Words and Phrases - "interest"
Mr. X implemented an estate freeze in favour of his children and a holding corporation respecting his wholly-owned operating corporation, which he continued to control. During the the reorganization, stock options to purchase common shares for $1 were issued to a key employee, who was not related to Mr. X, being the controlling shareholder of the holding corporation, which is the dividend recipient for the purposes of ss. 55(3) and (3.01). Shares received during the estate freeze were transferred to the holding corporation and subsequently redeemed, with the resulting deemed dividend not fully covered by safe income on hand.
Is the granting or the exercise such stock options a triggering event under s. 55(3)(a) causing s. 55(2) to apply? After noting that ss. 55(3)(a)(i), (iii) and (iv) would not apply to the granting of the option, as s. 49(1)(b) deemed such grant not to be a disposition, CRA then addressed ss. 55(3)(a)(ii) and (v), and stated, respecting the option grant:
[H]aving an interest in a corporation has a broad meaning and is not limited to the holding of shares in that corporation. Instead it references the holding of an economic interest in the corporation. …
A stock option often has conditions that make the exercise of the option uncertain and contingent. Subject to the application of subsection 245(2), there would generally be no significant increase in the interest in a corporation at the time of such an option, the exercise of which is contingent in fact and in law.
However … an increase in an interest in the corporation occurs when the stock option is granted rather than when the option is exercised … in a situation such as that described, where a key employee, instead of an immediate receipt of shares in the corporation, receives a stock option with characteristics and price such that there is no real uncertainty or contingency as to the exercise of the stock option.
Respecting the option exercise, and after noting that, as the exercise would not constitute a disposition, ss. 55(3)(a)(i), (iii) and (iv) would not apply, it stated:
Where the CRA concludes that there is no increase in an interest in a corporation at the time of the granting of a stock option the exercise of which is contingent in fact and in law, there will be an increase in interest when the option is exercised.
… In this situation, if the exercise of the stock option occurred as part of the same series of transactions or events in which the dividend resulting from the redemption of the freeze shares was received and if the increase in interest in the corporation was a significant increase, subsection 55(2) would apply to the deemed dividend received upon the redemption of the freeze shares.
… In a situation, such as the one you describe, where a corporation grants a stock option to a key employee at the time of an estate freeze, it appears to us that there would be arguments for concluding that the granting and the exercise of the option were part of the same series of transactions or events in which the dividend from the redemption of the freeze shares was received.
12 December 2018 Interpretation Letter of the CRA Charities Directorate to Simon Cheung File GC 341217
The Charities Directorate stated the following respecting a proposal to eliminate a foundation's positive divestment obligation percentage arising from having exceeded the 20% limitation (giving rise to an excess corporate holding percentage):
We understand that the foundation, a registered charity, has been bequeathed with shares of a private corporation (the corporation), and the foundation now plans to dispose of these shares to the corporation, in exchange for a promissory note lo pay for the shares by the corporation. We also understand that the plan is being considered in connection with the foundation's divestment obligation for excess corporate holdings.
You ask whether the "Interest*' that will be held by foundation in the corporation, as a result of the above plan, falls within the “direct or indirect interest in a corporation, other than shares” referred to in subsection 188.1(3.2). You also ask whether the said interest is limited to some form of participating equity interest in the corporation, such as stock options or other rights to acquire shares.
We find no specific or comprehensive definition of the above "interest" in the Act. As such, we take the said term to include (in a broad, general sense) any right to have the advantage accruing from anything, and any right in the nature of property (such as a right of a creditor for repayment from the debtor's assets, as in the foundation's case), and not limited to stock options or other rights to acquire shares (and those that come with owning the shares).
As part of a complex set of transactions, a predecessor of the taxpayer agreed to assume a $225M loan that was due in perhaps 43-years’ time and that was non-interest-bearing (except in the remote event of oil production from the Beaufort Sea) in consideration inter alia for the payment to it of $17.5 million by the debtor. The predecessor treated the $207.5M difference between these two amounts as an amount which, although conceded not to be interest in form, was interest in substance and therefore could be treated as being recharacterized as interest under s. 16(1): the economic substance of the situation was that it received $17.5 million as the present value of $225 million.
Nadon JA confirmed the rejection by Hogan J of this argument given that it was clear that the $207.5M difference could not be reasonably regarded as interest to the creditor, stating (para. 90):
[I]nterest is an amount paid by one person to another as the cost of using the other person’s money. Hence, symmetry is the essence of interest and consequently there cannot be interest if no amount is paid or payable by one person to another. Thus it is because interest is, by its nature, symmetrical that the Judge was correct in interpreting subsection 16(1) in the way that he did. In other words, an amount is not interest if it does not have the character of interest to both the recipient and the payor.
