30 September 2003 Internal T.I. 2003-0023137 - DETERMINING THE PENALTY AMOUNT

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 CCRA.

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

Principal Issues:

(i) Does subsection 18(9.1) apply to a penalty or bonus payment made on the early redemption of an outstanding debt obligation?

(ii) If yes in (i) above, how should the penalty or bonus payable be deducted (i.e. in the year paid or in future taxation years)?

Position TAKEN:

(i) Yes, 18(9.1) may apply to the payment to the extent that it otherwise meets the conditions set out in the subsection.

(ii) Treated as interest expense in the future taxation years in which interest would otherwise have been paid but for the early repayment of the debt obligation, subject to the global tests and annual tests discussed herein.

Reasons FOR POSITION TAKEN:

(i) Factual determination.

(ii) Subsection 18(9.1) provides that the amount payable described in paragraph 18(9.1)(d) (penalty or bonus payable) will be deemed paid as interest and may be deducted in future years to which the interest would have related but for the repayment of the debt obligation before its maturity, but only to the extent of the value (either present value or straight line are acceptable options) at the time of the payment of the interest that would otherwise have been payable in future years.

									September 30, 2003

XXXXXXXXXX  TSO						HEADQUARTERS
Large Business Audit Section					P.  Diguers

Attention: XXXXXXXXXX
2003-002313

XXXXXXXXXX

This is in reply to your memorandum dated June 06, 2003 in which you request our views in regard to the application of subsection 18(9.1) of the Income Tax Act (Canada) (the "Act") to a penalty or bonus paid because of the early repayment before maturity, by the above referenced taxpayer, of two classes of outstanding notes payable. We acknowledge the information provided in subsequent conversations in connection with your request (XXXXXXXXXX/Diguer), as well as additional correspondence.

Facts

1. XXXXXXXXXX ("Debtor") is a taxable Canadian corporation incorporated under the laws of Canada. Debtor is an XXXXXXXXXX company.

2. On XXXXXXXXXX, Debtor issued, under the terms of a purchase agreement (the "Purchase Agreement"), XXXXXXXXXX Notes (the "Notes") having an aggregate principal amount of $XXXXXXXXXX. The proceeds from the Notes were used to reduce the amount outstanding under an existing term facility. Debtor has not provided any information in connection with the use by it of funds obtained under the said existing term facility.

3. The Notes were issued under a trust indenture (the "Trust Indenture") made between Debtor and XXXXXXXXXX (the "Trustee"). The principal terms of the Notes and the Trust Indenture are as follows:

(a) The Notes were issued on XXXXXXXXXX and mature on XXXXXXXXXX. The Notes are denominated in Canadian dollars and are comprised of two classes; Class A Series Notes ("Class A Notes") in the aggregate principal amount of $XXXXXXXXXX and Class B Series Notes ("Class B Notes") in the aggregate principal amount of $XXXXXXXXXX.

(b) The Notes bear interest at the rate of XXXXXXXXXX% of the principal amount payable XXXXXXXXXX in each year commencing XXXXXXXXXX.

(c) On maturity of the Notes, the aggregate amount payable by Debtor is equal to the principal amount thereof and any accrued but unpaid interest thereon.

(d) The Notes are direct obligations of Debtor, are guaranteed by certain wholly-owned subsidiaries and are secured by Debenture/ Security Agreements, general assignments of book debts and pledge agreements provided by Debtor and each of the wholly-owned subsidiaries.

(e) The Notes are redeemable by the Debtor (section XXXXXXXXXX of the Trust Indenture) or by the note holder (section XXXXXXXXXX of the Purchase Agreement) at any time, subject to the conditions set out in the relevant documents.

(f) The Trust Indenture contains detailed covenants including covenants restricting the ability of Debtor and its wholly-owned subsidiaries from incurring additional indebtedness for borrowed money, to sell, lease, assign or transfer, abandon or convey any of its assets subject to certain exceptions. The Trust Indenture contains further provisions including specific consequences in the event of a change of control of Debtor ("Change of Control") or in an event of default by Debtor as set out in the Trust Indenture.

(g) The Change of Control provision provides that the Debtor must, within XXXXXXXXXX business days of the change of control, offer to redeem the Notes on the XXXXXXXXXX day after the event (the "Mandatory Redemption Offer") by making the following payment:

(a) in the case of the Class A Notes, payment ("Class A Redemption Payment") of the sum of:

(i) the principal amount of the Class A Notes or a portion thereof to be redeemed, multiplied by the Principal Conversion Factor (XXXXXXXXXX ) - [equals US$XXXXXXXXXX ];

(ii) the accrued interest thereon to the date of such redemption multiplied by the Interest Conversion Factor (XXXXXXXXXX ); and

(iii) an amount equal to the U.S. Make-Whole Amount [see paragraph (3(h) below], determined as of XXXXXXXXXX business days prior to the date of such redemption.

such sum of (i), (ii) and (iii) being payable in U.S. dollars, or
(Our emphasis added)

(b) in the case of the Class B Notes, payment ("Class B Redemption Payment") of the sum of:

(i) the principle amount of the Class B Notes or a portion thereof to be redeemed, and accrued interest thereon to the date of such redemption; and

(ii) a premium equal to the Canada Make-Whole Amount [see paragraph (3(i) below], determined as of XXXXXXXXXX business days prior to the date of such redemption.

