- Contingent Liabilities
- Proposed Amendments to Withholding Tax Rules
- Life Insurance Policy Reserves
While today's Federal Budget is likely to be a lightening rod for politics, less than a week ago the Department of Finance quietly released a number of technical income tax proposals.
The tax proposals released on March 16, 2011 essentially overturn three tax cases where the Federal Court of Appeal ruled in favour of the taxpayer. Two of the proposed changes have a relatively narrow application, but one of the changes regarding contingent liabilities and their tax consequences could have broad implications.
By Eugene Friess
Proposed section 143.4 of the Income Tax Act (Canada) (the "Act") will limit the recognition of a "contingent amount" for tax purposes. This new rule is in response to the Federal Court of Appeal's decision in Collins v. The Queen (2010 FCA 12) where the taxpayers were permitted to deduct the full amount of accrued, but unpaid, interest, even though they had the right under the loan agreement to subsequently elect to pay a substantially lower amount.
As often happens with remedial legislation, though, the proposed amendment is not limited to reversing the unfavourable decision in Collins. Indeed, as we suggest here, it has a much broader reach, and may have some unintended harmful consequences.
The Collins Decision
In Collins, the taxpayers borrowed funds in 1981 under an Alberta government financing program designed to encourage the construction of apartment buildings. In 1993 the loan agreement was amended so that the taxpayers were required to pay only $20,000 on account of interest in each of the following 15 years, instead of the full 10% per annum stipulated as the interest payable elsewhere in the loan agreement. The balance of the interest owing, calculated at the full 10% per annum rate, was payable at the end of the 16th year. However, the amended loan agreement gave the taxpayers an option to "payout" their obligations under the agreement by paying a lump sum of $100,000 plus $20,000 for each year remaining in the initial 15 year term.
In calculating their income, the taxpayers used the accrual method to deduct interest at the full 10% per annum rate, rather than deducting only the $20,000 which they had actually paid. The Crown in Collins argued that this was inappropriate since there was no legal obligation to pay any interest above the $20,000 per year and the obligation to pay interest at the full 10% rate was contingent.
The Federal Court of Appeal decided against the Crown's position. The Federal Court of Appeal reasoned that it was the right to pay less than 10% that was contingent, and not the obligation to pay interest at 10%. Since the taxpayers were accrual basis taxpayers, they were permitted to deduct the interest on the loan as it accrued, even if it could be subsequently reduced.
Treatment of contingent liabilities
The term "contingent" and related concepts appear throughout the Act. For example, paragraph 18(1)(e) prohibits a taxpayer from deducting a contingent liability except as expressly permitted.
While it may appear straight forward, there are a number of legal subtleties. For example, some liabilities may be subject to a condition precedent, in which case there is no liability until the condition is satisfied. This is a classic contingent liability, the deduction of which is prohibited by paragraph 18(1)(e). Other liabilities may be subject to a condition subsequent, in which case the liability exists initially, but may cease to exist in the future if the condition arises.
As illustrated by Collins, the treatment of a liability with a condition subsequent can be quite different from the treatment of a liability that is subject to a condition precedent. Nevertheless, the rules are well known. All this will change with proposed section 143.4.
New Section 143.4
Proposed section 143.4, in effect, expands the scope of contingent liabilities to include liabilities which are subject to a condition subsequent. In particular, proposed section 143.4 addresses situations where a taxpayer has the right, exercisable in the future, to reduce an expenditure or cost. The new section will operate, simply, by requiring all "expenditures" to be reduced for tax purposes by any "contingent amount."
"Contingent amount," is defined for this purpose as follows:
"contingent amount", of a taxpayer at any time ... includes an amount to the extent that the taxpayer, or another taxpayer that does not deal at arm's length with the taxpayer, has a right to reduce the amount at that time.
The term "right to reduce" is defined as follows:
"right to reduce," an amount in respect of an expenditure at any time, means a right to reduce or eliminate the 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.
