9 September 1986 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.

September 9, 1986

Memo to File (#280-235)

W.H. Cooper Leasing and Financing Section Financial Industries Division Rulings Directorate

RE: PARTICIPATING DEBT

I. BACKGROUND

In the 1970s and early 1980s inflation soared above historical levels into double digits [Sullivan, Creative Real Estate Financing, 83 CMC 196-257]. This dramatic and swift turn of events caught borrowers and lenders, alike, unprepared. Where, before, lenders typically provided borrowers with up to 100% long-term fixed-rate mortgage financing on real estate projects, short-term variable-rate mortgages with "equity kickers" became the norm. So too in the high-flying world of corporate takeover financings, fixed-term loans jumped to double digit interest rates and borrowers soon found themselves unable to support their crushing debt loads relying on conventional financing methods.

All of these events were occurring at roughly the same time as the Income Tax Act (the "Act") was being amended to change the definition of "income bond" or "income debenture" in subsection 248(1) of the Act. Prior to November 17, 1978, the statutory scheme facilitated the use of income debentures by loss companies and other non-taxable corporations as an after-tax financing vehicle. Under the old definition, brought forward intact from the 1952 Act, the deduction of participation payments, arguably in substance distributions of profits, was denied by virtue of the definition in subsection 248(1) of the Act of an "income debenture" which referred to "a bond or debenture in respect of which interest or dividends are payable only when the debtor company has made a profit before taking into account the interest or dividend obligation". Paragraph 18(1)(g) of the Act and its predecessor ensured no deduction was available for such payments while subsection 15(3) of the Act deemed such payments to have been paid by a corporation resident in Canada to a taxpayer as dividends.

With the introduction in 1978 of the financial difficulty restriction of the "income debenture" definition the way was, once again, open for issuers to pay compensation for the use of borrowed money based on the issuer's profitability or other similar measure of ability to pay. With this change in law no doubt in mind and to protect themselves against the effects of inflation or, in cases of financial difficulty, to provide breathing room to borrowers heavily burdened with debt, lenders offered financing with so-called "interest" rates that wholly or in part varied with some indicator sensitive to inflation. In the case of real estate project financings, these instruments are referred to as income participation mortgages. In the case of financial difficulty capital reorganizations, the financing instruments are referred to as income debentures. In either type of financing, the compensation for the use of borrowed funds was computed by reference to revenue, profit, cash flow or some other similar criterion. In general terms, such debt instruments are referred to as "participating debt".

Participating debt is a term which may also be used to describe another type of "financing" arrangement which primarily arose out of lenders' concerns related to real estate project financing. To further combat or reduce the effects of inflation and, perhaps, with a view to sharing in the benefits of inflation enjoyed by the owners of such highly leveraged projects, lenders also began to take equity interests in such projects as part of their financing arrangements. Such equity interests included shared appreciation mortgages, convertible mortgages, equity joint ventures and equity options [Sullivan, supra., at p.197]. These equity features more clearly raised the basic legal question underlying all participating debt instruments: are they debt or equity?

Although there is no clear legal dividing line between debt and equity, it has been said that the essential difference between debt and equity is the fact that with debt, the lender's return is not dependant on the profitability of the borrower, whereas with equity just the opposite is true. Of course, under this definition participating debt qualifies as equity.

As stated in Gower's Principles of Modern Company Law [at p. 397], in its discussion of securities which a corporation may issue:

They fall into two primary classes which legal theory tries to keep rigidly separated but which in economic reality merge into each other. The first of these classes is described as shares; the second as debentures. The basic legal distinction between them is that a share constitutes the holder a member of the company, whereas the debentureholder is a creditor of the company but not a member of it.

Indeed, there is little relevant case law which deals with this distinction between debt and equity. The following factors provide "evidence of what is considered to be the crux of a true debt: the lender intended that the investment be repaid in full by a date certain":

(1) the loan is secured by property with a value in excess of the loan principal; (2) there is a fixed maturity date such that the loan is repayable at all events and in the not too distant future; (3) the loan is not subordinated to other liabilities of the business; (4) the return on the loan is fixed and does not depend upon profits from the enterprise; and (5) the borrower is not thinly capitalized. [Jack M. Feder, 'Either a Partner or Lender Be': Emerging Tax Issues in Real Estate Finance 36 Tax Lawyer 191-22].