(h) The expression "U.S. Make-Whole Amount" is defined in the Trust Indenture as follows:

"U.S. Make-Whole Amount" shall mean in connection with any redemption or acceleration of any Class A Series XXXXXXXXXX Note, the sum (whether positive or negative) of

(a) the excess, if any, of

(i) aggregate present value as of the date of such redemption or acceleration of each dollar of principal (in Canadian dollars) being redeemed or accelerated (multiplied by the Principal Conversion Factor) and the amount of interest (in Canadian dollars) (exclusive of interest accrued to the date of redemption or acceleration) (multiplied by the Interest Conversion Factor) that would have been payable in respect of such dollar if such redemptions or acceleration had not been made, determined by discounting such amounts in accordance with standard financial practices at the Reinvestment Rate from the respective dates on which they would have been payable over

(ii) XXXXXXXXXX % of the principal amount (in Canadian dollars) (multiplied by the Principal Conversion Factor) of the outstanding Class A Series XXXXXXXXXX Notes being redeemed or accelerated;

provided, however, that in no event shall the amount under (a) be less than zero,

plus

(b) the Settlement Amount deemed paid by (or less the Settlement Amount deemed received by) the holder of such Class A Series XXXXXXXXXX Note in connection with such redemption or acceleration,

such U.S. Make-Whole Amount to be paid in U.S. Dollars.

(Our emphasis added)

(i) The expression "Canada Make-Whole Amount" is defined in the Trust Indenture as follows:

"Canada Make-Whole Amount" means, in connections with any redemption or acceleration of Class B Series XXXXXXXXXX Note, the excess, if any, of

(i) aggregate present value as of the date of such redemption or acceleration of each dollar of principal being redeemed or accelerated and the amount of interest (exclusive of interest accrued to the date of redemption or acceleration) that would have been payable in respect of such dollar if such redemption or acceleration had not been made, determined by discounting such amounts from the dates on which they would have been payable at a rate equal to the sum of XXXXXXXXXX% plus the Government of Canada Yield calculated at 10:00 a.m. Toronto time on the Business Day which is XXXXXXXXXX Business Days prior to the redemption or acceleration over

(ii) XXXXXXXXXX% of the principal amount of the outstanding Class B Series XXXXXXXXXX Notes being redeemed or accelerated;

provided, however, that in no event shall the Canada Make-Whole Amount be less than zero.

(j) The expression "Settlement Amount" is defined in the Trust Indenture as follows:

"Settlement Amount" shall mean, with respect to the Swap [defined in the Trust Indenture as, inter alia, a cross-currency interest rate swap] related to any Class A Series XXXXXXXXXX Note, in determining the U.S. Make-Whole Amount, the net amount deemed paid or received by the holder of such Class A Series XXXXXXXXXX Note by reason of a termination (or deemed termination) of such Swap, which shall be an amount equal to the Settlement Amount as defined by the International Swap and Derivatives Association, Inc's standard 1992 Multicurrency-Cross Border Master Agreement (the "Master Agreement") where the parties have elected to calculate such amount in accordance with Second Method payment method (as defined in the Master Agreement) and Market Quotation payment measure (as defined in the Master Agreement) and payable in U.S. Dollars.

(k) The Notes and Trust Indenture are governed by the laws of the Province of XXXXXXXXXX.

4. Sometime in XXXXXXXXXX the majority shareholder of Debtor sold its shares of Debtor to another party resulting in a change of control, as defined in the Trust Indenture, and as a consequence the Mandatory Redemption Offer was triggered.

5. Following receipt of the Mandatory Redemption Offer the holders of the Class A Notes and Class B Notes exercised their right to repayment and as a result, on XXXXXXXXXX, Debtor redeemed all the issued and outstanding Class A Notes and Class B Notes. Debtor carried out the redemption by making the required Class A Redemption Payment and Class B Redemption Payment, as described in paragraph 3(g)(a) and 3(g)(b) above, (Class A Redemption Payment and Class B Redemption Payment collectively referred to as the "Redemption Payment") to the holders of the Notes.

6. Included in the Redemption Payment is, with respect to the Class A Notes, the U.S. Make-Whole Amount and with respect to the Class B Notes, the Canada Make-Whole Amount.

7. The aggregate amount of the Redemption Payments made by Debtor upon the redemption of the Class A Notes and Class B Notes was $XXXXXXXXXX (the "Mandatory Redemption Amount"). While there appears to be a discrepancy (XXXXXXXXXX)¹ it appears that, initially it was determined that the Mandatory Redemption Amount is comprised of the following amounts.

REDEMPTION AMOUNTS
CLASS A NOTES
CLASS B NOTES

TOTALS

PRINCIPAL
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
ACCRUED INTEREST
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
REDEMPTION PREMIUM*
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
TOTAL
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX

*The Redemption Premium equals the total of the Canada Make-Whole Amount [$XXXXXXXXXX ] and the US Make-Whole Amount [$XXXXXXXXXX ].

Central to the issue in the case at hand is the Redemption Premium.

8. Proceeds for the redemption of the Class A Notes and the Class B Notes were financed by use of funds drawn from an existing term facility that was increased by an amendment to the term facility's credit agreement with a syndicate of banks.

