Principal Issues: 1) Could the taxpayer deduct interest on a participating loan in connection with the issuance of debentures? 2) Did the provisions of subsection 18(9.1) of the Act apply to the payment of additional interest in connection with the redemption of the debentures?
Position: 1) Yes, if the conditions of the position set out in Income Tax Technical News No. 16 and reiterated in 2002 at the APFF Congress are met; 2) No.
Reasons: 1) Text of the Act, The Queen v. Sherway Centre Ltd, 98 DTC 6121 and Agency positions; 2) Subsection 18(9.1) of the Act: since payment is calculated on the basis of revenues, profits, cash flow, market price or a similar criterion.
March 10, 2003
Rimouski Tax Services Office Headquarters
Financial Industries Division
Michelle Desrosiers
Notary, M.Fisc.
Attention Mr. Jean-Luc Proulx
2002-017218Deductibility of additional interest paid on redemption of debentures
This is further to your letters of November 4 and 29, 2002, in which you asked for our opinion on the tax treatment to be applied to the payment of additional interest on the redemption of debentures issued by the taxpayer.
The facts as we understand them are as follows:
1. XXXXXXXXXX (the “Corporation") is a taxable Canadian corporation.
2. In XXXXXXXXXX, it approached financial institutions offering traditional financing to obtain a loan for its commercial activities. At that time, its financial situation was precarious.
3. Following unsuccessful approaches to those financial institutions, the Corporation was forced to accept the financing offered by XXXXXXXXXX ("the Creditor"), without which it would have been necessary for it to terminate its operations.
4. The financing extended over XXXXXXXXXX years, i.e., the Creditor subscribed for three subordinated participating debentures with terms of XXXXXXXXXX months.
5. The first debenture issued in XXXXXXXXXX ("Debenture 1") had the following terms:
- Issued for a total amount of $XXXXXXXXXX, consisting of an original debenture of $XXXXXXXXXX and, if applicable, additional debentures for an amount not exceeding $XXXXXXXXXX, in respect of interest payable during the period from the issue date to the end of the Corporation's XXXXXXXXXX financial year.
- Base interest was capped at XXXXXXXXXX% of the face value of the debentures and was equal to the greater of:
i) interest equal to the base rate plus XXXXXXXXXX% computed daily on the value of the debentures issued and compounded monthly; and
ii) XXXXXXXXXX% of net income, after taking into account the interest computed in accordance with item i) above.
- Base interest could be paid by issuing additional debentures. These would have the same attributes as the original debenture.
- All debentures matured XXXXXXXXXX years after the signing of the subscription agreement. However, they were redeemable prior to maturity on a simple notice from the Corporation.
- At maturity or upon redemption, the Corporation was required to repay the principal and any unpaid interest plus additional interest equal to the greater of $XXXXXXXXXX, or XXXXXXXXXX% of the fair market value of its equity less the base interest and the debenture amount of $XXXXXXXXXX. "Equity" meant the Class A shareholders' equity, the issued and paid-up share capital of the Class B, C, D and E shares, the issued subordinated debentures and deferred subsidies.
6. In XXXXXXXXXX, the Corporation issued a $XXXXXXXXXX debenture ("Debenture 2") in payment of interest due on Debenture 1. This second debenture complied with the terms of the Debenture 1 subscription agreement.
7. In XXXXXXXXXX, the two parties entered into another debenture subscription agreement ("Debenture 3"). That agreement provided for a subscription amount of $XXXXXXXXXX and essentially reproduced the terms described in item 5 above, except for the base interest, which was capped at XXXXXXXXXX% of the face amount of the issued debenture and corresponded to the higher of the base rate plus XXXXXXXXXX%, and XXXXXXXXXX% of net income after taking into account the interest already computed, a term of XXXXXXXXXX years and additional interest computed on the greater of XXXXXXXXXX% of the fair market value of the equity minus the base interest and the amount of the debenture, and $XXXXXXXXXX.
8. Having regard to the interest payable on the debentures proving to be too costly and to it now being possible for the Corporation to obtain financing from financial institutions offering loans at a lower cost, the Corporation asked the Creditor in XXXXXXXXXX to redeem its debentures. An agreement was reached between the parties effective XXXXXXXXXX. Under that agreement, the redemption price was payable in cash on the closing date for the redemption of the debentures. Payment was made on XXXXXXXXXX.