II. CURRENT TAX TREATMENT

Generally, unless the issuer of participating debt is in the business of lending money, compensatory payments pursuant to a participating debt (which is not considered to be an "income debenture") are payments on account of capital within paragraph 18(1)(b) of the Act [Canada Safeway Ltd. v. M.N.R. [1957] CTC 335 (S.C.C.), at p.344]. In support of a deduction for such payments, issuers usually cite paragraphs 20(1)(c) and 20(1)(e) of the Act. While it is arguable that paragraph 20(1)(f) might also be relevant in light of the definition of "principal amount" in subsection 248(1) of the Act, no participating transaction is likely to proceed on the basis of a one-half deduction for tax purposes only after the participating payments exceed the amount advanced under the loan. Moreover, within the scheme of the Act, it is clear that paragraph 20(1)(f) was intended to deal with discounts, not participation payments.

Paragraph 20(1)(c)

In order to obtain a deduction for participating payments under paragraph 20(1)(c) of the Act, the issuer must demonstrate that the participating debt is "borrowed money" and that the annual payments constitute "interest".

Where the debt instrument is in all other regards similar to conventional debt obligations, the funds advanced will constitute "borrowed money". However, if the participation payments represent a distribution of profits proportionate to the amount of the project being financed, and the lender has an option to acquire that proportionate interest in the project at today's prices upon maturity of the so-called debt, the Department will question whether the arrangement is debt or equity.

With respect to the question as to whether the participating payments are "interest", the Department has accepted the following definition of "interest" found in the decision of Miller v. The Queen 85 DTC 5354 (F.C.T.D.), a condensation of earlier Supreme Court of Canada decisions advanced by the Minister of National Revenue in that case [see also comments of Gibson, J. in Yonge-Eglinton Building Building Ltd. v. M.N.R. 72 DTC 6456, at p.6458]:

1. interest accrues on a day-to-day basis [A.G. Ontario v. Barfried Enterprises Ltd. [1963] S.C.R. 570 at p.575];

2. interest is the return or consideration or compensation for the use or retention by one person of a sum of money belonging to another [Reference re Validity of Section 6 of the Farm Security Act, 1944, of the Province of Saskatchewan (1947] S.C.R. 394 at pp.411-412]; and

3. interest is referable to a principal sum in money or an obligation to pay money [Reference re Farm Security Act, supra., at pp.411-412; see D.S. #6022-9(b)].

In addition to the above noted requirements, it is the Department's view [per D.S. #6022-9(b)] that an amount of "interest" determined by reference to cash flow, revenue, profit or other similar criteria will only be considered to be referable to a principal sum in money or an obligation to pay money if the maximum rate of interest that can be paid under the obligation has been determined in advance and that maximum "cap rate" of interest is reasonable in the circumstances [Re Balaji Apartments and Manufacturers Life Insurance Co. (1979) 100 D.L.R. (3d) 695 (O.H.C.) and paragraph 20(1)(c); see comments of Lindsay, Tax Aspects of Real Estate Financing, 83 CMC 258, at pp.270 and 278]. Thus, even if the participating debt represents "borrowed money", the annual participation payments may not be "interest" for the purposes of paragraph 20(1)(c) of the Act.

This further requirement that the maximum interest rate payable on a participating debt be reasonable is based on the "reasonable amount" test in paragraph 20(1)(c) of the Act. In general terms, it is the Department's view that interest rates determined under participating debt arrangements agreed to by arm's length parties will be reasonable provided there are no other equity features forming part of or associated with the debt arrangements. While a cap rate of interest as high as 35% has been accepted in 1981 by the Department on a participating debenture issued to raise funds for a gas well drilling program, it is the Department's view that a participating interest rate which materially exceeds the equivalent conventional lending rate, where there is similar security and risk, is indicative of an underlying equity relationship. Although the Department may not attack the relationship, itself, in such circumstances, the Department would look for other participation features, such as an option on the mortgaged property, as well as attempting to challenge the reasonableness and "interest" nature of the payment [see A.W. Walker & Co. Ltd. v. I.R.C. [1920] 3 K.B. 648].