9. In computing income for its taxation year ending XXXXXXXXXX Debtor deducted, pursuant to section 9 of the Act, the aggregate of the Redemption Premium (Class A Notes and Class B Notes) in the aggregate amount of $XXXXXXXXXX on the basis that this amount constitutes an expense which was incurred for the purpose of gaining or producing income.

10. Following a review of Debtor's income tax return for the taxation year ended in XXXXXXXXXX the XXXXXXXXXX TSO sent a letter dated September 27, 2002 (the "Proposal Letter") to the taxpayer in which the XXXXXXXXXX TSO proposed to reassess Debtor's XXXXXXXXXX income tax return to deny the Redemption Premium on the basis that the Act does not provide for the deduction of this amount as a lump-sum in the taxation year in which it is paid. The XXXXXXXXXX TSO further proposed, in it's Proposal Letter, to allow the taxpayer to deduct, pursuant to subsection 18(9.1) of the Act, the Redemption Premium amortized (using the straight-line method) over the XXXXXXXXXX years that remained on the Class A Notes and Class B Notes at the time of their early redemption.

Taxation Year
Comments
$ Amount
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX

XXXXXXXXXX

11. The Debtor's representatives have made several submissions. In the most recent submission, the Debtor's legal representative from XXXXXXXXXX (the "Representative"), has stated that Debtor disagrees with the XXXXXXXXXX TSO's Proposal Letter. In particular, Debtor argues that:

(a) Sections 9 or 20(1)(e) apply

The Redemption Premium may be deducted pursuant to sections 9 or 20(1)(e) of the Act. However, Debtor wishes to co-operate fully with ... CCRA in resolving this matter as expeditiously as possible and so is prepared at this time to accept the deduction of the Redemption Premium by it as set out ... below in accordance with the provision of subsection 18(9.1) of the Act.

(b) In computing the amount that may be deducted pursuant to subsection 18(9.1) of the Act the Redemption Premium may be amortized (using the present value method) and deducted as follows:

Taxation Year
Amortization of Redemption Premium

XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX

(c) The requirements of the second mid-amble of subsection 18(9.1) of the Act

Under the provisions of that [the second mid-amble of subsection 18(9.1) between paragraphs 18(9.1)(d) and 18(9.1)(e) (hereinafter the "Mid-Amble")], the Redemption Premium is deductible by Debtor in computing its income for at taxation year ending after XXXXXXXXXX:

(i) to the extent that the Redemption Premium can reasonably be considered to relate to an amount (the "Related Interest Amount") that, but for the early redemption of the Debenture on XXXXXXXXXX would have been paid or payable by Debtor as interest on the Debenture for such taxation years; and [provided]

(ii) the amount of the Redemption Premium deducted by Debtor in such a taxation year does not exceed the value (the "Value Amount") as at XXXXXXXXXX of the Related Interest Amount that would have otherwise been paid or payable by Debtor on the Debenture in such taxation year.

(Our emphasis added)

XXXXXXXXXX TSO's position:

? The Redemption Premium constitutes a payment described in 18(9.1)(d) such that subsection 18(9.1) applies to the Redemption Premium.

? Agrees with the Debtor's view that the provisions of subsection 18(9.1) allow the amortization of the Redemption Premium on a present value basis.

? Disagrees with the taxpayer's method of amortization of the Redemption Premium. Rather, the Redemption Premium should be amortized over the remaining term of the debt obligation [see Rulings document No. 9503766].

? The amortized amount [computed by the TSO] reasonably relates to the interest of the remaining term. In this regard, the Redemption Premium represents the compensation for the interest rate spread between the Notes' interest rate (XXXXXXXXXX %) at the time of their issuance and the interest rate available on the financial markets at the time the default occurred in XXXXXXXXXX (when the reinvestment interest rates were XXXXXXXXXX % - XXXXXXXXXX %). This means that Redemption Premium relates to the entire remaining term of the loan.

? The appropriate methodology for amortizing the Redemption Premium should be based on the interest rate spread over the original remaining period of the Notes. However, the taxpayer believes that they are entitled to take a very broad interpretation of subsection 18(9.1) such that it is appropriate to amortize the Redemption Premium based on the entire amount of interest that would have been payable in each of the subsequent periods based on the original terms of the Notes and not just on the amount relating to the interest rate spread. The taxpayer's present value amortization method would result in the Redemption Premium being amortized within XXXXXXXXXX years and not the remaining XXXXXXXXXX years of the term.

You ask:

(a) Is the taxpayer's method of amortizing the Redemption Premium based on the entire interest payment in each of the periods subsequent to the default date acceptable under subsection 18(9.1)?

(b) If no in (a) above, is the present value discounting method a reasonable approach for the amortization of the Redemption Premium or is there a preferred method that should be used?

(c) Clarify what is the Canada Customs and Revenue Agency's (the "CCRA") interpretation of the following terms and phrases:

(i) value;
(ii) paid or payable;
(iii) in respect of; and
(iv) relate to,

in the context of subsection 18(9.1).

