On March 16, 2011, the Department of Finance released draft legislative proposals designed to counteract the effects of three taxpayer-friendly Federal Court of Appeal (“FCA”) decisions: Collins v. R. (2010 D.T.C. 5028), Lehigh Cement Ltd. v. R. (2010 D.T.C. 5081) and National Life Assurance Co. of Canada v. R. (2008 D.T.C. 6141). The draft proposals will impact the deductibility of contingent expenditures, withholding tax on interest paid to non-residents of Canada, and the computation of segregated fund policy reserves of life insurance corporations under the Income Tax Act (Canada) (the “ITA”).
Deductibility of Contingent Expenditures
The Collins case concerned interest payable by two Canadian individuals on a loan from an Alberta crown corporation. The interest expense was incurred for the purposes of constructing an apartment building and to earn income from the operation thereof, and as such should generally have been deductible in computing the income of the taxpayers. The taxpayers used the accrual method of accounting, such that the interest deduction would be claimed in the year in which the interest became payable. In this regard, the Court indicated that a taxpayer using the accrual method must claim the interest deduction in the year in which the amount becomes payable; the deduction cannot be deferred and claimed in a subsequent year.
The issue was that the loan agreement provided for an “early payout” option at the option of the borrower, whereby if the loan was paid off by a certain date, interest would effectively be substantially reduced for prior years. Interest could not have been deducted as it accrued if liability for that interest was contingent. However, the Court held that it was not the payment of the interest that was contingent, but rather the taxpayers’ exercise of the early payout option. On this basis, the Court found that the full interest amount was deductible as it accrued, as opposed to the reduced amount pursuant to the early payout option.
The draft proposals will prevent this result by disallowing the deduction of expenditures (including expense, expenditure or outlay made or incurred by the taxpayer or cost or capital cost of property acquired by the taxpayer) where the taxpayer, or another person not dealing at arm’s length with the taxpayer, has a “right to reduce” the amount of the expenditure. It is proposed that a “right to reduce” a particular expenditure amount shall mean “a right to reduce or eliminate an [expenditure] amount including for greater certainty, a right to reduce that is contingent upon the occurrence of an event, or in any other way, if it is reasonable to conclude, having regard to all the circumstances, that the right will become exercisable.”
The draft provisions take into account situations where a right to reduce an expenditure amount arises in a taxation year subsequent to the taxation year in which interest was accrued and deducted. In this situation, the maximum amount by which the interest may be reduced, less the amount, if any, paid to obtain the right to reduce the particular amount, gives rise to a deemed income inclusion for the taxpayer in the year in which the right arises (subject to an anti-avoidance rule that may deem the right to reduce to have existed at the time that the deduction was initially claimed in certain circumstances).
The proposed legislation is broadly drafted and its effects are potentially far reaching. Of particular concern is the legislation’s potential impact on “earnout” provisions included in share and asset purchase agreements, whereby obligations to make payments on account of the purchase price are conditional on, for example, the future production and income from the purchased property. It would appear that the draft legislation could particularly affect “reverse earnouts”, where the purchase price may be reduced subsequent to closing if particular income or production targets are not met.
Uncertainties remain with certain aspects of the draft legislation, such as the determination of the circumstances in which it is considered reasonable to conclude that a right to reduce will become exercisable. The foregoing draft proposals would apply to taxation years ending on or after March 16, 2011. The Department of Finance accepted comments on the draft legislation until April 15, 2011; further explanations as to the application of the draft legislation may be forthcoming. In the meantime, taxpayers should consider the impact of these draft proposals on contractual rights to reduce expenditure amounts.
Non-Resident Withholding Tax on Interest
Lehigh Cement1 involved a Canadian resident corporation with an outstanding loan to a non-arm’s length non-resident party. Generally, interest paid to a non-arm’s length non-resident lender (other than “fully exempt interest”) by a Canadian resident borrower will be subject to Canadian withholding tax under paragraph 212(1)(b) of the ITA at a rate of 25% or a reduced rate under a tax treaty. However, interest paid by a Canadian resident borrower to an arm’s length non-resident lender (other than “participating debt interest”) is generally exempt from Canadian withholding tax under paragraph 212(1)(b) of the ITA. The non-arm’s length non-resident lender in Lehigh Cement sold the right to receive the interest payments to an arm’s length non-resident party in order to avoid the application of Canadian withholding taxes on interest.
