characterized as a purchase and sale rather than a borrowing, discount can easily be characterized as compensation for the use of borrowed money (the borrowed money being the issue price of the obligation rather than its face amount, subject to the possible application of subsection 20(2)). Discount is also usually calculated as a stated percentage of the amount borrowed. Whether discount is interest depends on whether discount accrues on a daily basis.

No consensus exists on the accrual question.

In Barfried, the Supreme Court of Canada implied strongly that discount accrued on a day-to-day basis. The case concerned the constitutional validity of the Unconscionable Transactions Relief Act (Ontario). This statute empowered a court to grant certain relief to a debtor if the "cost of the loan" was excessive. The statute defined "cost of the loan" to include numerous charges, including interest and discount. The court rejected an argument that the statute was provincial legislation in relation to interest. While daily accrual was an essential feature of interest, all the charges included in the definition "cost of the loan", with the exception of interest and discount, lacked the daily accrual feature (at p.145). Albeit in a negative way, the court stated that discount accrues on a daily basis. Nevertheless, the court did not say that discount contained the other features of interest. Since discount and interest were referred to under separate names, one might argue that this implies a difference between the two concepts.

The court failed to cite any authority to back up its view that discount accrued on a daily basis. The court did cite authority, however, for its conclusion that "bonus" did not accrue on a daily basis. Unfortunately, the "bonus" dealt with in the bonus cases cited by the court bears an uncanny resemblance to discount.

In Singer v. Goldhar (1924), 55 O.L.R. 267 (App. Div.), $3500 was advanced to a borrower under a mortgage that called for payment of $4700 with no interest. The court held that the mortgage violated the federal Interest Act because it failed to explicitly state the rate of interest chargeable on the loan. In reaching this conclusion, the court found that the $3500 advanced represented the loan principal and that the excess, or "bonus" represented interest. At page 271, the court stated that the transaction was analagous in this respect to the discount of a bill of exchange in that the excess of the face amount over the advanced amount represented compensation for the amount advanced. - The court treated discount and bonus as essentially the same. One suspects that the term "bonus" was used in the case purely because the loan was evidenced by a mortgage rather than a bill of exchange.

In Barfried, the Supreme Court of Canada explicitly rejected the conclusion in Singer that bonus was interest. Given that the "bonus" in Singer was essentially a "discount", one is left wondering how discount can accrue on a daily basis whereas "bonus" does not. The Supreme Court does not explain what sort of discount it had in mind as accruing from day to day.

The status of Singer as good law is also open to questions as a result of London Loan & Savings Co. v Meagher, [1930] 2 DLR 849 (SCC), and Asconi Building Corp. et al v Vocisano, [1948] 1 DLR 794 (SCC). In London Loan, the defendant granted a $30,000 mortgage to X at a stated interest rate of 7 1/2% plus a $3,000 bonus. The mortgage deed made no reference to the bonus. Instead, the dependant issued the loan proceeds and received back a $3,000 cheque. X went into liquidation and the liquidator paid off the full face amount of the mortgage. On learning of the bonus payment, the liquidator sought to recover the $3,000 by virtue of the federal Interest Act. The liquidator argued that the loan was for only $27,000 with interest of $3,000 plus 7 1/2% on $30,000 and that the true rate of interest was not disclosed as required under the statute. The court dismissed this argument as begging the question, since $30,000 was advanced of which $3,000 was paid to the lender on account of the debtor's obligation to pay a bonus. At page 852, the court stated as follows:

As already pointed out, the $3,000 that the mortgagor agreed to pay as consideration for the loan, whether regarded as interest or as something differing from interest, could have been recovered as a debt, not under the mortgage, but under the agreement for the loan [. . . ]

The court did not decide whether the bonus was interest, since it was payable under the agreement for the loan rather than the mortgage.

At page 854, the court commented on the Singer case but stated merely that the "result" in Singer - that the mortgage had been satisfied - did not conflict with the reasoning used in London Loan.