Our comments

We have grouped our comments under the following three headings:

(A) Subsection 18(9.1);

(B) The Penalty Amount; and

(C) Recharacterizing the components of the Redemption Premium

(A) - Subsection 18(9.1)

The law

Subsection 18(9.1) provides, in part, as follows:

(9.1) Penalties, bonuses and rate-reduction payments

Subject to subsection 142.4(10), where at any time a payment, other than a payment that

(a) can reasonably be considered to have been made in respect of the extension of the term of a debt obligation or in respect of the substitution or conversion of a debt obligation to another debt obligation or share, or

(b) ... ,

is made to a person ... by a taxpayer in the course of carrying on a business ... in respect of borrowed money or on an amount payable for property acquired by the taxpayer (in this subsection referred to as a "debt obligation")

(c) ... or

(d) as a penalty or bonus payable by the taxpayer because of the repayment by the taxpayer of all ... of the principal amount of the debt obligation before its maturity,

the payment shall, to the extent that it can reasonably be considered to relate to, and does not exceed the value at that time of, an amount that, but for the ...repayment described in paragraph (d), would have been paid or payable by the taxpayer as interest on the debt obligation for a taxation year of the taxpayer ending after that time, be deemed,

(e) for the purposes of this Act, to have been paid by the taxpayer and received by the person ... at that time as interest on the debt obligation, and

(f) for the purpose of computing the taxpayer's income in respect of the business or property for the year, to have been paid or payable by the taxpayer in that year as interest pursuant to a legal obligation to pay interest,

(i) ... and

(ii) in the case of a repayment described in paragraph (d),

(A) where the repayment was in respect of all or part of the principal amount of the debt obligation that was borrowed money, except to the extent that the borrowed money was used by the taxpayer to acquire property, on borrowed money used in the year for the purpose for which the borrowed money that was repaid was used, and

(B) where the repayment was in respect of all or part of the principal amount of the debt obligation that was either borrowed money used to acquire property or an amount payable for property acquired by the taxpayer, on the debt obligation to the extent that the property or property substituted therefor is used by the taxpayer in the year for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business.

(Our emphasis added)

Jurisprudence

There is no jurisprudence available on point with respect to the application of subsection 18(9.1) in a situation where a taxpayer has made a payment of an amount in respect of a debt obligation as a penalty or bonus because of the repayment of the debt obligation before its maturity.

Analysis

The Act requires taxpayers to defer the deduction of prepaid interest [subsection 18(9)], as well as amounts such as interest rate buy-downs [subsections 18(9.1) and 18(9.2)] and early repayment penalties or bonuses [subsection 18(9.1)] which typically represent interest which would otherwise have been payable on the underlying debt obligation.

Payments that may be deductible under subsection 18(9.1) are, subject to paragraphs 18(9.1)(a) and 18(9.1)(b) thereof, described in paragraphs 18(9.1)(c) (i.e. interest rated buy downs) and 18(9.1)(d) (i.e. penalties or bonuses). Paragraph 18(9.1)(f) is the authority for the deductibility of payments described in 18(9.1)(c) and (d).

Where the conditions set out in subsection 18(9.1) are met, the payment is deemed for the purposes of the Act to have been paid and received at that time as interest on the debt obligation.

As such, other provisions of the Act may not apply. For example, paragraph 20(1)(e) [which provides for a deduction of certain expenses which are "not otherwise deductible"] would not apply to a payment described in either paragraph 18(9.1)(c) or (d).

Paragraphs 18(9.1)(d) refers specifically to payments made "as penalty or bonus payable by the taxpayer because of the repayment by the taxpayer of all or part of the principal amount of the debt obligation before its maturity" (the "Penalty Amount"). However, for an amount to be deductible under paragraph 18(9.1)(f), it is not sufficient that the payment be a Penalty Amount described in paragraph 18(9.1)(d).

In this regard, the Mid-Amble places two conditions on the deductibility of payments described in paragraphs 18(9.1)(c) and 18(9.1)(d). First, a payment is deductible only to the extent that it can reasonably be considered to relate to an amount that, but for the repayment of the debt obligation, would have been paid as interest by the taxpayer. Whether a payment may reasonably be considered to relate to an amount otherwise payable as interest is a question of fact. For example, consideration should be given to whether the payment is made in respect of the substitution or conversion of a debt obligation to another debt obligation or share. Second, the payment must not exceed the "value" at that time of an amount that, but for the payment, would have been paid or payable as interest on a debt obligation for a taxation year ending after the repayment by the taxpayer.

The Penalty Amount, or portion, if any, thereof, that meets the two conditions set out in the Mid-Amble (the "Eligible Penalty Amount") and that does not exceed the Value Amount of the interest that would have been paid by the taxpayer as interest in a future taxation year is deemed to be interest paid on the repaid debt obligation pursuant to paragraph 18(9.1)(e) and may be deducted pursuant to paragraph 18(9.1)(f) as interest expense in the said future taxation year.

In past discussions with the Department of Finance they informed us that the two conditions set out in the Mid-Amble are intended to apply to the total otherwise payable for the term of the obligation in future taxation years (i.e., note the reference in the Mid-Amble to "a" taxation year ending after that time) and to each taxation year that the taxpayer actually claims a deduction (note the reference in paragraph 18(9.1)(f) to the computation of the taxpayer's business or property income for "the" year.

In this regard, The Technical Notes to Bill C-18 prepared by the Department of Finance, dated May 30, 1991, implementing, inter alia, the 1990 and 1991 budget proposals state, inter alia, as follows.

