Principal Issues: Whether issuance of a promissory note may be considered as a payment of accrued interest for the purposes of subparagraphs 74.5(1)(b)(ii) and (iii) and paragraphs 74.5(2)(b) and (c)?
Position: No.
Reasons: Textual, contextual and purposive interpretation of these provisions.
FINANCIAL STRATEGIES AND INSTRUMENTS ROUNDTABLE 5 OCTOBER 2018
2018 APFF CONFERENCE
Question 10
Annual payment of interest at the prescribed rate on a loan through the issuance of an unconditional demand promissory note
Subsection 74.5(1) of the Income Tax Act (footnote 1) provides that the attribution rules in subsections 74.1(1) and (2) as well as those in section 74.2 do not apply if certain conditions are satisfied. One of them provides, inter alia, that if the consideration received by the transferor included indebtedness, it must bear interest at the prescribed rate (of 2% in the second quarter of 2018). In addition, interest in respect of the indebtedness must be paid not later than 30 days after the end of the year.
Consider the following simple example: Mrs. B made a loan to her spouse of $500,000 at the prescribed rate of 2% on June 1, 2018. Her spouse used the borrowed funds to purchase stock market investments. As at December 31, 2018, accrued interest amounted to $5,863.01. At the beginning of January 2019, the spouse of Mrs. B will issue to the latter, as the payment of interest for the seven months of 2018, an unconditional demand promissory note as absolute payment of the accrued interest. The note issued representing the interest paid will be repaid by Mrs. B’s spouse when certain stock market investments have generated sufficient income or when certain investments have been sold.
In paragraph 15, Interpretation Bulletin IT-109R2 (footnote 2) stated that:
“For the purposes of section 78, an ordinary promissory note is regarded as a promise to pay a debt at a later date, and not as payment of the debt on the date on which the note was issued. This is so unless the agreement between the parties clearly indicates that the note was accepted as absolute payment.”
On the other hand, although an unfavorable Technical Interpretation was issued by the CRA (No. 9213685 (footnote 3)) with respect to the payment of interest through the issuance of a demand promissory note, it was however published before an important decision of the Federal Court of Appeal on this concept was rendered in 2003.
Indeed, in the Banner Pharmacaps NRO Ltd. v. Canada (footnote 4) decision, the Court indicated this to the question of whether a dividend had been paid by the issuance of a note:
[7] Second, we respectfully disagree with the conclusion of the Tax Court Judge that, as a matter of law, a dividend cannot be paid by delivery of a promissory note. The legal effect of delivery of a promissory note depends upon all the relevant facts, the most important fact being the intention of the maker of the note as determined by the evidence. For example, in some circumstances a promissory note may be evidence of a debt to be paid at some future time. In other circumstances, delivery of a promissory note may itself be payment of a particular obligation.
[8] In the context of this case, the most important evidence is the resolution declaring the dividend. That resolution must be presumed to express the intention of Banner Canada because there is no evidence to the contrary. It states in the clearest possible terms that a dividend in the amount of $5,647,775 was to be paid on the date of the resolution, and that the dividend was to be paid by means of delivery of a promissory note in that amount. As the promissory note was in fact delivered as the resolution required, it is impossible to conclude that the dividend was not paid when it was supposed to be paid, on February 15, 1996. It follows that Banner was required to include the amount of the dividend in its income for its 1996 taxation year. (Emphasis added)
Questions to the CRA
a) Does the CRA agree that the issuance in early January 2019 of an irrevocable unconditional demand promissory note in the amount of $5,863.01 payable upon request by Mr. B to his spouse Mrs. B for the full amount of accrued interest as at December 31, 2018 satisfies the requirements in subsection 74.5(1) that the interest on the loan be paid no later than 30 days after the end of the year?
b) Will there be any tax consequences associated with the fact that the $5,863.01 note bears no interest?
CRA Response to Question 10(a)
Where any of the attribution rules provided in subsections 74.1(1) and (2) and section 74.2 would otherwise apply as a consequence of the transfer of a property by an individual, subsection 74.5(1) provides an exception where certain conditions are satisfied. In particular, where the consideration received by the transferor included indebtedness, the indebtedness must bear interest at a specified rate, and the interest must be paid annually in accordance with the requirements of subparagraphs 74.5(1)(b)(ii) and (iii). As for subsection 74.5(2), it may apply in certain situations where the same attribution rules otherwise would as a consequence of a loan. Paragraphs 74.5(2)(b) and (c) provide requirements similar to those set out in subparagraphs 74.5(1)(b)(ii) and (iii). In the situation you described, since it was a loan that Mrs. B made to her spouse, it appears to us that subsection 74.5(2), and not subsection 74.5(1), would be relevant.
In Banner Pharmacaps, the Federal Court of Appeal indicated that a dividend can be paid by issuing a promissory note where the resolution declaring the dividend states in clear terms that the dividend must be paid by the issuance of a note. Read in context, the excerpt cited in the question illustrates that in the combined application of paragraph 12(1)(j) and section 82, the issuance of a note may in itself constitute the payment of a dividend if that is the intention of the corporation which declared the dividend.
The CRA is of the view that, irrespective of the intention of the parties, the issuance of a note may not constitute the payment of a particular obligation for certain purposes of the Income Tax Act since each provision must be the subject of a textual, contextual and purposive interpretation.
Paragraphs 74.5(2)(b) and (c), as with subparagraphs 74.5(1)(b)(ii) and (iii), are part of a set of rules intended, inter alia, to prevent a taxpayer and the taxpayer’s spouse from sharing income from property (including by means of loans bearing insufficient or no interest) to reduce the total amount of tax payable on that income. In that context, a textual, contextual and purposive interpretation of paragraphs 74.5(2)(b) and (c) and subparagraphs 74.5(1)(b)(ii) and (iii) favours a more restrictive interpretation of the word "paid", according to which the issuance of a note, although irrevocable, unrestricted and payable on demand, does not satisfy the requirement provided for in those paragraphs and subparagraphs.
It follows that, in the situation described, the exception provided for in subsection 74.5(2) could not apply.
CRA Response to Question 10(b)
Our comments are the same whether or not the $5,863.01 note bears interest.
Mélanie Beaulieu
(613) 670-8905
5 October 2018
2018-076155
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 R.S.C., 1985, c. 1 (5th Supp.) (“ITA”)
2 CANADA REVENUE AGENCY, Interpretation Bulletin IT-109R2 (archived), “Unpaid Amounts”, 23 April 1993.
3 CANADA REVENUE AGENCY, Technical Interpretation 9213685, 15 June 1992.
4 2003 FCA 367 (“Banner Pharmacaps”).