In Asconi, three of the four judges delivered written decisions expressing the view that Singer was inconsistent with the London Loan decision and consequently not good law (at p. 799 per Tashereau, J; at p. 801 per Herwin, J; and at p. 808 per Hellock, J.).

Arguably, Singer was overruled only on the narrow point concerning whether the bonus became part of the principal for purposes of calculating the interest payable on the loan. However, Kerwin, J., in Asconi also stated as follows (at p. 801):

While it is true that the Court [in London Loan] treated the bonus as interest, there is a great deal to be said for the opinion that the two are entirely distinct, and in view of the fact that Parliament is restricted to legislation in relation to interest, that phase of the matter should be kept in mind.

Even though Asconi did not address whether the bonus was interest, at least one judge did not accept the view that bonus was the same as interest.

In Lillian v. Gilmour v. The Queen, [1981] C.T.C. 401, Collier, J., of the Federal Court, Trial Division, concluded that original issue discount was prepaid interest (at p. 406). This finding was made on the basis of accounting evidence (that was not tested on cross-examination) as well as on the passage in Barfried to the effect that discount did not lack a daily accrual aspect. The corporation in Gilmour did not claim a deduction for the interest in question. The case concerned whether the discounts were an expense that had not been allowed as a deduction and vas consequently deductible in computing the corporation's undistributed income on hand.

In J. Harold Wood v. M.N.R., [1967] C.T.C. 66 (Exch), Gibson, J. suggested that "interest" for purposes of the Interest Act meant the same thing as "interest" when used in the Income Tax Act. If so, he interpreted the Barfried decision as suggesting that "discount" was not interest for income tax purposes. In this regard, he postulated that the Barfried decision equated only the following type of "discounts" with interest:

a) discount on Canada Treasury Bills; b) loans made by way of the purchase of non-interest bearing post-dated Banker's Acceptances of Canadian chartered banks; and c) the mechanical application by Canadian chartered banks of their "call loan" or collateral security loan business.

Mr. Justice Gibson, viewed original issue discount as equivalent to interest only in certain circumstances. He does not identify, however, the common factors that make items (a), (b) and (c) different from other forms of discount. The Supreme Court of Canada (at [1969] C.T.C. 57) reversed the decision reached by Mr. Justice Gibson without commenting on his interpretation of the Barfried case.

In Lomax v. Peter Dixon & Son, Ltd. (1943), 25 T.C. 353 (C.A.), the English Court of Appeal seemed to imply that discount on a zero-coupon bond was interest. The case was confined to the characterization of discount on an interest-bearing obligation, however. In addition, the English statute taxes "discount" as discount under a separate charging provision, provided that the discount is on income account. There is no need for an English court to decide that "discount" is interest for the discount to be taxable. Just after his famous summary, Lord Greene states that a discount on a zero-coupon obligation will "normally, if not always, be a discount chargeable [as income rather than capital]"; he does not say that such a discount will be interest.

The same comment can be made for several other English cases dealing with discount. Indeed, in Ditchfield v. Sharp et al., [1983] 3 All E.R. 681 .(C.A.), the taxpayer argued that an amount could not be taxed as discount because it was in fact interest (at p. 686). Fox, L.J., rejected this argument on the basis that an interest element would not prevent an amount from being taxable discount provided the discount was of an income nature. In concluding that the discount was on income account, the court was not concluding that the discount was interest. See also CIR v. Thomas Nelson & Sons Ltd., (1938), 22 T.C. 175 (Ct. of Session). While the Court in Lord Howard de Walden v. Beck (1940), 23 T.C. 384 (K.B.) referred to discount as "interest" (at p. 400), this comment is obiter and can easily be disregarded, as an instance of loose terminology. The issue concerned merely whether the discount was on account of income or capital.

