11 April 2000 Internal T.I. 2000-0001327 - INDEX LINKED GIC CONTINGENT LIABILITY

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

1. Whether paragraph 18(1)(e) would apply to deny a deduction for "accrued interest" on an indexed linked GIC.

2. Where a taxpayer is required to mark to market the unrealized gains on index linked options for accounting purposes, can the taxpayer report the gains on such options on a realization basis for tax purposes?

Position:

1. Yes, based on our view that the "accrued interest" represents a contingent amount.

2. Consistent with our position with respect to mutual fund trusts, the taxpayer is entitled to use the realization method provided that the taxpayer reports income from all its derivatives using the realization method consistently from year to year.

Reasons:
1. The interest payable on the maturity of the index linked GIC is calculated based on any increase in the TSE 35 index over the term of the GIC.  Consequently, such amount cannot be determined until maturity.
2. Jurisprudence supports the use of the realization method.  Also, this is consistent with our position on the reporting of derivative income by mutual fund trusts.
		April 11, 2000

	TORONTO NORTH TAX OFFICE	HEADQUARTERS
J. Leigh
	Attention:  W.J. Carroll                   (613) 952-1505
	                Large Case File Manager
		2000-000132

XXXXXXXXXX
Deductibility of Estimated Index Linked Payment

This is in reply to your request of December 6, 1999, wherein you requested our views on the deductibility of interest expense on an index linked GIC and on the reporting of income on an equity linked option. These issues have arisen in connection with an audit of XXXXXXXXXX.

The facts as we understand them are as follows:

XXXXXXXXXX GIC

1. XXXXXXXXXX These GICs were offered as registered and non-registered investments. The non-registered GICs were issued by XXXXXXXXXX.

2. The interest on the GICs is payable on maturity and is calculated based on any increase in the TSE 35 index. The rate of interest is equal to the percentage increase in the index between the initial level and the final level. The initial level of the index is set at the close of the second business day after the date of purchase of a GIC, and the final level of the index is calculated by taking the average of the TSE 35 closing levels of each month during the final 12 months of the term of the GIC.

3. Customers who purchased the GICs are guaranteed to receive back the principal amounts invested. However, they are not guaranteed any minimum rate of interest, nor are they subject to a maximum rate of interest (subject to usury restrictions). The available terms for the GICs were three or five years.

4. In XXXXXXXXXX offered XXXXXXXXXX GICs, from the conservative mix with high saving and fixed income components, to the very aggressive mix with high growth components in the stock indices. Customers who purchased these mixed GICs are guaranteed a minimum interest.

Equity-Linked Options

5. The sales of the GICs were tracked on a daily basis. Once the exposure reached $XXXXXXXXXX completely hedged the exposure by paying a premium and purchasing TSE 35 call options with three and five-year terms from XXXXXXXXXX, a related entity, and arm's length third parties.

6. XXXXXXXXXX has the right to exercise an option, on a specified future date, at a stated price.

7. Upon the exercise of an option, XXXXXXXXXX will receive proceeds based on any gain in the TSE 35 index above a pre-determined exercise price.

Financial Reporting

8. You advise that XXXXXXXXXX is currently required under GAAP to mark-to-market the equity linked options that it has purchased.

9. For its XXXXXXXXXX fiscal year, XXXXXXXXXX reported for both accounting and tax purposes a mark-to-market increase in the value of the options purchased, based on the level of the TSE 35 index at fiscal year-end, which was offset by the increase in the amount it accrued on account of its interest obligations on the GICs.

You pose the following questions:

1. Is XXXXXXXXXX entitled to claim a deduction for tax purposes in respect of the interest accrued on the GICs in accordance with GAAP?

2. Would it be reasonable to accept that the mark-to-market increase in the value of the equity linked options could be reported on a realized basis?

Your views

Although adopting the GAAP presentation provided it represents a "truer picture" has been adopted by the courts in recent cases, you are of the opinion that this is provided that a specific provision of the Income Tax Act (the "Act") does not override such presentation. In this case, the accrued interest expense on the GICs is not fixed nor determinable until maturity and is therefore contingent in nature. Accordingly, you have proposed to disallow the accrued interest amount pursuant to paragraph 18(1)(e) of the Act.

With regard to the reporting of income on the equity linked options, the mark-to-market gains are a match against the accrued interest on the GICs. In your view, reporting these gains on a realization basis would achieve a "truer picture" for tax purposes.

