2015-0589841E5 Financial instrument as a debt obligation

Principal Issues: Whether a financial instrument with certain contingency conditions could represent a debt obligation?

Position: Question of fact.

Reasons: Previous rulings.

Author: Teow, Christina
Section: 20(1)(c)

XXXXXXXXXX
                                                2015-058984
                                                Christina Teow

August 24, 2015

Dear XXXXXXXXXX:

Re:  Impact of Contingency Clause on Interest Deductibility

We are writing in response to your letter of May 27, 2015 concerning the impact of a certain contingency clause on the deductibility of interest on notes issued by a taxable Canadian corporation.

In the hypothetical situation you describe, the notes would carry a fixed rate of interest, have a term of up to 60 years and be unsecured.  Upon the occurrence of an event of default, which would be limited to the insolvency or bankruptcy of a taxable Canadian corporation (“Canco”), the notes would automatically rank equally with preferred stock with respect to any amounts due in connection with such events. Upon any distribution of Canco’s assets to creditors in connection with an insolvency, bankruptcy or similar proceeding, all principal of, and premium, if any, and interest due or to become due on all other indebtedness of Canco must be paid in full before holders of the notes are entitled to receive any payment from such distribution.

We assume that Canco would use the proceeds of the notes for purposes of earning income from a business or property (other than to acquire property the income from which would be exempt or to acquire a life insurance policy). You have asked for confirmation that the hypothetical terms as provided, including the contingency clause, would support the characterization of the notes as a debt obligation such that interest on the notes is deductible under paragraph 20(1)(c) of the Income Tax Act (Canada) (the “Act”).

Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R6, Advance Income Tax Rulings, dated August 29, 2014.  Also, where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office. Nonetheless, we have provided some general comments below.

Our Comments

In general terms, a borrower lender relationship exists if the lender will be able, at a given time, to enforce repayment of the amount advanced, either by receiving the cash itself or property having an equal value.

At the 1995 Tax Executives Institute Round Table, the CRA stated:

“While the Act does deem payments of interest or dividends on certain financial instruments to be treated differently from their legal form (i.e. small business bonds, small business development bonds, income bonds and certain term preferred shares issued by non-residents) generally payments of interest or dividends usually derive their income tax consequences from the legal nature of the payment. This does not mean that the payments are not reviewable under the general anti-avoidance rule.” (endnote 1)

Furthermore, the Supreme Court of Canada (“SCC”) considered the issue of economic substance and legal relationships in the case of Shell Canada Ltd v The Queen, [1999] 4 CTC 313.  This case included consideration of an interest expense deduction under paragraph 20(1)(c) with respect to transactions that were entered into before the general anti-avoidance rule in section 245 became effective.

The SCC stated at paragraph 39:

“… this Court has never held that the economic realities of a situation can be used to recharacterize a taxpayer's bona fide legal relationships.  To the contrary, we have held that, absent a specific provision of the Act to the contrary or a finding that they are a sham, the taxpayer's legal relationships must be respected in tax cases. Recharacterization is only permissible if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect: Continental Bank Leasing Corp. v. Canada, [1998] 2 SCR 298, at para. 21, per Bastarache J.”

In other words, absent a sham or a specific provision of the Act to the contrary, legal relationships are respected.

In this situation, the determination of whether the terms of the notes, including the preferred stock ranking clause, would prevent interest on the notes from being deductible under paragraph 20(1)(c) of the Act can only be made in the context of an advance income tax ruling request. We note that all of the requirements of paragraph 20(1)(c) must still be met, including the requirement that the rate of interest must be reasonable under the circumstances.

We trust that these comments will be of assistance.

Yours truly,

G. Moore
For Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

ENDNOTES

1  1995 Tax Executives Institute Round Table – XXIII, 9530990

All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without the prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5.

© Her Majesty the Queen in Right of Canada, 2016

Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistribuer de l'information, sous quelque forme ou par quelque moyen que ce soit, de façon électronique, mécanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.

© Sa Majesté la Reine du Chef du Canada, 2016