Davies v Premier Investment Co. Ltd., [1945] 2 ALL ER 681 (KB), relied on the comments made in Lomax to characterize a premium received by a noteholder as interest income. The notes in question bore no stated interest rate and were repayable on the sixth anniversary date of their issue at a 30% premium. The issuer had the right to redeem notes prior to the sixth anniversary date, however, in which case the "premium" on redemption would be calculated as 2.5% for each six months the note had been outstanding (5% per year, which equals 30% over six years). In a very real sense, the "premium" had an accrual feature and qualified as interest as summarized by the court (at p. 683):

If the premiums were intended to be an accretion of capital, one would suppose that it would remain the same whether the loan was repaid on [its sixth anniversary date] or at an earlier date. But, so far from that being the case, it was provided that, if the loan was repaid at an earlier date, it would carry interest at the rate of 5 per cent, per annum.

Given that standard discounts are payable only on maturity and are not pro-rated in the event of early redemption, this case is of limited value in determining whether standard discounts qualify as interest. If anything, the decision indicates that standard discounts may well not be interest.

The English House of Lords, in a 3-2 split decision, has taken the view that discount is not interest: Willingale v. International Commercial Bank Ltd., [1978] A.C. 834. The Court of Appeal judgement indicates that none of the discounts were on capital (as opposed to income) account ([1977] 2 All E.R. 618, at p. 622). None of the court judgements specify whether the discounts involved were original-issue or subsequent discounts. Ormrod, L.J., in the Court of Appeal, indicated (at p. 629) that evidence existed on which the Revenue Commissioners could have found that the taxpayer was lending money rather than buying bills. One can therefore infer that original-issue discount was involved. The bank usually (but not always) held its bills to maturity.

The taxpayer was a bank formed to provide medium-term financing by way of loans with a maximum term of 10 years. Part of the bank's business consisted of purchasing zero-coupon and interest-bearing bonds at a discount. For accounting purposes, the bank recognized the discount as income on a straight-line basis. For tax purposes, however, the bank argued that the discount could not be realized until actual realization on maturity or on sale prior to maturity.

The bank won its argument by convincing three out of five Law Lords that it was dealing in bills of exchange rather than lending money. Once this view of the matter was taken, the majority applied purchase-and-sale analysis to conclude that unrealized appreciation in the purchased bill of exchange could not be taxed prior to realization. In contrast, the two dissenting judgements rejected the purchase-and-sale analysis, casting the transaction instead as a loan of money. Based on a moneylending analysis, the two dissenting judgements concluded that the discount was interest.

The result in Willingale turns on whether the discounting transactions were moneylending transactions. Consequently, the statements regarding the nature of interest and discount are obiter. Nevertheless, Lords Salmon and Fraser specifically ruled that discount, unlike interest, does not accrue from day to day (at pages 841-H, 843-E and 845-B). These opinions seem to have been based on the consideration that the market value of a note would be affected by factors other than the "accrued" amount of the discount (i.e. a higher profit might be realized by selling the note prior to maturity if interest rates have decreased). The concern with "profit" is indicative of the majority view that the taxpayer was engaging in purchase-and-sale transactions rather than moneylending.

Willingale dealt with characterization of the discount from the recipient's viewpoint. Some commentators have suggested that characterization might be different if seen from the issuer's perspective. Nothing in the judgement indicates that this would be the case, however. Presumably, someone who is issuing a note to a purchaser would be selling a note rather than borrowing money. The only possible difference between the issuer and the holder is that the issuer is not concerned with fluctuations in the fair market value of the note over time, since the issuer will be bound to pay the same amount of discount at maturity no matter who holds the note. It is consequently easier to see an accrual of the obligation from the issuer's perspective. Nevertheless, it is possible to do the same from the holder's perspective by disregarding market value fluctuations due to interest rate changes and other factors (see Lord Russel's dissenting judgement); the majority in Willingale chose not to do this.