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|Tax Topics - Income Tax Act - Section 16 - Subsection 16(1)||s. 16(1) can only apply to a debtor if it equally applies to the creditor||384|
Solar Power Network Inc. v. ClearFlow Energy Finance Corp., 2018 ONCA 727
A typical loan made by the lender (ClearFlow) to the borrower bore base interest rate of 12% p.a. compounded monthly, an administration fee that was charged when the Loan was initially advanced, and each time it renewed (of, say, 1.81% of the loan balance), and a “discount fee” of 0.003% per day of the outstanding principal. Sharpe JA confirmed the finding of the application judge that the administration fee was not interest, as well as his finding that the discount fee was interest, stating (at paras. 42-43):
[T]he amount of the fee did not vary according to the administrative work required by the loan as in the case of the administrative fee, and the fee was charged at a daily fixed rate unrelated to any ongoing or specific events… [It] bore all the hallmarks of the test for interest: it was consideration or compensation for the use of money, it related to the principal amount, and it accrued over time.
He went on to find that the disclosure of the “rate” of such interest through the provision of a simple formula complied with s. 4 of the Interest Act. For this and other reasons the borrower was unsuccessful in its arguments that the total interest under the loan was subject to a 5% cap imposed under s. 4.
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|Tax Topics - Income Tax Act - Section 20 - Subsection 20(1) - Paragraph 20(1)(c)||daily discount fee had the 3 attributes of interest||359|
Solar Power Network Inc. v. ClearFlow Energy Finance Corp., 2018 ONSC 7286, rev'd 2018 ONCA 727
The typical loan agreement for a loan (a “Loan”) by the respondent (“ClearFlow”) to the applicant (“SPN”) provided for a base interest rate of 12% p.a. compounded and calculated monthly, an administration fee (the “Administration Fee”) that was charged when the Loan was initially advanced, and if it was not paid off, again each time it renewed (either 1.81% or 3.55% of the balance, depending on the terms of the specific Loan Documents), and a “discount fee” of 0.003% of the outstanding principal of the Loan which was calculated on a daily basis for every day that the Loan was outstanding (the “Discount Fee”). After having defaulted, SPN submitted that the Administrative Fee and the Discount Fee were in fact interest charges and, since these fees were not annualized, they violated s. 4 of the Interest Act.
In finding that the Administration Fee was not interest, McEwen J stated (at paras 35 36 and 39):
…[T]he higher rates [higher Administration Fee charged for Promissory Notes (3.55%) as opposed to under the Loan Agreement (1.81%)] were directly linked to the greater amount of administrative work that was required for the riskier Loans.
… [T]he Administration Fee was charged on a one-time only basis and would only be charged if a Loan was not repaid within the specific time frame. It therefore did not necessarily accrue over time, since there would be no accrual if the Loan was repaid in the designated time frame.
… I find that the Administration Fee was compensation for the considerable costs incurred to negotiate, conduct due diligence, set-up, and administer the Loans, and was not simply compensation for ClearFlow not having the use of the money.
However, after stating (at para. 22) that he accepted the conclusion in Sherway Centre that “an amount paid as compensation for the use of money for a stipulated period can be said to accrue day-to-day,” McEwen J found that the Discount Fee constituted interest, stating (at para. 45):
… [I]t is my view … the Discount Fee meets the three … elements of interest: it is consideration or compensation for the use or retention of money owed to ClearFlow; it related to the principal amount; and, it accrued over time (literally day-to-day). ClearFlow viewed the Discount Fee as providing an incentive for SPN to pay down the Loans as quickly as possible. Unlike the Administration Fee, the Discount Fee meets all of the criteria of interest without any reasonable commercial explanation to the contrary.
On this basis, the Loan Documents did not comply with s. 4 (so that all interest was capped at 5% p.a.). First, the Discount Fee was not expressed as an annual interest rate. A clause that effectively provided a verbal formula indicating that the stipulated rate was to be multiplied by 365 (or 366, as applicable) did not suffice. In this regard, he stated (at para. 53):
Formulas can be confusing and even misleading. … The requirement of an express statement does away with this type of dispute and uncertainty, particularly where in this case there are multiple loans, which may roll-over.
Second, the formula was defective in that it excluded the effect of compounding.