In more recent rulings, cap interest rates based on an effective overall yield to maturity of 13.5% per annum and a flat 12% per annum were accepted at the outset of the financings as reasonable limits. In the first ruling, there was no fixed interest rate. The participating interest rate was based on 50% of the cash flow from an existing shopping mall and the funds borrowed represented approximately one-half of the owner/borrower's equity interest in the mall prior to the advancement of funds. In this case the interest rate in a given year could be any rate determined by formula provided the effective yield to date did not exceed 13.5% [D.S. #6022-9(b)]. The second transaction arose out of the refinancing of a borrower in financial difficulty. In that case, a fixed interest rate of 6.5% was augmented by 1% for each $10 million of net income; not to exceed 12% in any one year [D.S. #6032-6]. An important feature in this ruling was the fact that the participating notes were merely replacing 13% fixed rates which were in default. To date, to our knowledge no rulings have been given under paragraph 20(1)(c) of the Act on a new real estate project financing.

Such participating interest payments have the added advantage of avoiding the complications of a fixed rate debt obligation which provides for the deferral of some portion or all of the interest obligation where there is insufficient profit or cash flow to honour the obligation in the current year. Such contingent amounts of interest would be considered to arise in respect of the current year but will only be payable in the subsequent year [Mid-West Abrasives Co. of Canada Ltd. v. The Queen 73 DTC 5429 (F.C.T.D.)], although no such deduction would be permitted in either year.

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Paragraph 20(1)(e)

In general terms, it is the Department's view that paragraph 20(1)(e) of the Act does not provide a deduction for compensation paid for the use of borrowed money regardless of form [see J.R. Robertson, Tax Aspects of Real Estate Transactions: A Perspective from Revenue Canada, 83 CMC 416].

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... a borrower may be required as a condition of a loan agreement to pay to the lender for a certain number of years a portion of the revenue from the property acquired with the borrowed money. Such payments would be a deductible expense to the borrower under paragraph 20(1)(e) of the Act in the year in which they become payable.

This statement is ostensibly based on the Yonge-Eglinton case. However, it should be noted that in the judgement of Thurlow, J., it was recognized that the commitment fees in issue were "not in any sense a payment for the use of the money to be borrowed ... " [at p.6184]

CURRENT POSITION AND OUTSTANDING ISSUES

To date, to our knowledge, there have been no favourable rulings granted by the Department in respect of participation payments under paragraph 20(1)(e) of the Act. However, if a borrower were able to successfully argue that such payments are deductible under paragraph 20(1)(e) of the Act and the lender was a non-resident, there would likely be no tax exigible on this payment out of or distributed from profits under Part I or Part XIII of the Act. This problem was recognized by the Department as early as 1982 [see letter of R.M. Beith, Corporate Rulings Directorate to Current Amendments dated June 16, 1982].

Where a prospective resident purchaser of a property is tax exempt or otherwise not taxable it may be desirable for that resident purchaser to "acquire" the property by making a loan to the vendor equal to the portion of the equity being bought. In order to distribute the purchaser's share of the profits, a participation payment based on a proportionate share of the property's profits or cash flow would be payable as compensation for the use of the "borrowed money". This type of arrangement, by its very nature, will include the granting of an option or some other rights of ownership to the property equivalent to the equity interest being acquired; exercisable at today's price upon maturity of the so-called loan. Such an arrangement facilitates a transfer of capital cost allowance (otherwise unusable by the purchaser) from a non-taxable purchaser to the "borrower" during the term of the "loan" provided the "borrower" is able to maintain a deduction for the participation payments under paragraphs 20(1)(c) or 20(1)(e) of the Act. Additional tax advantages may accrue to an international insurance company as the potential gain on the property acquired by such a lender may not be subject to any tax (by virtue of special rules in the Act applicable to insurers).

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CONCLUSION

Regular payments of a compensatory nature payable pursuant to a participating debt will only be deductible under paragraph 20(1)(c) of the Act. Such a deduction will be available if those payments are legally considered interest, are reasonable and do not represent compensation for an equity interest held by the "lender" in the "borrower's" property. In order to qualify as "interest" the participation payments must:

1. accrue on a day-to-day basis (revenue, profit and cash flow do not, themselves, so accrue);

2. be referable to a principal sum in money or an obligation to pay money provided that such interest payments must be limited or capped at a reasonable interest rate to ensure a direct relationship to the principal in all cases; and

3. be compensation for the use by one person of a sum of money belonging to another.

It is thought that these requirements will permit the deduction of compensation for an outstanding indebtedness based on some measure of the borrower's ability to pay, such as profit, revenue or cash flow, provided the arrangement does not legally give the lender an equity interest in any of the borrower's assets.