Torrens v The Commissioners of Inland Revenue (1933), 18 TC 262 (KB), typifies the ambiguity as to the legal nature of discount. The issue centered squarely on whether the discounted portion of a three-month note qualified as "interest payable on an advance" for purposes of applicable income tax legislation. The two-member court was equally divided on the issue: Best, L.J., viewed the discounting transaction as a purchase and sale (leading to the conclusion that the discount was not interest) whereas Megan, J., viewed the discounting transaction as a loan (leading to the conclusion that the discount was interest).

Best, L.J., described the underlying transaction as follows (at p.267):

The bank, instead of making an advance or allowing an overdraft in the ordinary way and charging interest from day to day on the amount of such overdraft, discounted the notes and dealt with them in the way described; and when a banker discounts a bill for a customer, giving him credit for the amount of the bill and debiting him with the discount, there is a complete purchase of the bill by the banker, in whom the whole property and interest in it vest, as much as in any chattels he possesses.

He summarizes his conclusion at page 268

Interest is the return given for the use of an advance, whilst discount is the deduction made from the amount of a bill of exchange or promissory note by one who gives value for it before it is due and if the Legislature had intended to deal with discount this Section they could easily have said so.

Other provisions of the English statute distinguished between discount and interest. The same argument would be made based on paragraphs 20(1)(f) of the Canadian statute, which provision refers to "discount" and "interest" as separate concepts.

Lord Justice Best specifically rejected cases and textbooks that described discount as prepaid interest, noting that the equation of discount with interest was made merely for convenience in calculating the discount (at p. 268).

In contrast, Mr. Justice Megan viewed the transaction as follows (at p. 269),

The substance of the transaction must not be overlooked. The notes were drawn payable to Messrs. C. & J. Black, endorsed by them and paid into the Appellant's account. By this means, the bank obtained the security of Messrs. Black, as well as of the Appellant, for the amount credited, and I do not think that the form of the notes really affects the reality of the transaction. In my opinion, as soon as the various notes were credited to the Appellant's account, they were, in fact, advances made by the bank and the difference in the amount credited and the face value of the note at maturity is "interest" so far, at any rate, as the Appellant is concerned. [---] Were it a case where ordinary bill brokers bought bills in which there was a speculative element, where the price paid for the bill depended on the credit of the parties, different consideration might arise - but, as I understand the present case, nothing other than ordinary bank interest was involved.

Since the court was evenly divided, the decision of the Commissioners that the discount was not interest-stood.

The Judicial Committee of the Privy Council also has concluded that discount is not interest: Chow Yoong Hong v. Choong Fah Rubber Manufactory, [1961] 3 All E.R. 1163. This case did not deal with income tax. P sold cheques issued by a third party to D at a discount in return for D's post-dated cheques. All D's cheques "bounced" and P sued. D defended on the basis that the contracts were unenforceable because P was not a licensed moneylender.

The Privy Council found that the discounting transaction was not moneylending. The statute in question defined "interest" as an amount payable in excess of the principal in consideration of a "loan". Since there was no loan, there could be no interest. On this view, discount would not meet the first of the requirements set out in the Saskatchewan Farm Security case.

The Privy Council also made the following general comments on the distinction between discount and interest (at p. 1167):

When payment is made before due date at a discount, the amount of the discount is no doubt often calculated by reference to the amount of interest which the payer calculates his money would have earned if he had deferred payment to the due date. But that does not mean that discount is the same as interest. Interest postulates the making of a loan and then it runs from day to day until repayment of the loan, its total depending on the length of the loan. Discount is a deduction from the price fixed once and for all at the time of payment. It appears to their Lordships to be very improbable that if the plaintiff was truly a moneylender and there were truly loans for which the post-dated cheques were only a form of security, he would have been content that the rate of discount which he considered remunerative should apply only until maturity of the cheques (never in any of the sixteen cases longer than a month) and thereafter, if the security proved valueless, to take until repayment only such rate of interest as the court awarded.