Proposed subsection 143.4(2) generally limits "expenditures" which are recognized for tax purposes by excluding contingent amounts. In effect, an "expenditure" for tax purposes will be reduced to the lowest amount that the taxpayer is required to pay after exercising applicable rights to reduce the expenditure. In determining the amount of the expenditure, the new rules take into account the fact that a taxpayer may have to pay to acquire the right to reduce the contingent amount.
Where a contingent amount is not recognized for tax purposes in a year, but is in fact paid in a later year, it will be deemed to have been incurred and to have become payable in the year it is paid, and it will be deemed to retain the same character as the original expenditure. Unfortunately, it is not clear how this relieving provision will operate for an expenditure that would otherwise form part of the cost of property. That is, will the subsequent amount be added to the cost or capital cost of the property when paid? It would seem so, but the proposed language is not completely clear.
Proposed subsection 143.4(4) addresses a less typical situation, where the expenditure is not contingent in the year it is deducted, but later becomes contingent. Where a taxpayer's right to reduce an expenditure arises in a subsequent taxation year, the earlier deduction is addressed by deeming the "subsequent contingent amount" to be income pursuant to paragraph 12(1)(x) of the Act. In these circumstances, subsection 12(2.2) of the Act may provide some relief if an election can be made to reduce an outlay or expense (other than the cost of property) and consideration could be given to whether paragraph 20(1)(hh) would allow a deduction if the full amount is ultimately paid.
In case these extensive deeming rules are not sufficient, there is a new anti-avoidance rule in proposed subsection 143.4(6) that will apply if one of the purposes of a taxpayer acquiring a right to reduce an expenditure after the end of the year was to avoid a reduction in the year under subsection 143.4(2).
Implications of the new rule
These new provisions raise a number of questions. Conditions and contingencies abound in commercial agreements. Funds are held in escrow pending conditions being met. Earnouts and reverse-earnouts are dependent on conditions. Under previous law, confirmed by the Federal Court of Appeal in Collins, obligations subject to a condition precedent were readily identifiable as contingent obligations and would not generally be recognized for tax purposes until the happening of the future event. The option provision at issue in Collins, like an obligation with a condition subsequent, is logically distinct. Under the drafting strategy of the proposed legislation, the distinction between these two concepts is essentially collapsed. It remains to be seen whether the expanded meaning of the concept "contingent" will create unforeseen challenges and confusion.
It is also not clear whether the treatment of subsequent contingent amounts, to the extent they are deemed to be 12(1)(x) amounts, will result in the re-characterization of capital receipts as income.
Finally, for every party who is subject to a contingent liability there is another party who is entitled to receive the contingent payment, but it is not clear how the reductions and inclusions required by these new provisions will affect the recipient in respect of the timing and nature of their corresponding inclusions or receipts.
At first glance, therefore, given the very fundamental nature of the concept "contingent", it appears to us that the legislative reversal of the decision in Collins may require more thought.
These new provisions apply for taxation years ending on or after the announcement date of March 16, 2011 and there is no limitation period for assessments, determinations and redeterminations under proposed section 143.4.
Proposed Amendments to Withholding Tax Rules
By: Henry Chong
Continuing a long standing practice of reversing an unfavourable court decision by legislation, the Department of Finance responded to the recent court decision in Lehigh Cement Ltd. v. The Queen, 2010 FCA 124, with a proposed amendment to paragraph 212(1)(b) of the Income Tax Act (Canada) (the "Act"). The proposed amendment limits the ability of a non-resident lender to avoid Canadian withholding tax on interest payments by assigning the right to receive such payments to an arm's length person.
Canadian withholding tax on arm's length interest has been eliminated as a result of legislative changes effective January 1, 2008, with the exception of "participating debt interest". However, Canadian withholding tax at a rate of 25% still generally applies under paragraph 212(1)(b) to interest that is paid to a person with whom the payor is not dealing at arm's length. Such withholding tax on non-arm's length interest may be subject to relief under an applicable income tax treaty. Under most of the tax treaties Canada has entered into the 25% withholding tax rate for interest is reduced to 10%. For US residents, Canadian withholding tax is generally eliminated for interest (other than certain participating interest) paid by a Canadian resident to a non-arm's length person who qualifies for relief under the Canada-United States Income Tax Convention (1980) (the "U.S. Treaty").