New subsection 18(9.1) also applies to a bonus or penalty, paid in the course of carrying on a business or earning income from property, in consideration of the early repayment of all or part of a borrowing or an unpaid purchase price for property. The portion of such penalty or bonus that relates to and does not exceed the value, at the time that such penalty or bonus is paid, of a payment of interest that would otherwise have been paid by the taxpayer in a future taxation year on such debt, shall be treated as an interest expense for such future taxation year.

(Our emphasis added)

The Department of Finance has further indicated that from a tax policy perspective, it is intended that a taxpayer prorates the deduction of a bonus payment over the remaining term of the obligation (i.e. the portion that reasonably relates to each year). Furthermore, the amount deducted in any year is not to exceed the value of the interest that would otherwise have been deducted in that year (e.g. the value of interest that, but for the early repayment, would have been payable 3 years hence, say $1,000@ PVF in that 3rd year).

The Department of Finance has also indicated that taxpayers should not be in a better position with a large deduction in one year due to an early redemption. Any deduction for a penalty or bonus payable described in paragraph 18(9.1)(d) should be spread over what would have been the remaining term of the debt obligation, provided that the relevant portion does not exceed the value of the interest that would otherwise have been deducted in that future year.

Viewed from this perspective, in interpreting paragraph 18(9.1), the Mid-Amble sets out the "global tests" and the "yearly tests" are set out in 18(9.1)(f). Accordingly, the portion, if any, of the Eligible Penalty Amount (the Penalty Amount described in paragraph 18(9.1)(d) that meets the two conditions set out in the Mid-Amble) is, subject to the yearly test, prorated over the remaining term (but for the repayment) of the debt obligation. The prorated portion of the Eligible Penalty Amount is deductible pursuant to paragraph 18(9.1)(f) as interest expense in the future taxation year to which it relates.

Moreover, clauses 18(9.1)(f)(ii)(A) and (B) support Finance's view with respect to the deductibility of the Penalty Amount in future taxation years. Additionally, if subsection 18(9.1) were to be interpreted in the manner suggested by the Representative then it appears that clauses 18(9.1)(f)(ii)(A) and (B) would be redundant.

With respect to the Value Amount of an amount at the time of the repayment described in the Mid-Amble in subsection 18(9.1) the CCRA has indicated [see Rulings document No. 9503766] that both the straight line method and the present value method of amortization are acceptable for the purposes of subsection 18(9.1) (i.e. to apportion the amount of the penalty or bonus over the future years during which the debt obligation would have been outstanding).

Summary

To summarize, the Penalty Amount to which paragraph 18(9.1)(d) applies is the aggregate of all amounts that are payable as penalty or bonus by the taxpayer because of the repayment of the principal amount of the debt obligation before its maturity.

In determining the Eligible Penalty Amount that may be deducted under paragraph 18(9.1)(f), initially, the Penalty Amount is, subject to paragraphs 18(9.1)(a) and 18(9.1)(b), required to satisfy two conditions set out in the Mid-Amble.

First
The extent to which the Penalty Amount can reasonably be considered to relate to an amount that, but for the repayment of the debt obligation, would have been paid as interest by the taxpayer; and

Second

The Penalty Amount must not exceed the Value Amount at that time of an amount that, but for the repayment of the debt obligation, would have been paid or payable as interest by the taxpayer in future taxation years on the debt obligation.

The Eligible Penalty Amount may be deducted by the taxpayer as interest in the future taxation years to which the interest would have related but for the repayment, but only to the extent of the Value Amount (both straight line and present value are acceptable options) at the time of the payment of the Penalty Amount, of an amount that would otherwise have been payable as interest in future taxation years. In other words, the Value Amount of the future interest payments must be deducted over the term of the debt obligation as it existed before the repayment of the principal. The Value Amount of the Eligible Penalty Amount that relates to each future taxation year is deductible in that future taxation year.

B - Penalty Amount

With respect to the case at hand, the Redemption Premium, as described in paragraph 7 above, includes amounts that, do not appear to be, in our view, Penalty Amounts for purposes of paragraph 18(9.1)(d). Nevertheless, it is our understanding that the US Make-Whole Amount and the Canada Make-Whole Amount described in paragraphs 3(h) and (i) above, respectively, represent the present value of the interest rate spread between the original interest rate of the loan (XXXXXXXXXX %) and the reinvestment rate at the time of the repayment (XXXXXXXXXX % for Class A Notes and XXXXXXXXXX % for Class B Notes) and may be considered payments made by Debtor as a condition to repaying all of the principal amount of the Class A Notes and Class B Notes. Thus, it appears that the said Make-Whole Amounts may, subject to the two conditions set out in the Mid-Amble of 18(9.1), be Penalty Amounts.

However, as discussed with XXXXXXXXXX , we also have some concerns with respect to the amount [$XXXXXXXXXX ] reported by the taxpayer (see paragraph 7 above) as the U.S. Make-Whole Amount ((iii) above) in that it does not appear to have been computed in accordance with the terms set out in the Trust Indenture.

At our request, XXXXXXXXXX subsequently made further enquiries with the Debtor and in an e-mail to the Rulings Directorate dated July 25, 2003 (the "E-Mail"), confirmed that she had determined that, inter alia, the US Make-Whole Amount reported by the taxpayer included "other" amounts in addition to those specifically required to be included under the relevant definition (see paragraph 3(h) above).