It is not without significance that the defendant in this case was trying to get out of a legitimate commercial deal by relying on a statute set up to protect persons with limited financial acumen. The finding that a discounting transaction was not moneylending afforded an easy way of getting around this misuse of the statute. As well, the plaintiff was discounting a bill of exchange rather than issuing its own bill of exchange; consequently, the decision did not involve original issue discount.

While the law is far from clear, the trend seems to be for courts to treat a discounting transaction as a sale of securities rather than a loan. While the sale is effected for a financing purpose, the legal rights between the parties are viewed as those of vendor and purchaser. Purchase and sale law is commonly accepted as applying to the discounting of accounts receivable for financing purposes and courts seem to apply the same analysis to discounting of original notes issued by an entity on its own credit.

XXXX

Taxation Treatment of related Financing Costs on Zero-Coupon Bonds

Our understanding of the facts concerning the financing costs on the zero-coupon bonds is as follows:

XXXX

Your memo advised in this regard that the hedging transactions are on income account and clearly form part of XXXX business operations. In a subsequent telephone conversation, you stated that it was an open question whether XXXX in fact carries on a business.

We would refer you to paragraph 14 of IT 346R:

14. The general principles relating to the determination of whether a foreign exchange gain or loss is on account of income or capital, as outlined in IT-95 , "Foreign Exchange Gains and Losses", also apply to gains or losses resulting from futures transactions in foreign currency where such transactions are part of a taxpayer's business operations.

XXXX does not carry on a business, such transactions would ordinarily be on capital account unless viewed as adventures in the nature of trade.

In our opinion, a F/X gain/loss on a forward exchange contract can only be determined at the time the forward exchange contract is settled, irrespective of whether the F/X gain/loss is on income or capital account. Pending the revision of IT-95R , if, in accordance with the comments in that bulletin, a taxpayer accrues a F/X gain/loss on a loan during its' term (i.e., the loan is on income account), he must also accrue the F/X gain/loss on the forward exchange contract.

A taxpayer will not have a F/X gain/loss on either a foreign currency debt or a forward exchange contract if:

(i) the foreign funds to be purchased under a forward exchange contract are irrevocably committed to payment of a specific debt; and

(ii) the foreign exchange contract can be considered to be an agreement relating to that specific debt.

In such a case, we consider that the net cost of the overall arrangement has been fixed in advance and is limited to the premium (the difference between the net Canadian dollar proceeds of the debt issue and the Canadian dollar cost of the forward exchange contract) on the forward exchange contract. The deductibility of the premium is governed by the provisions of paragraph 20(1)(f) of the Act, which limits the timing of the permissible deduction to the year in which the premium is actually paid (see IT-114 ).

Discount on Eurodollar Debt issue

We understand the facts respecting this issue as follows:

The Eurodollar debt obligations issued by XXXX carry a market rate of interest and, in addition, are issued at a discount. The discount falls within the description set out: in subparagraph 20(1)(f)(i) of the Act as it read during the 1979 to 1982 taxation years. All obligations were issued after June 18, 1971.

XXXX has amortized the discounts on a straight-line basis over the term of the obligation. You propose to disallow the straight-line amortization and instead allow XXXX to deduct the discount only at maturity.

We concur with your proposed treatment.

You advise that XXXX maintains the discount is deductible as a simple revenue expense under subsection 9(1). We assume that XXXX bases its argument on the Federal Court decision in Canada Permanent Mortgages Corporation v. M.N.R., [1971] C.T.C. 694. This case concerned a taxpayer who carried on a financing business. The taxpayer issued debentures to raise money for use in making loans and paid finder's fees in connection with the issuance of the debentures. For most taxpayers, a finder's fee would have been a capital outlay and therefore non-deductible as the Act read at that time. In the case of Canada Permanent, however, borrowed money constituted its stock-in-trade and deduction of the finder's fee was allowed on that basis.

The general principle enunciated in Canada Permanent is subject to express provisions to the contrary set out in the Act. Paragraph 18(1)(f) of the Act prohibits any deduction for an amount paid or payable as or on account of the principal amount of an obligation described in paragraph 20(1)(f) except as expressly permitted by paragraph 20(1)(f). This prohibition applies to all taxpayers whether the obligation constitutes a capital item or stock-in-trade. Consequently, the nature of any business being carried on by XXXX is irrelevant to the deductibility of a discount on obligations carrying a stipulated rate of interest. Paragraphs 18(1)(f) and 20(1)(f) apply to the discount unless the discount is in the nature of interest. If the discount is in the nature of interest, payment of the discount will not be on account of the principal amount of the obligation (see the definition of "principal amount" in subsection 248(1) of the Act) and the prohibition in paragraph 18(1)(f) would not apply.

Since the obligations in question already carry a commercial rate of interest, the discount is on capital account and cannot represent interest [see Lomax v. Peter Dixon & Son, Ltd. (1943), 25 T.C. 353 (C.A.)]. In any event, as discussed earlier XXXX does not carry on a financing business.

Selling Concessions on Eurodollar Bonds

This issue concerns whether certain selling concessions were additional discounts, non-deductible issue costs or deductible commissions. We understand the facts to be as follows:

XXXX

If the ceiling concessions in fact represent additional discounts, they would be deductible only pursuant to paragraph 20(1)(f).

The issue therefore narrows to whether the selling concessions represent a discount. If so, paragraphs 18(1)(f) and 20(1)(f) will apply.

You have indicated that you believe the selling concessions represent a discount because

a) the concessions were passed on to the ultimate lenders, and

b) the underwriters received separate commissions.

This is a factual question. Since you have not provided us with detailed facts, we are unable to offer significant guidance in this regard. We refer you to paragraph 5 of IT-341R , as amended by a Special Release dated August 2, 1984. To determine whether the concessions represent a discount, you will have to compare the commissions and selling concessions paid in this case with amounts paid to underwriters in similar debt issues.

PART XIII ISSUES

We understand the facts respecting withholding tax issues to be as follows:

XXXX

You have asked us to comment on the following issues:

a) assuming that withholding tax is exigible, is XXXX free from liability for withholding if payments are made by an agent?

b) does the debt lose eligibility for the 212(1)(b)(vii) exemption if the issue documents permit parties not dealing at arm's length with XXXX to purchase the debt?

c) is payment by XXXX of the discount on the debt obligations subject to withholding tax under paragraph 212(1)(b), assuming that no withholding tax exemption applies?

a) Liability to Withhold

The taxpayer argues that subsection 215(2) of the Act requires the paying agent to withhold Part XIII tax.

As far as this statement goes, it is correct. Nevertheless, the statement ignores the provisions of subsection 215(1) of the Act, which requires the payor to withhold Part XIII tax. Subsection 215(1) requires that the payor withhold an amount on account of Part XIII tax in the first instance. If the payor has not withheld, then subsection 215(2) requires that the paying agent withhold the requisite amount. Nevertheless, the payor is still responsible for its failure to withhold in the first instance. Liability is placed on both the payor and his agent; if neither withholds, both are subject to assessment and penalty.

b) Arm's Length Requirement

The exemption under 212(1)(b)(vii) is lost if the debt is acquired by a person not dealing at arm's length with the debtor. Nevertheless, the mere possibility that a non-arm's length party might acquire the debt in the future would not cause a current arm's length holder to lose the benefit of the exemption. The determining factor is the status of the debt holder at the time interest on the debt is paid or credited.

c) Whether Discount is Interest

As discussed previously, the better view appears to be that discount is not interest. This applies both for the zero-coupon Commercial Paper (which does not carry a stated rate of interest) and the Eurodollar Bonds (which do carry a stated rate of interest).

If discount is not interest, the discount paid on the zero-coupon paper nevertheless may be an amount paid "on account or in lieu of payment of, or in satisfaction of," interest.