Because the exemption from withholding tax in the Act looks only to whether the recipient of the interest deals at arm's length with the debtor, it may have been possible under existing law for a non-resident lender to avoid withholding tax by assigning the right to receive the interest payments to an arm's length non-resident purchaser. In order to restrict this kind of planning, the proposed amendment to paragraph 212(1)(b) will also tax interest (other than the limited categories of exempt interest) that is paid or payable to a non-resident where the debt obligation is between a lender and debtor that do not deal with each other at arm's length (a "non-arm's length debt") regardless of whether the person that receives the interest deals at arm's length with the debtor. As a result of the proposed amendment, interest on non-arm's length debt will remain subject to Canadian withholding tax under the Act, even if such interest is paid to an arm's length person who acquires the right to receive such interest from the non-arm's length lender.
The proposed amendment will apply to arrangements put in place on or after March 16, 2011. As well, the amendment will not affect the exemption available under the U.S. Treaty.
By way of background, the court in Lehigh considered an exemption from withholding tax that applied before 2008 to interest paid to a non-arm's length person under certain debt obligations where the debtor was under no obligation to pay more than 25% of the principal amount of the obligation within the first 5 years of the term of the debt (the "5-25 exemption"). This exemption has been replaced with a much broader exemption, but the principle from Lehigh is still relevant and it lead to the current proposed amendment.
In Lehigh, a Canadian subsidiary of a multinational group (the "Debtor") was indebted to a related company located in Belgium (the "Lender") that acted as the group's financing or treasury centre. Interest payments on the debt did not qualify for the 5-25 exemption and was subject to Canadian withholding tax. Approximately 10 years after the debt was initially incurred, the parties amended the terms of the debt to, amongst other things, remove the obligation to repay more than 25% of the outstanding principal within 5 years from the date of the amendment and to permit the Lender to sell all or any portion of the right to receive interest payments to a third party. The right to receive interest payments for the balance of the term of the debt was assigned by the Lender to an arm's length financial institution in Belgium (the "Assignee") for $43 million. It appears that the Lender was not subject to any Canadian tax on the assignment of the interest receivable.
Following the amendment of the terms of the loan and the assignment of the interest receivable, the Debtor stopped withholding any amount from the interest payments to the Assignee on the basis that such payments qualified for the 5-25 exemption from withholding tax because they were now paid to a arm's length person even though the underlying debt on which the interest was paid remained between non-arm's length parties.
The Canada Revenue Agency ("CRA") reassessed for failure to withhold on the basis that the restructuring of the debt to split the interest payment from the underlying debt obligation was an avoidance transaction that resulted in a misuse or abuse of the Act under the general anti-avoidance rule in subsection 245(2) of the Act. The trial court agreed with the CRA. However, that decision was reversed by the Federal Court of Appeal. In the Federal Court of Appeal's view, the splitting or assignment of the right to receive interest from the underlying debt was a long standing and normal aspect of commercial financing transactions that Parliament was aware of when they drafted the 5-25 exemption and could have dealt with if the exemption was not intended to apply where the right to interest payments under a non-arm's length debt was acquired by a arm's length person. As well, the Crown was unable to identify a clear underlying policy for the exemption that was being abused as a result of the restructured debt. Finally, the court seemed to be persuaded by the fact that the same result could have been achieved if the debt obligation itself was assigned by the Lender to the Assignee.
As a result of the decision, the Lender was able to receive an amount on account of its interest receivable that would have otherwise been subject to Canadian withholding tax as tax free proceeds from the assignment of the right to receive the interest payments and the Assignee was able to recover its cost of the interest receivable through the interest payments received free of Canadian withholding tax under the 5-25 exemption.
While the 5-25 exemption has since been repealed, Finance moved quickly to reverse the court's decision by legislation to avoid what was likely perceived as the bigger problem that would have been created under current law if the decision was allowed to stand. Because the Act now generally taxes only interest paid to non-residents on non-arm's length debt, the decision of the court would have, in principle at least, allowed non-residents the option to avoid such tax by simply assigning the right to receive the interest to an arm's length non-resident financial institution that operated outside of Canada.