9. In this regard, the Corporation obtained a loan of $XXXXXXXXXX from the XXXXXXXXXX and a loan of $XXXXXXXXXX from the XXXXXXXXXX. Those loans were used to redeem the debentures issued to the Creditor. These sums were received by the Corporation on XXXXXXXXXX.
10. The agreement between the Corporation and the Creditor to redeem the debentures provided for a redemption price of $XXXXXXXXXX, plus interest computed from XXXXXXXXXX to the closing date at the bank’s preferred rate plus XXXXXXXXXX%. The amount of $XXXXXXXXXX was broken down as follows:
Debenture principal:
Debenture 1: $XXXXXXXXXX
Debenture 2: $XXXXXXXXXX
Debenture 3: $XXXXXXXXXX
Accrued and unpaid interest
at XXXXXXXXXX
at base rate plus XXXXXXXXXX%:
Debentures 1 and 2: $XXXXXXXXXX
Debenture 3: $XXXXXXXXXX
Additional interest: $XXXXXXXXXX
11. An amount of $XXXXXXXXXX was paid in XXXXXXXXXX and prior to the redemption of the debentures by the Corporation as interest on Debentures 1 and 3. Consequently, an amount of $XXXXXXXXXX was deducted in computing the Corporation's income pursuant to paragraph 20(1)(c) of the Income Tax Act (the "Act").
12. According to a representative of the Creditor, an interest rate of XXXXXXXXXX% to XXXXXXXXXX% on this type of debenture was reasonable, given the Corporation's financial situation. In the representative’s opinion, this rate would represent the market rate for the Corporation.
13. The Corporation also deducted in computing its income the amount of $XXXXXXXXXX in accordance with the provisions of subsection 18(9.1).
14. There was no prepayment penalty specified in the loan agreements.
Your Position
You consider the interest expense of $XXXXXXXXXX claimed by the Corporation to be reasonable and you allowed it as a deductible expense pursuant to paragraph 20(1)(c).
You consider that the provisions of subsection 18(9.1) do not apply to qualify the amount of $XXXXXXXXXX as interest on the basis that the loan was novated.
The Corporation's Position
It is not the provisions of subsection 18(9.1) that should apply to the current situation, as its counsel argued, but rather the provisions of paragraph 20(1)(c), given the wording of the Act and the decision in The Queen v. Sherway Centre Ltd. 98 DTC 6121. Alternatively, given the comments made by MacDonald JA in Sherway Centre Ltd. and, in passing, by Thurlow JA in MNR v. Yonge-Eglinton Building Ltd. 74 DTC 6180, if the provisions of paragraph 20(1)(c) are not applicable, then those of paragraph 20(1)(e) are. In addition, pursuant to subparagraph 20(1)(e)(v) then applicable, the total expenditure should be deducted in the year of payment and not amortized over XXXXXXXXXX years.
Your Questions
You wish to know our interpretation of the tax treatment of the $XXXXXXXXXX of expenses incurred under the debenture purchase agreement, entitled "additional interest". More specifically, you would like our opinion on the following questions:
1) Should the total amount of $XXXXXXXXXX be considered a dividend that is not deductible from the corporation's income?
2) Should a reasonable amount of interest (XXXXXXXXXX% to XXXXXXXXXX%) be computed on the total borrowings of $XXXXXXXXXX and should this maximum interest be allowed as a deduction under paragraph 20(1)(c) (taking into account the interest already deducted by the corporation), i.e., $XXXXXXXXXX if the interest rate used is XXXXXXXXXX%?
3) Do the provisions of subsection 18(9.1) apply to the amount of $XXXXXXXXXX? If not, can paragraph 20(1)(e) be applied by adding this amount to the issuance costs of the new loan?
4) During the repayment process, professional fees were incurred, such as those related to the valuation of the Corporation's shares, the review of the loan agreements and the release fees. How should those costs be treated in light of the tax treatment of the $XXXXXXXXXX?
5) Is the interest paid on the redemption price of $XXXXXXXXXX, computed from XXXXXXXXXX to the closing date at the bank's base rate plus XXXXXXXXXX%, deductible by the Corporation?