Based upon this further review of the Redemption Payment, XXXXXXXXXX prepared an amended analysis of the Redemption Premium portion of the Mandatory Redemption Payment on the Notes as described in paragraph 7 above as follows:

Redemption Premium

Series A Notes:
Foreign Exchange on Principal			$XXXXXXXXXX
Foreign Exchange on Accrued Interest		       XXXXXXXXXX
Make-Whole Amount				       XXXXXXXXXX 		$XXXXXXXXXX

Series B Notes:
Make-Whole Amount 						    XXXXXXXXXX

Other
Waiver Costs							       XXXXXXXXXX
Bond Forward Settlement						       XXXXXXXXXX
Bank Fee								       XXXXXXXXXX
Bank Fee								         XXXXXXXXXX
Balance per G/L							$XXXXXXXXXX

Using the results of her analysis, XXXXXXXXXX determined that the components of the Class A Redemption Payment (paragraph 3(g)(a)) that comprise the Class A Notes Redemption Premium (paragraph 7 above) is as follows:

					Foreign Currency
					     Exchange		Total
(i) Principal Repayment	$  XXXXXXXXXX      $ XXXXXXXXXX     $ XXXXXXXXXX

(ii) Accrued Interest		$   XXXXXXXXXX    $  XXXXXXXXXX   $  XXXXXXXXXX

(iii) Make-Whole Amount					    $   XXXXXXXXXX

TOTAL			$XXXXXXXXXX 	   $ XXXXXXXXXX     $ XXXXXXXXXX *

* This amount reconciles to XXXXXXXXXX "Summary of Cashflows" for Series A.

However, XXXXXXXXXX analysis does not reconcile with the Class A Notes Redemption Premium reported in paragraph 7 above. With the aid of XXXXXXXXXX analysis of the aggregate Redemption Premium we have reviewed the material submitted and determined that the Class A Redemption Premium described in paragraph 7 above appears to be comprised of the following components:

Foreign Exchange on Principal	$XXXXXXXXXX
Foreign Exchange on Accrued Interest	       XXXXXXXXXX
Make-Whole Amount	       XXXXXXXXXX
Waiver Costs	       XXXXXXXXXX
Bond Forward Settlement	       XXXXXXXXXX
Bank Fee	       XXXXXXXXXX
Bank Fee	         XXXXXXXXXX
Total		$XXXXXXXXXX

Using XXXXXXXXXX analysis of the aggregate Redemption Premium as a point of reference we have considered the components of the Redemption Premium listed therein individually and offer the following comments.

Series A Notes Make-Whole Amount - $XXXXXXXXXX

XXXXXXXXXX set out in the E-Mail her analysis of the computation of the US Make-Whole Amount required under the terms of the Trust Indenture as follows:

COMPUTATION OF CLASS A REDEMPTION PAYMENT

(see paragraph 3(g)(a) above):

Pursuant to clause XXXXXXXXXX

XXXXXXXXXX

We agree with XXXXXXXXXX amended computation of the US Make-Whole Amount as described above.

Series B Notes Make-Whole Amount - $XXXXXXXXXX

COMPUTATION OF CLASS B REDEMPTION PAYMENT:

Pursuant to clause XXXXXXXXXX

XXXXXXXXXX

We accept for purposes of our review, the Representative's computation of the Canada Make-Whole Amount however, we have not further reviewed or otherwise examined this information.

Foreign exchange on the Class A Notes - $XXXXXXXXXX and $XXXXXXXXXX

We agree with XXXXXXXXXX comments in the E-Mail to the effect that while the Series A Notes were denominated in Canadian dollars, the payment by Debtor required under the terms of the Mandatory Redemption Offer, described in paragraph 3(g)(a)(i) above, in effect fixes the amount of the repayment of the principal amount (by way of a Principal Conversion Factor) in US dollars. This results in US investors receiving, under the terms of the Mandatory Redemption Offer, the full amount of their original US dollar outlay by using the exchange rate that was in effect at the time of the original issuance of the Class A Notes.

As discussed above, any penalty or bonus payable because of the repayment of the debt obligation before its maturity will, to the extent that it otherwise qualifies, be subject to subsection 18(9.1) of the Act. However, a gain or loss on a foreign currency exchange transaction would generally not be a penalty or bonus payable to which subsection 18(9.1) would apply. Rather, a foreign currency exchange transaction is viewed independently of the debt repayment to which it relates, and, as discussed below, the appropriate treatment of a foreign currency exchange gain or loss may only be determined once it is determined whether such gain or loss is on account of income or capital.

As stated in paragraph 1 of IT-95R Foreign Exchange Gains and Losses ("IT-95R"):

There are no provisions in the Act which specify whether a foreign exchange gain or loss is on account of income or capital. In determining whether such a gain or loss is on account of income, the basic principles of determining income from a business or property for purposes of subsection 9(1) of the Act must be applied. Thus the major problem in determining the income tax status of foreign exchange gains or losses is..., in the case of funds borrowed in a foreign currency, the use of the funds. A related problem is the determination of the method of accounting to be followed in reporting foreign exchange gains or losses for tax purposes.

(Our emphasis added)

Similarly, in determining the income tax status of a foreign exchange gain or loss where the borrowed funds are denominated in Canadian currency and are subject to repayment in a foreign currency at the exchange rate that existed at the time of the borrowing, we would generally consider the use of the funds.

In the present case, the Redemption Payments by Debtor under the terms of the Trust Indenture include the losses on foreign currency exchange transactions realized by Debtor in connection with the Redemption Payments. As stated above, the foreign currency exchange transactions are not Penalty Amounts, for purposes of paragraph 18(9.1) and moreover must be viewed independently of the debt repayment. Similarly, any hedging transactions in connection with the Notes must also be treated independently.

However, in the present case the proceeds from the Notes were used to reduce the amount outstanding under an existing term facility (see paragraph 2 above). Moreover, Debtor has not provided any information in connection with the use by it of funds obtained under the said existing term facility. Consequently, we are unable to determine the "use of the funds" in the present case.

As a cautionary note, certain comments in IT-95R Foreign Exchanges Gains or Losses dated December 16, 1980 do not reflect the CCRA's current views. In this regard, CCRA's current views are informed by subsequent decisions by the courts' including, Koontenay (92 DTC 6023), Friedberg (93 DTC 5507), and Canderel (98 DTC 6100), the substantial amendments to section 1650 of the CICA Handbook in 1983 and the CCRA at the 1984 Canadian Tax Foundation Annual Conference and in Income Tax Technical News No. 14 of December 9, 1998. Moreover, IT-95R does not address the issue of foreign exchange gains or losses involving hedging transactions. Therefore, while some of the general principles expressed in the bulletin are still applicable, including paragraphs 1 and 3 mentioned herein, certain positions expressed in the bulletin may not be relied upon as representing current law or the interpretative position of the CCRA in the area of the taxation of foreign exchange gains or losses.

In the event that you determine that all the proceeds from Notes were used to repay borrowed money under Debtor's existing term facility and the previously borrowed funds under the term facility were used (and the proceeds of the Notes used to repay the previously borrowed money were used continuously until their redemption described herein) in the ordinary course of Debtor's business operations, as indicated in paragraph 3 of IT-95R, any foreign exchange gain realized on the repayment of the Notes would be considered to be an income gain and any foreign exchange loss incurred on repayment of the loan would be considered to be an income loss.

Conversely, capital treatment will result where it can be shown that the borrowed funds form part of the permanent or fixed capital of the company, regardless of the use of the funds. Subsection 39(2) will apply where the foreign exchange gain or loss is on account of capital.

Other

We have not been provided with sufficient information at this time to provide you with our views on the additional expenses including Waiver Costs, Bond Forward Settlement and Bank Fees. However, it would appear that none of these amounts would constitute an amount that is a "penalty or bonus payable ... because of the repayment... of the debt obligation" for purposes of subsection 18(9.1).

Hedging

Foreign currency exchange risk

With respect to the bond forward settlement expense ($XXXXXXXXXX ) included in the Redemption Premium (see XXXXXXXXXX analysis above) and other hedging fees that may have been incurred by Debtor we offer the following additional comments.

Typically, businesses seek to limit their exposure to the many types of risk they encounter. In this regard, with respect to foreign currency risk, a business will generally manage such risk. Foreign currency risk may be managed in many ways.

Generally, a business exposed to a foreign currency risk on a principal amount or an interest amount will enter into a financial arrangement, typically a financial derivative, whereby it seeks to reduce or eliminate (i.e. hedge) its foreign currency risk. A financial derivative includes an arrangement undertaken under the terms of, for example, an option, a forward contract, a futures agreement or a swap agreement.

Inaction on the part of a business with respect to foreign currency risk is generally associated with "playing the market" and may be considered a form of speculation.

In the case at hand Debtor was, in the event of a triggering of the Mandatory Redemption Offer, obligated, under the terms of the Trust Indenture to repay the principal amount using the exchange rate that was in effect at the time of the original issuance of the Class A Notes. This condition left the Debtor exposed to a substantial foreign currency risk which ultimately resulted in requiring Debtor to make a $XXXXXXXXXX foreign currency exchange payment. On the basis of the information provided it appears that Debtor did not enter into any financial arrangement to reduce its exposure to this foreign currency risk on the principal amount. In this regard, we find Debtor's apparent inaction to be somewhat unusual given that Debtor or the Note Holders hedged (by way of cross-currency interest rate swaps) the interest payments on the Notes. It also appears that in XXXXXXXXXX Debtor hedged against increases in the interest rates in the intervening period to the time of pricing the note issue.

If Debtor did nothing to offset its exposure to the currency risk, it remains to be determined whether Debtor was in fact speculating (i.e. playing the market). Conversely, perhaps Debtor considered a "change of control" to be highly unlikely at the time of issuing the Notes and accordingly assessed the risk to be low. In any event, such a determination is relevant in determining the appropriate treatment, for tax purposes, as described in IT-95R and discussed above with respect to the foreign currency exchange payments.

Accordingly, we suggest that you confirm with Debtor that it undertook no steps to limit its foreign currency risk exposure on the principal amount and its reasons for not hedging its currency risk.

Tax treatment of interest rate swaps, currency swaps and forward contract

CCRA is of the view that a foreign currency borrowing and a financial derivative such as an interest rate swap, a currency swap and a forward contract, between the borrower and a counterparty are two separate transactions. In this regard, CCRA has also stated that a derivative agreement such as a swap is a contractual arrangement which is separate from any associated asset or liability for which it may be designed. Thus, any income earned or expense incurred from the swap or other financial derivative would generally not be considered as being derived from the associated asset or liability for which it may be designed to hedge (see document # 2000-0042885).

