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In Barejo Holdings, the Tax Court Considers Grey Areas


The characterization of an agreement as debt has many potential tax implications. It is often difficult to identify the key distinguishing characteristics of debt, equity and other types of financial instruments.

In the decision of the Tax Court of Canada in Barejo Holdings ULC v. The Queen, the Court was asked (upon application by the parties) to answer the specific question as to whether a particular derivative financial instrument constituted debt for purposes of the Income Tax Act (the “Act”).

In response to expected tax legislation changes in Canada, “SLT”, a controlled foreign affiliate of the Canadian taxpayer, had transferred a bundle of investment assets (the “Assets”) to the foreign subsidiaries of two Canadian banks. SLT immediately used the proceeds of the sale to purchase financial instruments, described by the parties as “Notes,” issued by other subsidiaries of the two banks. The Notes’ “principal amount” was defined to be their issue price, but the amount payable by the issuers was to be based on the value of the Assets at the maturity date. The Notes had an interest rate of zero. Each of the Notes were stated to rank pari passu with the issuers’ other unsecured obligations and were guaranteed by the parent Canadian banks. Under a related management agreement, the Assets were to be managed by an investment manager appointed by SLT. Although the Assets were to be valued on a weekly basis, it was impossible to ascertain the amount that would be payable under the Notes until the maturity date.

The Court’s approach was to first come up with a general meaning of debt as used in the Act, the second was to decide whether the Notes sufficiently met that meaning. The Court noted that it was clear from the terms of the Notes and related documents, they were a form of hybrid investment, having some of the characteristics of debt and some terms that were “quite far along the continuum of what one might generally expect in a common debt instrument”.

Rejecting the notion of a bright-line test, the Court indicated that it would be possible to characterize a particular instrument based on a weighing of various factors. The Court stated that particular instances of the term “debt” and other debt-related terms in the Act may have differing meanings, depending on the text and context of a specific provision or regime in the Act. It also noted that differences in the applicable law governing the particular agreements should be considered and evidence such as supporting or contradictory wording along with the intention of the parties should form part of the overall weighing process.

The Court then formulated a list of the “core essential characteristics of debt generally for purposes of the Act”:

  1. An amount or credit is advanced by one party to another party.
  2. An amount is to be paid or repaid by that other party upon demand or at some point in the future set out in the agreement in satisfaction of the other party’s obligation in respect of the advance (the possibility that the amount once ascertained may be a nil amount, need not disqualify the obligation).
  3. The amount described in ii. is fixed, determinable or will be ascertainable when payment is due.
  4. There is an implicit, stipulated or calculable interest rate (which may include zero).

The Court indicated that its intent was not to formulate an all-encompassing test: "all of these core essentials may not need to be perfectly met in particular circumstances.” Also, it was recognised that a particular financial instrument may be both a “debt” and something else; terms such as “debt”, “derivative” and “tracking property” as used in the Act are not mutually exclusive.

Then applying these criteria, the Court found that the Notes were debt for purposes of the Act:

  1. They were entitled “Notes”. The word “notes” is consistently used in the Act and in financial markets to describe debt obligations or indebtedness.
  2. They have a maturity date, upon which there is a payment obligation that relates (albeit in a complex fashion) to the amount for which the Notes were issued.
  3. The documents describe the amount for which they were issued as a “Principal Amount”.
  4. At maturity, the amount payable by the issuer under the Notes is readily ascertainable.
  5. An interest rate is stipulated in the Notes and it is reasonable to consider zero as an amount for these purposes.
  6. The parties agreed the Notes would rank pari passu with other debt.
  7. The guarantees provided that the guarantors would be liable as if they were primary debtors.

The Court rejected the taxpayer’s assertion that the Notes were not initially debt, but may become debt at maturity once they have an ascertainable repayment amount. The Court found little support for the premise that a contract can change from “not debt” to “debt”, distinguishing the cases cited by the taxpayer which dealt with liquidated and unliquidated damages claims.

Attempting to classify creative financial instruments using traditional terms such as “debt” can be a hazy and imprecise endeavor. The Barejo decision is notable because it makes it clear that:

  1. An instrument may be a “debt” without having a fixed and ascertainable principal amount.
  2. A derivative can also be a debt.

It is unsurprising that the Court in Barejo did not attempt to formulate any applicable “at all times” rules. The closest thing to a blanket statement made by the Court was its remark stating that the term “interest” is in almost all cases used exclusively in relation to a debt instrument.

The only thing that is clear then, is that the definition of debt is still unclear - distinguishing debt from non-debt instruments should continue to largely be a matter of considering multiple criteria and applying judgement about the appropriate weight that should be given to each factor.

For more information about the Barejo case and / or key distinguishing characteristics of debt, equity and other types of financial instruments, contact Jennifer Hanna, Business Advisor, International Tax Services at 403.537.7612 or [email protected].