Client's views

XXXXXXXXXX made a detailed submission in response to your proposal to disallow the accrued interest on the GICs. Briefly, XXXXXXXXXX submission included the following points:

• The purpose of issuing the GICs is for XXXXXXXXXX to obtain funding for its money-lending businesses at a reasonable cost. The effective funding cost for XXXXXXXXXX is the premium paid to obtain the equity linked options as the options hedge the equity-linked return. From business and economic perspectives, the GICs and the equity linked options are one integrated funding mechanism.
• Any gains or losses in respect of the equity-linked return and the equity linked options are recognized in an integrated manner by XXXXXXXXXX on a mark-to-market basis for both tax and financial reporting purposes, in accordance with GAAP. Since the marked-to-market equity-linked return was fully offset by any marked-to-market gains on the equity linked options, XXXXXXXXXX maintains that it did not in fact claim any interest deduction for fiscal XXXXXXXXXX.
• If the Agency disallows the deduction for the accrued interest on the GICs, XXXXXXXXXX has requested that it be allowed to use the realization method to report the gains on the equity linked options. By doing so, the deduction for the equity return would not be claimed until the year of maturity and the income inclusion for any gain on the equity linked options would be recognized in the year the gain is realized. XXXXXXXXXX contends that the adoption of the realization method would provide the truer picture of its income if the accrued interest on the GICs is disallowed.

Our views

We have consistently maintained both from the holder and the issuer's perspective that the "bonus" payable on maturity of an index linked debt obligation is a contingent amount. As a result, the rules in paragraph 7000(2)(d) of the Regulations would not apply to require the bonus to be reported on an accrual basis but rather the bonus is to be included in the holder's income in the year it is received or receivable pursuant to paragraph 12(1)(c) of the Act. From the issuer's perspective, our view is that the issuer would be entitled to a deduction under section 9 of the Act at the time the bonus became payable (i.e., on the maturity) provided the proceeds received by the issuer from the index linked obligation are used by the issuer for the purpose of earning income in the ordinary course of business.

In XXXXXXXXXX case, we are dealing with a similar instrument only it is completely hedged thereby fixing the cost of the instrument to XXXXXXXXXX. While we do not disagree that in economic terms any equity-linked return payable on maturity may be offset completely by any gains on the equity linked options, the GICs and the equity linked options are legally separate transactions and support for characterizing transactions based on their legal relationships has been reinforced by the Supreme Court in Shell Canada Ltd., 99 DTC 5699. The Supreme Court held that, absent a specific provision of the Act to the contrary, or the finding of a sham, a taxpayer's legal relationships must be respected. Accordingly, notwithstanding the economic reality argument put forth by XXXXXXXXXX, it is our view that XXXXXXXXXX did in fact claim a deduction in respect of the accrued interest on the GICs in computing profit under section 9 of the Act for fiscal XXXXXXXXXX.

The deductibility of any particular expenditure under section 9 of the Act is subject to other provisions of Part I of the Act. Paragraph 18(1)(e) of the Act precludes a deduction in respect of an amount as, or on account of a reserve, a contingent liability or amount or a sinking fund except as expressly permitted by Part I. Since it is possible that the TSE 35 index may suffer a decline from the initial level to the final level, there is a potential that no interest will be payable on maturity of the GICs and the customer would be entitled to a return of principal only. Accordingly, consistent with our position on bonus payable on index linked debt obligations, it is our view that the accrued interest claimed by XXXXXXXXXX on the GICs is a contingent amount and paragraph 18(1)(e) of the Act would apply to deny XXXXXXXXXX deduction for such amount.

Your second question concerns the use of the realization method to report the income on the equity-linked options for tax purposes. The issue of whether the use of the realization method or the mark-to-market method is appropriate for reporting derivative income is one that this Directorate has considered before but in the context of mutual fund trusts. The issue was referred to XXXXXXXXXX (The Queen v. Friedberg, 93 DTC 5507 (SCC), supported the realization method and Canadian General Electric Co. Ltd. v. MNR, 61 DTC 1300 (SCC), supported the mark-to-market method). The XXXXXXXXXX preferred the mark-to-market method XXXXXXXXXX but they acknowledged that existing jurisprudence supported the realization method. Our conclusion was to maintain the status quo and accept the use of either the mark-to-market method or the realization method for tax purposes provided that the mutual funds accounted for the derivatives using the same method consistently from year to year.

We note that there is nothing in the Act that requires XXXXXXXXXX to use the mark-to-market method to report the gains on the equity linked options for tax purposes since the mark-to market rules in the Act do not specifically cover derivatives. Consistent with our position with respect to derivative reporting by mutual funds, it is our view that XXXXXXXXXX is entitled to report the gains and losses on the equity linked options using the realization method provided that all its derivatives are accounted for using the realization method consistently from year to year.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Canada Customs and Revenue Agency's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version, or they may request a copy severed using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (613) 994-2898. A copy will be sent to you for delivery to the client.

We hope that our comments are of assistance.

F. Lee Workman
Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings Directorate

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