2019-0798721C6 IFA 2019 Q4 – 78(1)(b)(ii) deemed loan & thin capitalization

Principal Issues: 1. Assuming compound interest does not accrue on unpaid simple interest and subparagraph 78(1)(b)(ii) deems the amount of that simple interest, net of any taxes deducted or withheld, to be a loan, is that deemed loan considered to be included in “outstanding debts to specified non-residents” as defined in subsection 18(5)? 2. Where compound interest does accrue on unpaid simple interest and subparagraph 78(1)(b)(ii) deems the amount of that simple interest, net of any taxes deducted or withheld, to be a loan, is the amount of that deemed loan considered to be an outstanding debt to a specified non-resident only when the compound interest has been paid?

Position: 1. No. 2. Yes.

Reasons: 1. The deemed loan does not meet the conditions noted in the subsection 18(5) definition of “outstanding debts to specified non-residents”. 2. Generally, where subparagraph 78(1)(b)(ii) deems the amount of such simple interest, net of taxes, to be a loan, an amount equal to the deemed loan would not be considered to be an outstanding debt to a specified non-resident for purposes of subsections 18(4) and 18(5) until the compound interest is paid and is deductible pursuant to paragraph 20(1)(d).

Author: Patel, Komal
Section: 78(1), 18(4), 18(5), 20(1)(c), 20(1)(d)

2019 International Fiscal Association Conference
CRA Roundtable

Question 4 - Thin Capitalization and Section 78

The thin capitalization rules apply to “outstanding debts to specified non-residents”, which are generally debts or other obligations to pay an amount to certain non-resident creditors, on which deductible interest is paid or payable. Where a debt bears only simple interest, any accrued and unpaid simple interest itself will not be considered to be an outstanding debt to a specified non-resident. Even where the simple interest bears compound interest, that simple interest will not be considered to be an outstanding debt to a specified non-resident until the compound interest is paid and is therefore deductible in accordance with paragraph 20(1)(d) of the Income Tax Act (the “Act”). See 2016-0626841E5. 

In general terms, if the accrued and unpaid simple interest is owing to a non-arm’s length creditor, that interest is unpaid at the end of the second taxation year following the taxation year in which the interest was incurred, and an agreement is filed under paragraph 78(1)(b) of the Act, the accrued and unpaid interest is deemed to have been paid to the creditor, and the creditor is deemed to have made a loan back to the debtor on the first day of the third taxation year. The Act does not, however, set out the terms of this deemed loan.

For purposes of the following questions and responses, assume that no tax is required to be deducted or withheld on the deemed payment of the accrued simple interest.

(a) Assuming compound interest does not accrue on unpaid simple interest and subparagraph 78(1)(b)(ii) deems the amount of that simple interest to be a loan, is that deemed loan considered to be included in “outstanding debts to specified non-residents” as defined in subsection 18(5) of the Act?

CRA Response

It is our view that the amount of such accrued and unpaid simple interest that is deemed to be a loan pursuant to subparagraph 78(1)(b)(ii) of the Act would not be considered to be an outstanding debt to a specified non-resident based on the subsection 18(5) definition of “outstanding debts to specified non-residents”.

(b) Where compound interest does accrue on unpaid simple interest and subparagraph 78(1)(b)(ii) deems the amount of that simple interest to be a loan, is that deemed loan considered to be an outstanding debt to a specified non-resident only when the compound interest has been paid?

CRA Response

Generally, where subparagraph 78(1)(b)(ii) deems the amount of such simple interest to be a loan, an amount equal to the deemed loan would not be considered to be an outstanding debt to a specified non-resident for purposes of subsections 18(4) and 18(5) of the Act until the compound interest is paid and is deductible pursuant to paragraph 20(1)(d).

Komal Patel/Ann Kippen
2019-079872
May 15, 2019

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