CCRA has set out its views on the appropriate treatment for tax purposes of three forms of swap agreements notably, currency swaps, interest rate swaps and forward agreements.

Currency swaps and interest rate swaps

CCRA's views on currency swaps and interest rate swaps are set out in its response to question # 60 at the 1984 Canadian Tax Conference (see also Q. # 11 at the 1993 CTF) and remain unchanged. This information may be relevant in the event that you determine that Debtor has entered into swap agreements in respect of the Class A Notes.

Forward agreements

CCRA's views on forward agreements is set out in its response to question # 63 at the 1984 Canadian Tax Conference and remain unchanged. In this regard, it continues to be our view, that any gain or loss on a forward agreement (determined at the time of contract fulfillment) will be characterized as on income or capital account depending on the underlying use of the funds that gave rise to the liability that the forward contract is designed to hedge. This information is relevant given that Debtor has included in the Redemption Premium (see XXXXXXXXXX analysis above) a forward agreement settlement payment in the amount of $XXXXXXXXXX .

Financing fees - paragraph 20(1)(e)

Subparagraph 20(1)(e)(i) of the Act provides for the deduction of an amount in computing the income of a taxpayer that is an expense incurred in the year... in the course of the ...issuance of shares of the capital stock of the taxpayer. Subparagraphs 20(1)(e)(ii), (ii.1) and (ii.2) further provide for the deduction of expenses incurred in borrowing money, incurring indebtedness or rescheduling or restructuring debt.

In the present case Debtor has included in the Redemption Premium bank fees in the amount of $XXXXXXXXXX and $XXXXXXXXXX (see XXXXXXXXXX analysis above). As indicated above, we have not been provided with sufficient information to determine the purpose of the bank fees. Should it be determined that these bank fees were paid by Debtor to the bank and they constitute an expense incurred in the course of borrowing money, incurring indebtedness or rescheduling or restructuring debt as described in subparagraphs 20(1)(e)(ii), (ii.1) and (ii.2) of the Act, paragraph 20(1)(e) may apply to permit a deduction by Debtor for the eligible portion, if any, of the bank fees.

Thus, it appears that only certain components of the Redemption Premium may be deductible under section 9 or paragraph 20(1)(e). As such, the Representatives assertions, as stated in paragraph 11 above, to the effect that the Redemption Premium is, in its entirety, deductible under either section 9 or paragraph 20(1)(e) is, incorrect. The fact that one or more amounts that comprise the components of the Redemption Premium, when viewed independently, may be deductible under either section 9 or paragraph 20(1)(e) does not permit, be it by mere association or by other means, the deduction of other components that are otherwise not deductible under the said provisions.

C - Recharacterizing the components of the Redemption Premium

The Redemption Premium described in paragraph 7 above includes amounts that may be considered penalty or bonus payments made by the Debtor as a condition of repaying all of the principal amount of the Notes and for purposes of paragraph 18(9.1)(d). However, the Redemption Premium also includes amounts that do not appear to be, on the basis of available information, Penalty Amounts for purposes of paragraph 18(9.1)(d).

Relying on XXXXXXXXXX analysis of the Redemption Premium described above, we conclude that the amounts comprising the Redemption Premium should, on the basis of available information, be recharacterized as follows:

Penalty Amounts for purposes of 18(9.1)

Class A Notes:

Make-Whole Amount $XXXXXXXXXX

Class B Notes:

Make-Whole Amount XXXXXXXXXX
$XXXXXXXXXX *

*The Eligible Penalty Amount deductible under paragraph 18(9.1)(f), will be determined based upon our comments set out above (i.e. subject to the global limits (Mid-Amble of 18(9.1)) and annual limits (18(9.1)(f) described above)

Assuming a XXXXXXXXXX % discount rate, we have for illustrative purposes, computed an estimate of the Eligible Penalty Amount deductible under paragraph 18(9.1)(f) by Debtor in the relevant taxation years to be as follows:

Class A Notes
Present Value Method
Taxation Year
Amount deductible
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX

Class A Notes, Straight line method

$XXXXXXXXXX per year

Class B Notes
Present Value Method
Taxation Year
Amount deductible
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX

Class B Notes, Straight line method

$XXXXXXXXXX per year

Section 9 or subsection 39(2) (to be determined - see comments above)

Series A Notes:
Foreign Exchange on Principal	$XXXXXXXXXX
Foreign Exchange on Accrued Interest		 XXXXXXXXXX

Section 9 or section 39 (to be determined - see comments above)

Other
Bond Forward Settlement	 XXXXXXXXXX 	$XXXXXXXXXX

Unknown (perhaps section 9 or other i.e. 20(1)(e))

Waiver Costs	$XXXXXXXXXX
Bank Fee		  XXXXXXXXXX
Bank Fee		    XXXXXXXXXX 	 XXXXXXXXXX
Balance	$XXXXXXXXXX

We would be willing to consider this matter further in the event that the taxpayer provides additional information.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. 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 electronic library version, or they may request a severed copy 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 (819) 994-2898. A copy will be sent to you for delivery to the client.

If you have any questions concerning this matter please feel free to contact us.

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

ENDNOTES

¹ See your Exhibit B, letter from XXXXXXXXXX . to CCRA dated November 19, 2002.