13 July 2001 Internal T.I. 2000-0051017 - STRONG CURRENCY BORROWINGS

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 periodic swap payments can be recharacterized as interest for purposes of Part XIII Tax.

2. Whether swap payments are on account of capital.

Position: 1. No
2. Yes

Reasons:

1. No borrower-lender relationship.

2. Characterization of the hedging gains and losses in respect of foreign currency borrowing would be derived from the characterization of the borrowing.

									July 13, 2001

	HEADQUARTERS		HEADQUARTERS
	Audit Directorate		Income Tax Rulings
				  Directorate
	Attn:  Len Lubbers		N.L. Storry
	          GAAR & Technical Support Section		957-3499

			2000-005101

Strong Currency Loan Hedged by a Cross Currency Interest Rate Swap

This is in reply to your memorandum of October 11, 2000, wherein you requested our views regarding payments made under a cross currency interest rate swap and whether such payments should be recharacterized as interest for purposes of Part XIII of the Income Tax Act (the "Act") when the desired currency was Canadian dollars and when the parties to the swaps and the underlying loans being hedged are all related. Alternatively, pursuant to the Supreme Court of Canada decision in Shell Canada Ltd. v. Canada, S.C.C. (99 DTC 5669), should the swap payments be considered as on account of capital.

Facts

XXXXXXXXXX

Our Opinion

In our opinion, recharacterizing the periodic swap payments by XXXXXXXXXX to XXXXXXXXXX as interest cannot be supported. The relationship between the parties is not that of lender-borrower. No debt exists on which interest could be paid. The payments are computed with respect to a notional principal amount; however, in our view this is not a sufficient basis to recharacterize the legal relationship that existed between the parties. As a result, the periodic swap payments made by XXXXXXXXXX to XXXXXXXXXX are not subject to part XIII tax under paragraph 212(1)(b) of the Act.

However, it is our view that the swap payments deducted by XXXXXXXXXX under section 9 of the Act were, in large part, incurred to acquire a right under contract to purchase Japanese yen at the termination of the swap agreement at a rate, which was much more favorable to XXXXXXXXXX than the exchange rate the market was predicting at the time the agreement was entered into. The cost of such a right would, in our view, be included in the computation of the gain or loss on a hedge in respect of the principal amount of the loan. Moreover, based on the Supreme Court decision in Shell, whether the gain or loss resulting from a hedging contract should be characterized as being on income or capital account depends on the characterization of the underlying debt obligation to which the hedge relates. Following the reasoning in Shell, since the underlying debt obligation to which the hedge relates was a XXXXXXXXXX-year loan, albeit used to finance working capital, the loss resulting from the hedge should be characterized as being on capital account. The cost incurred to acquire the hedge, in respect of the principal of a loan on capital account, would be a capital expenditure the deduction for which would be denied under paragraph 18(1)(b) of the Act. The portion of the periodic swap payments which could reasonably be considered to be in respect of a hedge against exposure to interest rate and foreign exchange rate fluctuations affecting payments of interest, would in our view be deductible as a payments on income account.

Paragraph 20(1)(e)

XXXXXXXXXX

In support of the view that paragraph 20(1)(e) does not apply in this case, certain case law suggest that for an amount paid to be viewed as an "expense" of the payer it must result in the diminution of its assets. Both Equitable Acceptance Corporation 64 DTC 5045 (Ex. Ct.) and Antoine Guertin Ltée 88 DTC 6126 (F.C.A.) deal with the interpretation of paragraph 20(1)(e) and the predecessor thereto in reference to premiums paid under life insurance policies which were used as security for borrowings. It was the interpretation of the court in Guertin that the premiums paid could not be considered expenses incurred in the course of borrowing money because an "expenditure must as such have had no consideration other than the loan, or in other words, it must be an expenditure resulting in a diminution of the borrower's property." The premiums paid under the life insurance policy could not be viewed as expenses for the purposes of paragraph 20(1)(e) on this basis because the cash payments gave rise to an asset of equivalent value in a different form (i.e., the insurance policy).

We suggest that by analogy to the insurance premium in Guertin, at the time the hedging contract was entered into, a large portion of the stream of payments to be made by XXXXXXXXXX to acquire a right under the contract to exchange $XXXXXXXXXX Canadian dollars into Japanese yen in the future, at a rate much better than the market was predicting, would have been expected to give rise to an asset, which at that time would have been equal in value to the present value of that portion of the stream of payments. Accordingly, based on the rationale in Guertin, that portion of the payments could not be considered "expenses" for the purposes of paragraph 20(1)(e) of the Act.

We would suggest that you resist any arguments that the taxpayer may make to the effect that our interpretation produces a result that is anomalous because the aggregate deduction under the taxpayer's interpretation would be roughly the equivalent of the interest that would be deductible had the taxpayer borrowed in Canadian currency at the Canadian rates. That is not what the taxpayer did and as stated in Shell, "unless the Act provides otherwise, a taxpayer is entitled to be taxed based on what it actually did, not based on what it could have done, and certainly not based on what a sophisticated taxpayer might have done."

If you have any questions regarding the above, please contact the writer.

We trust these comments will be of assistance.

for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch