2021-0893791I7 Interest expense on subordinated income instrument

Principal Issues: 1. Whether an advance tax ruling issued to a taxpayer limits the Compliance Programs Branch from reassessing the taxpayer on subsequent transactions. 2. Whether the CRA remains bound by an advance tax ruling issued prior to the introduction of section 247. 3. Whether the expected yield to maturity of a debt instrument at the time the instrument was issued is appropriate when considering whether the arm's length standard has been met in the context of a transfer pricing analysis?

Position: 1. Where the subsequent transactions were not part of the ruling, no. 2. If the ruling can continue to be supported by new legislation, yes. 3. Yes.

Reasons: 1. A ruling is binding upon the CRA with respect to the recipient taxpayer and the described transactions, but does not limit the Compliance Programs Branch from reassessing subsequent transactions that were not part of the ruling and which are not those described in the ruling. 2. A ruling issued prior to the introduction of section 247 will remain binding as long as it can continue to be supported. 3. A proper application of the arm's length principle requires that regard be had for the economically relevant characteristics of the circumstances, which may include the interest rate set on a debt instrument at the time of its execution.

Author: Graham, Kanwal
Section: paragraph 20(1)(c); subsection 247(2).

Lucy Liagridonis                                                 HEADQUARTERS
Senior International Tax Analyst                         Income Tax Rulings Directorate
International Tax Division                                    K. Graham
Compliance Programs Branch

2021-089379


Subordinated Income Instruments

This is in reply to your request of March 2, 2021 asking for our views regarding the impact of an advance income tax ruling issued in XXXXXXXXXX to XXXXXXXXXX, subsequently known as XXXXXXXXXX (“Holdco”), on the current financing structure of Holdco. The relevant facts you presented in your request can be summarized as follows:

1. Holdco is a Canadian holding company and a subsidiary of a U.S. entity, XXXXXXXXXX. (“Parent”). Holdco’s primary activity is the provision of long-term debt financing to its Canadian operating entities (“Opcos”) in the form of debentures/subordinated income instruments (“SIIs”).

2. In the early 1980s, Holdco was incurring non-capital losses resulting in part from interest expenses associated with bank debt. For the purpose of reallocating funds from servicing bank debt to investing in its business operations, it was proposed that Holdco issue a 40-year U.S. $15 million debenture (“Debenture”) to Parent. (footnote 1) Interest at a rate of 11% per annum was charged on the Debenture, but it was only payable in a particular year to the extent of Holdco’s profits in that year. Where Holdco’s profits were insufficient in a year, there would be no obligation in a later year to pay interest in respect of a prior year. Parent was able to demand payment of the principal amount of the Debenture at any time with a 90-day notice period, but Holdco’s obligation to comply with the demand was subject to a net worth test.

3. In XXXXXXXXXX, Holdco obtained an advance income tax ruling (“Ruling”) from the CRA with respect to interest payable on the Debenture. The Ruling given confirmed that:

o interest payable on the Debenture would be deductible in accordance with subparagraph 20(1)(c)(i), subject to the application of subsection 18(4); and

o withholding tax will be exigible pursuant to paragraph 212(1)(b) at the time the interest is paid or credited to the Parent. (footnote 2)

4. Subsequent to the issuance of the Debenture, another 23 debentures were issued by Holdco to related non-resident entities during the years XXXXXXXXXX, each of which was subordinated to the ones issued before it (i.e., interest on the first debenture was to be paid in full before any interest was to be paid on the subsequently-issued debentures). Over the years, a number of corporate reorganizations were undertaken, with some of the debentures being consolidated and/or transferred to other Canadian entities within the corporate group.

5. Holdco currently has 14 SIIs outstanding that it issued (footnote 3) of a total amount of approximately C$1.6 B to a related non-resident entity, XXXXXXXXXX, and holds SIIs issued by Opcos totalling the same amount. Holdco charges 1 basis point more to the Opcos than it pays on its respective SIIs. The notes to Holdco’s financial statements state that no active or liquid market exists for these SIIs.

The Compliance Programs Branch (“CPB”) is undertaking a formal economic analysis of the reasonability of interest costs for the 2016 taxation year related to the cross-border financing in the form of the debentures/SIIs between Holdco and its related entities. You have requested our views by asking the following questions:

1. How long is the CRA bound by the Ruling, and is it impacted by the introduction of section 247 of the Act?

2. What impact, if any, does the Ruling, which was only issued with respect to the Debenture, have on CPB’s analysis of subsequently-issued SIIs?

