CRA confirms that the substituted loan exception in s. 18(9.1)(a) does not apply re a prepayment penalty incurred in refinancing with another arm’s length lender

S. 18(9.1) may deem a penalty that can reasonably be considered to relate to the amount of interest that would have been payable on a loan for subsequent taxation years to be deductible interest in those years – subject to an exception that applies where the penalty can reasonably be considered to have been made respecting the substitution of the debt obligation. In confirming that this exception did not apply where a taxpayer incurred an early repayment penalty on one loan from a financial institution on refinancing it with the proceeds of a loan from another arm’s length financial institution , CRA stated that it considers that:

a penalty incurred by a taxpayer who borrows money from one arm's-length party to pay a pre-existing debt owing to another arm's-length party would not constitute a substitution of a debt obligation for the purposes of paragraph 18(9.1)(a).

Neal Armstrong. Summary of 31 May 2018 External T.I. 2018-0755631E5 under s. 18(9.1)(a).