It is not surprising that Finance moved quickly to close a potential loophole. The proposed amendment, however, appears to be narrow and confined largely to the specific transaction dealt with in Lehigh. It does not appear to cover the "comparable" transaction discussed by the Federal Court of Appeal where both the debt and the interest receivable are assigned, whether together or separately to non-residents who deal at arm's length with the debtor, though some clarification on this point would likely be welcome. As mentioned above, it also does not affect the exemption from Canadian withholding tax on interest payments on non-arm's length debt under the US Treaty.
Life Insurance Policy Reserves
By: John Sorensen
Section 1406 of the Income Tax Regulations ("ITR") sets out rules for calculating life insurance policy reserves under s. 1404 and 1405. Section 1406 is being amended in response to decisions of the Tax Court of Canada ("TCC") and the Federal Court of Appeal ("FCA") in National Life Assurance Co. v. R., 2006 TCC 551 (aff'd 2008 FCA 14) ("National Life Assurance"). The case involved the proper treatment of certain negative amounts which arose in calculating the policy reserves.
Subparagraph 138(3)(a)(i) of the Income Tax Act (Canada) (the "Act") allows life insurers to deduct policy reserves on life insurance policies in calculating their income. Provisions of the ITR set out the rules for calculating the "maximum tax actuarial reserve" ("MTAR") that can be deducted. A portion of the MTAR formula was in issue in National Life Assurance, namely, the "A" amount calculated under ss. 1404(3) (the lesser of total reported reserves and the policy liability at the end of the taxation year). Para. 1406(b) requires that "A" be determined without reference to any liability in respect of a "segregated fund", other than a liability in respect of a guarantee relating to a segregated fund policy.
National Life Assurance
National Life Assurance involved the calculation of the MTAR for the 1997 and 1997 taxation years for a particular product called "UltraFlex". The taxpayer made three calculations in relation to variable investments in segregated funds. The second calculation yielded a negative amount. The first and second calculations were omitted from the "A" component of the reserve calculation, pursuant to para. 1406(b). Had the negative component calculated under the second calculation been included, this would have reduced the reserve deduction to which the taxpayer was entitled. The Minister of National Revenue ("Minister") reassessed the taxpayer by including the negative portion of the calculation in the "A" calculation.
Hershfield J. held that the negative component was not a liability, but was properly excluded from the calculation because it was calculated "with reference to" liabilities in respect of segregated funds. The Minister unsuccessfully appealed the TCC judgment to the FCA.
The FCA's approach was slightly different than the TCC's approach. The FCA stated that the starting point for determining the "A" amount is to calculate the reported reserves and then the policy liabilities for those policies, which is an actuarial exercise yielding a calculation of liability in accordance with actuarial principles. This result is then subject to para. 1406(b), the purpose of which is to reconcile differential treatments under regulatory and income tax law.
The scheme of the Act concerning segregated funds is unique. The taxpayer successfully argued that its role in relation to segregated funds is bifurcated, between acting as an insurer and acting as a trustee for a segregated fund. The taxpayer's liabilities in relation to the segregated funds were in its capacity as a trustee, not an insurer. Consequently, it argued that it should not be allowed to claim a reserve for obligations in its capacity as a trustee. Thus, para. 1406(b) begins with the actuarially determined liability, then reduces it by the life insurer's liability to make "variable benefit payments" (which in this case were the minimum guarantee amounts in the third part of the "A" calculation). The negative amount in the second part of the "A" calculation was considered to relate to the taxpayer's obligation to make variable benefit payments. Consequently, the negative second part of "A" was to be excluded from the calculation of the MTAR.
The proposed amendment would modify para. 1406(b) to require the exclusion of "any liability to pay to a policyholder an amount out of a segregated fund."
According to the Explanatory Notes, policy reserves calculated under s. 1404 and 1405 of the ITR will include not only guarantees in respect of segregated fund policies, but also the portion of the policy reserves that relate to negative segregated fund policy reserves. The amendment is intended to apply to the 2012 and subsequent taxation years.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.