Our Comments
1) Non-deductible dividend
The Act contains no specific definition of the word "dividend", but subsection 248(1) stipulates that a dividend includes a stock dividend. Since the Act does not give any specific meaning to the word "dividend", it must be given its ordinary meaning. Consequently, any proportional distribution of income or capital gains by a corporation to its shareholders may be considered a dividend payment, unless the corporation can demonstrate that it is some other type of payment. The fact that such a distribution is not to be called a dividend payment does not change its nature. In light of this proposition, in order for an amount to be considered a dividend, it must be distributed to a person who qualifies as a shareholder of the Corporation, which does not appear to be the case here. In fact, the amount of $XXXXXXXXXX was paid to the Creditor who, according to the facts, does not appear to own any shares in the Corporation. Consequently, you cannot characterize this amount as a non-deductible dividend to the corporation.
2) Calculation of deductible interest
Subparagraph 20(1)(c)(i) allows for the deductibility, in computing a taxpayer's income, of interest paid or payable pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property. Subparagraph 20(1)(c)(ii) also allows the deductibility of interest paid or payable pursuant to a legal obligation to pay interest on an amount payable for property acquired for the purpose of earning income from a business or property.
Also, in order to allow the deduction of interest related to the issuance of the three debentures pursuant to subparagraph 20(1)(c)(i), it must be shown that money was borrowed in those three transactions. The Act does not define the term "borrowing". However, Article 2314 of the Civil Code of Québec defines "simple loan" as a contract by which the lender hands over a certain quantity of money or other property that is consumed by the use made of it, to the borrower, who binds himself to return a like quantity of the same kind and quality to the lender after a certain time. This definition applies to loans of money. The loan contract is therefore concluded by the lender handing over the object to the borrower and not by a simple agreement of will. This interpretation confirms the position taken by the Supreme Court of Canada in MNR v. T.E. McCool, 49 DTC 700, a position still held by Canadian jurisprudence. In that case, Estey J. stated: "Terms such as 'borrowed capital', 'borrowed money' in tax legislation have been interpreted to mean capital or money borrowed with a relationship of lender and borrower between the parties."
Following the analysis of the facts submitted in your request, it appears that Debentures 1 and 3 constitute borrowed money and that the amounts paid or payable computed at the base bank rate plus XXXXXXXXXX% on the amount of those debentures qualify as interest and would therefore be deductible to the Corporation insofar as they are reasonable. The same applies to the interest on Debenture 1 paid by the issue of Debenture 2, which represents the amount of the debenture, i.e. $XXXXXXXXXX.
However, the interest computed on this amount of Debenture 2 will not be deductible under the provisions of subparagraph 20(1)(c)(i) since there is no lender-borrower relationship between the Corporation and the Creditor in this transaction. Furthermore, it should be concluded that the conditions set out in subparagraph 20(1)(c)(ii) were not satisfied when the debenture was issued, since it was an amount payable but not for the acquisition of property.
Paragraph 20(1)(d) also will not apply to these amounts, since the conditions set out in that provision were not satisfied. For an amount to be deductible for the purposes of paragraph 20(1)(d), it must be shown that the amount is paid on an amount which would be deductible under paragraph 20(1)(c), which is not the case here. The amount of Debenture 2 represents principal and not interest. However, the interest on the interest computed on Debentures 1 and 3 is deductible pursuant to paragraph 20(1)(d).
If you consider that a portion of the additional interest constitutes participating interest in respect of the amounts paid pursuant to the contract and which correspond to XXXXXXXXXX% or XXXXXXXXXX% (depending on the debenture) of the net income, after taking into account the interest computed at the base rate plus XXXXXXXXXX% of the value of the debentures, up to a total amount of XXXXXXXXXX% of the value of said debentures, our position in this regard was reiterated in 2002 at the Association de planification fiscale et financière and the Canadian Tax Foundation conferences. It was stated that the Agency's position on participating interest, which had been modified because of the Sherway Centre Ltd. case and which had been announced at the 1998 conference of the Canadian Tax Foundation [see 9823880], was still valid. The position is as follows: [TaxInterpretations translation]
Participating payments will be treated as interest and will be deductible in accordance with paragraph 20(1)(c) where the following conditions are met:
- The payment is limited to a stated percentage of the principal amount or the facts indicate that the participation payments were intended to establish the interest rate on the loan at the prevailing market rate;
- The limiting percentage, if any, reflects commercial interest rates; and
- No other facts indicate the presence of an equity investment.