An amount paid "in lieu of" interest is an amount paid "instead of" interest: Coleman E. Hall v. M.N.R., 70 DTC 6333, at p. 6335 (Exch). This definition, however, fails to address the breadth of the term "in lieu of". Does it include a financing charge that is paid instead of interest, or does it include only an amount paid to a taxpayer in place of interest that is already owing to the taxpayer?

In No. 593 v. M.N.R., 59 D.T.C. 104, Cecil L. Snyder of the Tax Appeal Board took a broad view of the phrase in question. The taxpayer had advanced two secured loans bearing interest of 4% and a $13,000 bonus on repayment at the end of six months. The Board found that the taxpayer had engaged in an adventure in the nature of trade so that the bonuses were taxable as income. As additional support for its conclusion, the Board noted at p.113 that the bonuses

. . . constituted, in fact, a receipt on account or in lieu or in satisfaction of the additional interest which the [taxpayer] might have received if had not elected to accept the substantial [bonuses]. . .

This obiter dictum has not been considered in any subsequent Canadian income tax case.

While it does not deal with the breadth of the phrase "in lieu of", the following comment from a United States tax case echoes the view taken of original issue discount in 593:

Earned original issue discount serves the same function as stated interest, concededly ordinary income and not a capital asset; it is simply "compensation for the use of [sic] forbearance of money". . . the earning of discount to maturity is predictable and measurable and is "essentially a substitute for . . . payments which [the Internal Revenue Code] expressly characterizes as gross income. The $6 earned on a one-year note for $106 issued for $100 is precisely like the $6 earned on a one-year loan of $100 at 6% stated interest. The application of general principles would indicate, therefore, that earned original issue discount, like stated interest, should be taxed under s. 22(a) as ordinary income.

See United States v Midland-Ross Corp., 65-1 U.S.T.C. 9387 (S.C.U.S.), at p. 95,393.

In The Queen v Immobiliare Canada Ltd., 77 D.T.C. 5332 (F.M.D.), a non-resident held debentures issued by one of its subsidiaries. Before the interest due date, the non-resident sold the debentures to a Canadian resident. The Minister argued that part of the consideration received by the non-resident was paid "in lieu of or in satisfaction of" interest. The Court rejected this argument on the basis that all interest that had accrued on the debenture remained outstanding after the sale (at p. 5335). Contrary to one's first impression, this conclusion does not lend support to the narrow interpretation. Since a commercial rate of interest was already payable on the debenture, the wider interpretation never arose as an issue. If the debenture had carried original-issue discount, the original issue discount also would arguably still have been outstanding after the purchase.

XXXX

The discount cannot be taxed under subsection 214(2). It is not reasonable to regard any part of the discount as a payment of interest, since no part of the discount qualifies as interest. In addition, the discount on the zero coupon bonds would be included in a Canadian recipient's income by subsection 12(9) and would consequently be excluded from inclusion under subsection 16(1) by the concluding words of subsection 16(1) for the 1981 and subsequent taxation years. While it may be reasonable to regard part of the discount as being some other payment of an income nature, that amount is not deemed to be interest by subsection 214(2).

Nevertheless, the discount nay be subject to withholding tax under either subsection 214(7) or (7.1) combined with subsection 214(14). This depends on whether the debt qualifies as an "excluded obligation" for the purpose of paragraph 214(8)(a). The definition of "excluded obligation" does not mirror the withholding tax exemption set out in subparagraph 212(1)(b)(vii). For example, the debt will not be an excluded obligation if it requires repayment in the circumstances described in clause 212(1)(b)(viii)(D). Nevertheless, it may be an excluded obligation even if held by a person not dealing at arm's length with the issuer.

If the debt is not an excluded obligation, the discount will be deemed to be interest at the time the debt is redeemed (214(7) and (14)). If the non-resident acquired the bond from a securities dealer and subsequently assigned the bond back to the same dealer, the same result would ensue under subsections 214(7.1) and (14). If no exemption were available, the deemed interest would be subject to withholding tax.

Director Financial Industries Division Rulings Directorate