3. In the context of transfer pricing analysis, is it appropriate to consider the expected yield to maturity of a debt instrument at the time the instrument was issued when considering whether the arm’s length standard is met in a particular year?

In this document, all legislative references are to the Income Tax Act (“Act”), unless otherwise specified, the term “Debenture” refers to the first debenture issued by Holdco for which the Ruling was issued, and the term “SII” refers to a subsequently issued debenture/subordinated income instrument.

Our Comments

An advance income tax ruling provides certainty with respect to the application of Canadian income tax law to proposed transactions. As noted in paragraph 14 of Information Circular IC70-6R12, Advance Income Tax Rulings and Technical Interpretations (“IC”), rulings are binding upon the CRA “with respect to the recipient taxpayer and the described transactions to the extent that there is no material omission or misrepresentation in the statement of relevant facts, proposed transactions or other information described in the Ruling and/or the related request and provided that the proposed transactions are implemented within the time limit specified in the Ruling. The CRA is not bound by facts and information disclosed in supplementary documents provided by the taxpayer but not included in the issued Ruling.” Further, as noted in paragraph 28 of the IC, “[a]ll the facts, proposed transactions, purpose(s) of the transactions and other information described in a Ruling may be the subject of discussion within the CRA at any time and may be later subject to an audit.”

The Ruling given to Holdco confirmed that interest payable on the Debenture would, subject to the application of subsection 18(4), be deductible in accordance with subparagraph 20(1)(c)(i). An eligible deduction for interest expense under paragraph 20(1)(c) is limited to the lesser of the amount paid in the year or payable in respect of the year and a reasonable amount in respect thereof.

In determining a “reasonable amount” of interest, paragraph 1.20 of Income Tax Folio S3-F6-C1, Interest deductibility, states that “the prevailing market rates for debts with similar terms and credit risks should be considered as well as the existence of any issue premiums.” That same paragraph also refers to the Supreme Court of Canada’s decision in Shell Canada Ltd. v The Queen [(SCC) 99 DTC 5669]: “Where an interest rate is established in a market of lenders and borrowers acting at arm’s length from each other, it is generally a reasonable rate.” The reasonability of a deduction for interest expenses for the purpose of paragraph 20(1)(c) is a test to be met in each relevant tax year.

The Debenture issued by Holdco and which was the subject of the Ruling, bears a maximum interest rate of XXXXXXXXXX%. In XXXXXXXXXX, the year in which the Ruling was issued, the Bank of Canada policy rate was XXXXXXXXXX%, and the long-term (over 10 years) Canada bond rate was XXXXXXXXXX%. (footnote 4)

We understand that in establishing the interest rate on a SII, Holdco’s objective was to yield a rate of return to maturity which approximates the Government of Canada’s long-term bond yield plus appropriate amounts for creditor risk, the term of the instrument, the expected timing of interest payments, the conditional nature of the interest payments, and the fact that Holdco was not expected to earn sufficient taxable income in the early years of the SIIs to pay interest. (footnote 5)

The Ruling confirmed the application of paragraph 20(1)(c) to Holdco in respect of the Debenture, whose proceeds would be used by Holdco to reduce its outstanding bank debt.

A ruling will cease to bind the CRA if legislation is amended after a ruling is issued and the ruling ceases to be supported by the legislation due to the amendment(s). The Ruling was issued in XXXXXXXXXX and the transfer pricing rules in section 247 were enacted in 1998.

Prior to the enactment of section 247 on XXXXXXXXXX, a transfer pricing rule was contained in subsection 69(2), which read as follows:

“(2) Unreasonable consideration — Where a taxpayer has paid or agreed to pay to a non-resident person with whom the taxpayer was not dealing at arm’s length as price, rental, royalty or other payment for or for the use or reproduction of any property, or as consideration for the carriage of goods or passengers or for other services, an amount greater than the amount (in this subsection referred to as “the reasonable amount”) that would have been reasonable in the circumstances if the non-resident person and the taxpayer had been dealing at arm's length, the reasonable amount shall, for the purpose of computing the taxpayer's income under this Part, be deemed to have been the amount that was paid or is payable therefor.”