Considering the facts brought to our attention, we are of the view that participating interest of XXXXXXXXXX% and XXXXXXXXXX% of net income up to a maximum rate of XXXXXXXXXX% of the face value of Debentures 1 and 3 could be deductible provided that the rate of XXXXXXXXXX% represents the market rate at the time the debentures were issued, facts not submitted with the request do not show that this arrangement constitutes a participation in profits and, finally, that the net profits for the interest calculation period are sufficient to allow a result corresponding to the rate of XXXXXXXXXX% of the face value of the debentures issued. It must also be shown that the amount of $XXXXXXXXXX includes an amount that the Corporation can deduct as participating interest equivalent to XXXXXXXXXX% or XXXXXXXXXX% of net profits for the year in question. If it is shown that the amount of $XXXXXXXXXX includes participating interest of XXXXXXXXXX% and XXXXXXXXXX% of net income, up to a maximum rate of XXXXXXXXXX%, and that the other conditions are satisfied, then this participating interest will be deductible in respect of Debentures 1 and 3. If the corporation is unable to show that the amount of $XXXXXXXXXX includes participating interest for the year in question and only constituted additional interest, then the entire amount will not qualify as interest and will therefore not be deductible under the provisions of subparagraph 20(1)(c)(i) for the reasons set out below. Participating interest that would have been paid on Debenture 2 would not be deductible for the same reasons as set out in the preceding paragraph.
3) Subsection 18(9.1) of the Act and paragraph 20(1)(f) of the Act
a) Subsection 18(9.1)
Subsection 18(9.1) applies in certain cases where a penalty or bonus is paid as a result of the repayment of all or part of the outstanding principal balance of a debt obligation (for example, a debenture) before its maturity. The provisions of subsection 18(9.1) allow, where all the conditions are satisfied, the deduction of an expenditure that would otherwise constitute a non-deductible capital expenditure by virtue of paragraph 18(1)(b).
However, this paragraph does not apply to a payment that is computed on the basis of revenues, profits, cash flow, the price of goods or a similar criterion. By applying the ejusdem generis rule of interpretation, which signifies that a collective term completing an enumeration is restricted to things of the same kind as those enumerated, we consider that additional interest computed on the basis of the equity of the Corporation constituted a payment excluded from the application of subsection 18(9.1). Consequently, you cannot allow the expensing of the additional interest on the basis of subsection 18(9.1).
b) Paragraph 20(1)(f) of the Act
Paragraph 20(1)(f) of the Act allows a deduction where an amount is paid in the year in satisfaction of the principal amount of an obligation on which interest was stipulated to be payable. Under subparagraph 20(1)(f)(ii), the amount of the deduction allowed in this case would be 2/3 of the lesser of the amount so paid and the amount by which the lesser of the principal amount of the obligation and all amounts paid in the year or in any preceding taxation year in satisfaction of its principal amount exceeds the amount for which the obligation was issued.
Subsection 248(1) defines the term "principal amount" as the maximum amount or maximum total amount, as the case may be, payable on account of the obligation by the issuer thereof, otherwise than as or on account of interest or as or on account of any premium payable by the issuer conditional on the exercise by the issuer of a right to redeem the obligation before the maturity thereof.
The term "interest" is not defined in the Act. However, the courts have addressed the issue on a number of occasions, and the following conditions can be discerned:
- The amount at issue accrues on a daily basis;
- It is computed based on the principal or a right to the principal;
- It represents compensation for the use of the principal or the right to the principal.
Considering these conditions in the light of the clauses in the contracts submitted for the purposes of this file, the additional interest did not meet the essential conditions for qualifying as interest for the purposes of the Act (unless you determine that our position on participatory payments applies).
It therefore remains to be determined, for the purposes of paragraph 20(1)(f), whether this additional interest constitutes "une prime que verserait l'émetteur s'il exerçait son droit de racheter l'obligation avant l'échéance de celle-ci" ["any premium payable by the issuer conditional on the exercise by the issuer of a right to redeem the bond before the maturity thereof"] in the context of the definition of principal which, as stated above, is the maximum amount payable in respect of the obligation by the person who issued it. The English version of the definition of "principal amount" refers to the following terms: "any premium payable by the issuer conditional on the exercise by the issuer of a right to redeem the obligation before the maturity thereof".