Joint Committee, "Small Business Deduction Rules under Section 125 of the Income Tax Act - Follow-Up to Our Meeting with Canada Revenue Agency", 2 June 2017 Joint Committee Submission to Finance respecting the Small Business Deduction, appending Submission to Randy Hewlett of the Income Tax Rulings Directorate dated 14 February 2017
Issues with cooperatives (p. 2)
Every farming or fishing Canadian-controlled private corporation (“CCPC”) selling substantially all of its products to a co-operative in which it holds an interest will be ineligible for the small business deduction (“SBD”), and a similar issue arises if they pool resources to form a processing company. (The subsequent letter to Finance acknowledged May 2017 draft legislation on farming and fishing co-operatives and stated that “co-operatives operate in sectors beyond farming and fishing.”)
Unclear meaning of “direct or indirect interest” (pp. 7, 2 and 5)
It is unclear whether “income” means “net income,” and the meanings of “direct or indirect” and “interest” also are unclear.
A small business that banks at a local credit union could lose the SBD on services-contract income (e.g., IT services) earned from the credit union.
Mr. Smith has units in the iShares Dow Jones Fund, which holds Ford Motors which, in turn, holds Ford Canada. This may indicate that an auto parts manufacturer of which he is a shareholder loses the SBD on its income from Ford Canada.
Inadequacy of 10% cap/”any” related shareholder test (p. 3)
In rural areas with fewer customers to draw on, non-arm’s length customers could account for more than 10% of a CCPC’s active business income. For example, a shareholder of a major contractor might be related to a shareholder of a local building supply store, thereby denying SBC access to the latter.
A small contractor could lose SBD access on income from a significant contract with a large private corporation having a very small employee-shareholder who was related.
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|Tax Topics - Income Tax Act - Section 125 - Subsection 125(7) - Specified partnership income - Paragraph (c)||46|
R. v. Melford Developments Inc., 82 DTC 6281,  CTC 330,  2 S.C.R. 504
In the absence of this provision, "interest" in Part XIII would refer primarily to "the payment of rent by a borrower for the use of the principal of the lender to whom the rent is paid". However, in the absence of the overriding effect of any Convention, the effect of s. 214(15) is to convert guarantee fees into "interest" for the purpose of the withholding tax provisions of that Part.
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|Tax Topics - Treaties||57|
|Tax Topics - Treaties - Income Tax Conventions - Article 11||guarantee fees were not interest||80|
Morscher v. MNR, 92 DTC 2214 (TCC)
The taxpayer, who carried on a commercial litigation practice in partnership with another lawyer, was denied the deduction of interest which Revenue Canada alleged related to partnership drawings in excess of the profit reported in the computation of income for purposes of the Act. The taxpayer was successful in characterizing the alleged excess borrowings as relating to the financing of work in progress of the partnership.
In obiter dicta, Brulé J. defined the word "interest".
Bennett and White v. The King, 49 DTC 514,  CTC 1,  S.C.R. 287
In finding that annual amounts described in various resolutions of the taxpayer as "interest" in fact were guarantee payments, Locke J. stated (p. 515):
"Interest is paid by a borrower to a lender: a sum paid to a third person as the consideration for guaranteeing a loan cannot be so described."
Pike v. Revenue and Customs Commissioners,  BTC 33,  EWCA Civ 824
The taxpayer subscribed for loan stock of a family company at a price equal to its principal amount. Although the loan stock did not bear any amounts described as interest, a premium was payable on any redemption or repayment thereof "equal to 7.25% per annum of the Principal Amount to be repaid or redeemed, accruing on a daily basis." A few days later, he transferred the loan stock to a family trust. His (denied) claim for a loss on this transfer (arising from discounting the principal and premium payable on maturity using a 12.25% discount rate) turned on concluding that no amount on maturity would be "payable…by way of interest" (per s. 3(6) of Sched. 13 to the Finance Act 1996.)
Before concluding (at para. 19) that "the true nature of the payment was that it was interest," Rimer LJ quoted (at para. 18) with approval a statement of the Upper Tribunal that "interest" has "certain characteristics:"
First, it is calculated by reference to an underlying debt. Second, it is a payment made according to time, by way of compensation for the use of money. Third, the sum payable accrues from day to day or at other periodic intervals. Fourth, whilst the payment so accrues, it does not, in order for it to be interest, have to be paid at any intervals: it is possible for interest not to become payable until the principal becomes payable (see Willingale). Fifth, what the payment is called is not determinative; the question must always be one as to its true nature. Sixth, the fact that an interest payment may be aggregated with a payment of a different nature does not 'denature' the interest payment (Chevron Petroleum UK Ltd v. BP Petroleum Ltd  STC 689, at 694, per Megarry V-C).