While former subsection 69(2) may have applied to re-state a transfer price between a taxpayer and a non-resident person with whom the taxpayer did not deal with at arm’s length to an amount that would have been reasonable in the circumstances had they been dealing at arm’s length, subsection 247(2) may apply to re-state the quantum or nature of an amount to that which would have been determined between person’s dealing at arm’s length. (footnote 6)

There is no indication that the conditions for the validity of the Ruling were not met. The Ruling would have represented the CRA’s view on future payments on the Debentures. The CRA is bound by the Ruling with respect to the Debenture only and not of transactions that are outside the scope of the proposed transaction described in the Ruling letter, such as the issuance of SIIs.

When section 247 was enacted, one of the objectives was to “harmonize the standard contained in section 69 of the Act with the arm’s length principle as defined in the revised OECD guidelines.” (footnote 7)

Subsection 247(2) applies in situations where a taxpayer or a partnership and a non-resident person with whom the taxpayer, the partnership or a member of the partnership does not deal at arm’s length (or a partnership of which the non-resident person is a member) are participants in a transaction or a series of transactions and:

(a) the terms or conditions of the transaction or series differ from those that would have been made between persons dealing at arm’s length, or

(b) the transaction or series

i. would not have been entered into between persons dealing at arm’s length, and

ii. can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit.

As stated by the Supreme Court of Canada in the case of The Queen v GlaxoSmithKline Inc. [2012 SCC 52], “[a] proper application of the arm’s length principle requires that regard be had for the ‘economically relevant characteristics’ of the arm’s length and non-arm’s length circumstances to ensure they are ‘sufficiently comparable.’”

If CPB were to examine paragraphs 247(2)(a) and (c) in respect of the interest expense on a SII issued by Holdco, that would require consideration of all economically relevant circumstances. In accordance with Chapter X of the current OECD Transfer Pricing Guidelines, the economically relevant characteristics of financial transactions to consider include:

* the contractual terms of the transaction;

* the functions performed, assets used, and risks assumed;

* the characteristics of the financial instruments;

* the economic circumstances of the parties and of the market; and

* the business strategies pursued by the parties.

In the case of any particular SII, the economically relevant characteristics include those that were in existence at the time the instrument was executed. Thus, for transfer pricing purposes, the expected yield to maturity of a particular SII is a relevant factor in determining whether the interest rate of the SII is consistent with the arm’s length principle. The results of the formal economic analysis underway in respect of the SIIs issued, and interest expense claimed by, Holdco will assist CPB in determining whether paragraphs 247(2)(a) and (c) would apply.

In accordance with recently enacted subsection 247(2.1), the rule embodying the arm’s length principle is a rule of general application and adjustments made to amounts under section 247 are to be computed prior to applying other provisions of the Act. Subsection 247(2.1) was added in order to clarify the interaction of subsection 247(2) and other provisions of the Act, and is applicable to taxation years that begin after March 18, 2019.

We caution that these observations are based upon the Act as it now reads. There were proposals released in 2023 to amend section 247 which, if passed in substantially unchanged form, may affect the evaluation of securities such as the SIIs.

We trust our comments are of assistance.

Unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the CRA’s electronic library. After a 90-day waiting period, a severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. You may request an extension of this 90-day period. The severing process removes all content that is not subject to disclosure, including information that could reveal the identity of the taxpayer. The taxpayer may ask for a version that has been severed using the Privacy Act criteria, which does not remove taxpayer identity. You can request this by e-mailing us at: ITRACCESSG@cra-arc.gc.ca. A copy will be sent to you for delivery to the taxpayer.

Yours truly,




Charles Taylor
Section Manager
for Division Director
International Division
Income Tax Rulings Directorate
Legislation Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:


1 The parent company of Holdco was named XXXXXXXXXX in the Ruling. It is not known whether this entity is the same as the current Parent, but we have assumed that it is.

2 idem

3 This figure is described in your request as an amount showing on Holdco’s books.

4 Canadian Economic Observer: Historical Statistical Supplement: Table 7.1 — Interest rates and exchange rates (statcan.gc.ca)

5 Information obtained from a memorandum prepared by Appeals HQ dated XXXXXXXXXX, addressed to the Chief of Appeals at the XXXXXXXXXX.

6 See Department of Finance Consolidated Explanatory Notes

7 See Annex 6 to the 1997 Budget Plan.

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