The debenture subscription agreements provided that the Corporation was to pay the additional interest whether or not it repaid the amounts borrowed before maturity. Thus, as soon as the debenture was created, the Corporation was subject to the payment of the premium. From that time on, it was assured that it would have to pay an additional amount on top of the amount borrowed. That obligation to pay remained even if the Corporation did not repay its loan before maturity. In our opinion, this situation reflects the spirit of paragraph 20(1)(f), which was enacted to allow the deduction of a premium payable in satisfaction of an obligation. Consequently, we are of the view that the additional interest paid by the Corporation to the Creditor upon repayment of its loan was included in the definition of principal and did not constitute a premium that the issuer was to pay conditional on its exercise of its right to redeem the obligation before maturity. Consequently, this additional interest came within the provisions of subparagraph 20(1)(f)(i). The Corporation was therefore able to deduct 66 2/3% of this additional interest in computing income for the year of payment.
Finally, since the additional interest constituted an amount payable as principal, it could not be deducted pursuant to paragraph 20(1)(e). That provision expressly excludes from its application any amount paid or payable on account of the principal of or interest on a debt.
4) Deduction of professional fees
Unlike disbursements incurred in connection with a loan, the Act does not allow the deduction of professional fees and any other expenses relating to the repayment of a loan. A deduction for those expenses will be allowed only if they qualify as eligible capital expenditures as defined in subsection 14(5). In the current situation, we do not have sufficient information to enable us to respond adequately. For more details on this subject, please refer to Interpretation Bulletin IT-143R2, Meaning of Eligible Capital Expenditure.
5) Interest paid on the $XXXXXXXXXX redemption price
Based on the facts described, it appears that for the redemption of the debentures on XXXXXXXXXX, the Corporation agreed to pay interest on the $XXXXXXXXXX redemption price, computed from XXXXXXXXXX at the bank base rate plus XXXXXXXXXX%, until the closing date. On XXXXXXXXXX, the Corporation paid an amount of $XXXXXXXXXX in respect of that interest.
The same tax considerations apply to the interest payable on the redemption price of the debentures from XXXXXXXXXX until closing. Interest computed on the portion of the redemption price corresponding to Debentures 1 and 3 and interest accrued to XXXXXXXXXX was deductible pursuant to subparagraph 20(1)(c)(i) and paragraph 20(1)(d). Interest on Debenture 2 was not deductible because the provisions of paragraphs 20(1)(c) and 20(1)(d) did not apply. Finally, the interest computed on the additional interest was not deductible pursuant to paragraph 20(1)(f) because it was interest and the conditions of paragraphs 20(1)(c) and 20(1)(d) were not satisfied. We are of the view that the additional interest did not constitute borrowed money or an amount payable for property acquired. This last proposition is valid provided that the additional interest did not include participating interest. In these circumstances, the interest payable on the participating interest will be deductible pursuant to paragraph 20(1)(d) for Debentures 1 and 3 only. This conclusion is correct only if all the other conditions set out above regarding the deductibility of participating interest are satisfied.
Conclusion
The interest computed on Debentures 1 and 3 was deductible pursuant to subparagraph 20(1)(c)(i). The same applies to the interest paid on those two debentures and computed from XXXXXXXXXX until payment of the debt. Compound interest computed on Debentures 1 and 3 was also deductible pursuant to paragraph 20(1)(d).
If a portion of the additional interest is shown to be participating interest and all of the conditions described herein are satisfied, then the portion of such interest that represented participating interest on Debentures 1 and 3 would be deductible under subparagraph 20(1)(c)(i) and the related compound interest was deductible pursuant to paragraph 20(1)(d). This treatment also applies to interest paid and computed on those two debentures from XXXXXXXXXX until payment of the debt.
Interest computed on Debenture 2 was not deductible. This conclusion also applies to compound interest computed on this debt.
The additional interest, except for the portion representing participating interest, was deductible pursuant to paragraph 20(1)(f), up to a maximum of 2/3 of the amount in question. Interest computed on the additional interest from XXXXXXXXXX until payment of the debt was not deductible. The provisions of subsection 18(9.1) did not apply in this situation.
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the electronic library version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
Best regards,
Ghislain Martineau
Section Manager
for the Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch
- 10 -