5-902745
Dear Sirs:
Re: Profit Sharing Arrangements
We are writing in response to your letter of September 27, 1990. You have asked for our opinion and comments on the tax implications of various profit sharing arrangements. We regret that other workload prevented us from replying earlier.
A number of the specific questions which you asked could only be answered upon a full examination of the facts and proposed transactions of a particular proposed arrangement, submitted in the form of a complete request for an advance income tax ruling.
A representative of Revenue Canada addressed many of the general concerns raised in your letter on the tax implications of participating loans in the Revenue Canada Panel at the 1989 Corporate Management Tax Conference (p. 8:9), as follows:
The department's concern in respect of participation loans is to determine whether such loan arrangements effect a distribution of profits or are an expense of doing business. A distribution of profit should be on a tax-paid rather than a tax-deductible basis.
No clear dividing line exists in law to distinguish debt payments from equity payments. As a general rule, the department takes the view that a lender's return on debt does not depend on the profitability of the borrower, whereas an investor's return on equity does depend on profitability. On this view of the matter, most participating loan arrangements qualify as equity rather than debt.
Some taxpayers have represented the view that participation payments are deductible under paragraph 20(1)(c) (of the Income Tax Act (Canada), which authorizes a deduction for amounts paid or payable pursuant to a legal obligation to pay interest. It is, however, doubtful that most participation payments qualify as interest. On the basis of the Miller case [Miller v The Queen 85 DTC 5354 (FCTD)], a payment must satisfy all three of the following criteria to qualify as interest:
1) it must be calculated on a daily accrual basis;
2) it must be calculated on a principal sum or a right to a principal sum; and
3) it must represent compensation for the use of the principal sum or the right to the principal sum.
To be referable to a principal sum, amounts are usually determined by applying a percentage to that principal. In our view, an amount that is determined on the basis of other criteria (such as cash flow, revenue, or net profit) is not referable to a principal sum. While it is possible to create formulas under which amounts calculated on the basis of those other criteria are expressed as a percentage of the principal sum, the mere expression of such an amount in this manner, does not necessarily qualify the amount as interest.
This is not to say that participation payments can never qualify as interest. As noted earlier, the question centres around the distinction between debt and equity payments. We have issued favourable rulings for participation payments that exhibited debt rather than equity characteristics....
In accordance with this position, the department will consider a participation payment to be interest provided that
1) the payment is limited to a stated percentage of the principal;
2) the limiting percentage reflects commercial interest rates prevailing between arm's-length parties at the time the loan is entered into; and
3) no other facts indicate the presence of an equity investment.
The relevant commercial interest rates will be those reflecting ordinary credit risks involved in a debt investment. Accordingly, the limiting percentage may reflect any increased credit risk arising as a result of the credit rating of the borrower. The limiting percentage may also reflect the risk that the lender may not receive all of the anticipated payments owing to insufficient profits in any one year. An inordinate rate may well indicate that the "lender" is assuming risks that are more in keeping with an equity investment....
Some taxpayers have represented the view that participation payments are deductible under paragraph 20(1)(e), which authorizes a deduction for expenses incurred in the course of borrowing money used for an income-earning purpose. The department, however, takes the view that paragraph 20(1)(e) does not authorize a deduction for payments made as compensation for the use of money. In our view, this interpretation is consistent with the taxation policy underlying paragraph 20(1)(e), namely, the provision of a deduction for incidental expenditures incurred in the course of effecting a borrowing.
The decision in Yonge-Eglinton [MNR v, Yonge-Eglinton Building Ltd. 74 DTC 6180 (FCA)] dealt with commitment fees, which do not represent compensation for the use of borrowed funds. As noted in that decision, the commitment fees were payable whether or not the taxpayer actually borrowed money and whether or not any unpaid principal balance existed. Accordingly, Yonge-Eglinton does not conflict with our view of paragraph 20(1)(e).
Thus, any financing arrangement which calls for a participation payment but which does not specify a limiting percentage rate which reflects commercial interest rates would, in our opinion, be a distribution of profits to the source of financing and would not be interest. The appropriate tax treatment by the recipient of a participation payment can only be determined upon an examination of all of the facts of a particular arrangement. We are therefore unable to comment on the tax consequences of a receipt of a participation payment except in response to a complete advance income tax ruling request.
Note that the Department's position as stated above would not change if a financial backer entitled to participation payments secured its position by registering a mortgage on the underlying real estate in a participating loan arrangement.
You have also asked whether a participating loan could be characterized as a joint venture or a limited partnership. As you acknowledge in the postamble to your letter, whether an arrangement is a joint venture or a partnership is a question of fact. Your supplementary questions concerning the tax consequences of particular forms of financing of joint venture or partnership arrangements could only be answered in response to a request for an advance income tax ruling.
Our comments are provided pursuant to the practice referred to in paragraph 21 of Information Circular 70-6R2.
Yours truly,
for DirectorFinancial Industries DivisionRulings Directorate