The Minister was not successful in arguing in this case that the general anti-avoidance rule (“GAAR”) applied to the transactions so as to deny the exemption from Canadian withholding taxes applicable to interest payments on arm’s length debt. In particular, the Minister argued that the fiscal policy objective of the relevant provision is to facilitate the access by Canadian resident borrowers to funds in international capital markets. Since the transactions in this case did not generate any funds for the Canadian borrower, the Minister’s position was that the transactions did not meet the policy objective of the relevant tax provision. In the backgrounder to the draft proposals, the Minister expressed the view that the sale by a non-arm’s length non-resident of the interest portion of a loan to a non-resident that deals at arm’s length with the payer of the interest in order to avoid Canadian withholding taxes is not consistent with the objectives of the Canadian withholding tax regime because the debt is still held by a non-arm’s length party and the borrowing cost for the resident of Canada is unchanged.
The proposed amendments will result in the application of Canadian withholding tax to interest paid by a Canadian resident borrower to a non-resident of Canada in respect of a debt or other obligation to pay an amount to a person with whom the Canadian resident borrower is not dealing at arm’s length. In other words, if the principal amount is owed by a Canadian resident borrower to a non-arm’s length non-resident party, interest payments to another non-resident of Canada will be subject to Canadian withholding tax regardless of whether the recipient of the interest deals at arm’s length with the Canadian resident borrower or not.
The scope of these proposed amendments is broad and could apply, for example, to interest coupon stripping which has long been a part of commercial financing transactions. These draft proposals would apply to interest that is paid or payable by a person or partnership on or after March 16, 2011, unless the payer of the interest incurred the obligation to pay such interest and the recipient acquired the entitlement to the interest as a consequence of an agreement or arrangement entered into by the recipient, and evidenced in writing, before March 16, 2011.
Computation of Segregated Fund Policy Reserves
National Life dealt with a life insurance company claiming a reserve respecting a “segregated fund policy”. Segregated fund policies are policies whereby the value of the policy is tied to the value of a specific, separate pool of assets held by the insurer. These policies often, but not always, include a guaranteed value amount, usually set at 75% of a given policy’s ‘initial’ value. The insurance company is generally liable for the guarantee amount, but does not retain ownership of the segregated fund assets themselves, which are held in a trust. As such, income from policy premiums is treated as income of the trust, rather than income of the life insurance company.
As with most insurance policies, segregated fund policies entitle insurance companies to deduct a reserve for liabilities related to the policies. However, since the company itself is not liable for the payment of benefits (other than guarantee payments), it may not claim a reserve respecting liabilities other than those relating to a guarantee payments. In National Life, the insurance company calculated its reserve on the basis that particular amounts were excluded from the calculation of its reserve which, it argued, generally prevented consideration of anything other than amounts payable with respect to the guarantee. Inclusion of those amounts would have actually reduced the reserve that could have been claimed by the company, because the amounts were negative and represented the present value of the insurance company’s future commissions, investment and administrative expenses, less the present value of future management fees and surrender charges. The Court held that this component was correctly excluded from the policy reserve calculation, as it did not relate to the company’s obligation to make payments with respect to the guarantee.
The proposed changes to the legislation will amend section 1406 of the Income Tax Regulations (Canada) to ensure that in computing an insurer’s policy reserves only the reserves in respect of benefits payable to segregated fund policyholders will be excluded. These changes would apply to the 2012 and subsequent taxation years.
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1 Refer to “International Tax: The Lehigh Cement Case – Canadian Non-Resident Withholding Taxes on Interest Payments” article in Miller Thomson LLP Tax Notes publication (October 2010) for a more detailed commentary on Lehigh Cement case.
