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:
Are , the net payments ("Swap Payments") or net receipts ("Swap Receipts"), as the case may be, from the settlement of Interest Rate Swaps considered in the determination of the "gross revenue" of a corporation ("Finco") from a principal business that is leasing as described in subsection 1100(16) of the Regulations?
Position TAKEN: No.
Reasons FOR POSITION TAKEN:
An interest rate 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.
No portion of the Swap Payments or the Swap Receipts, as the case may be, can be considered in the determination of, for purposes of the 90% test in paragraph 1100(16)(a) of the Regulations, gross revenue from the principal business of Finco. However, Finco's Swap Payments or the Swap Receipts, as the case may be, would, for purposes of the 90% test in paragraph 1100(16)(a) of the Regulations, be included in the determination of its gross revenue for the year from all sources.
October 30, 2003
XXXXXXXXXX TSO HEADQUARTERS
Large Business Audit Section P. Diguer
(613) 957-8953
Attention: XXXXXXXXXX
2003-003059
XXXXXXXXXX
This is in reply to your e-mail ("Request") dated February 12, 2003, addressed to the Technical Applications and Valuations Division, Compliance Programs Branch in which you request their views in regard to the meaning of the expression "gross revenue" for purposes of paragraph 1100(16)(a) of the Income Tax Regulations (the "Regulations") and clarification of the comments in paragraph 10 of Interpretation Bulletin IT-443, Leasing property-CCA Restrictions ("IT-443"). Your request was forwarded to the Rulings Directorate for reply.
In particular, you ask whether the expression "gross revenue" as it appears in paragraph 1100(16)(a) of the Regulations would be interpreted in such a manner that it would include a payment received on the settlement date from a swap counterparty under the terms of an interest rate swap arrangement in the situation described in your Request.
Facts
Briefly, it is our understanding that XXXXXXXXXX ("Finco") is a taxable Canadian corporation. Finco is in the business of purchasing retail loan contracts and retail lease contracts from XXXXXXXXXX dealers ("XXXXXXXXXX Leasing Business").
The purchase of a retail lease contract includes the assumption of title to the XXXXXXXXXX, such that Finco acquires ownership of the XXXXXXXXXX and receives the monthly lease payments directly from the dealers' customer. At the end of the lease, Finco receives the XXXXXXXXXX and may either dispose of it or re-lease it.
Finco is also in the business of providing inventory financing and mortgage loans to XXXXXXXXXX dealers ("Financing Business").
To obtain funds for its financing activities, Finco issues fixed rate debt of various terms (the "Debts"). In order to mitigate its interest rate risk, Finco will enter into interest rate swap arrangements ("Interest Rate Swap") with various swap counterparties. Under the terms of the Interest Rate Swap the swap counterparty agrees to pay an amount to Finco calculated as interest at a floating rate on a notional principal balance in return for Finco's agreement to pay an amount to the swap counterparty calculated as interest at a fixed rate on the same notional principal balance. On each settlement date, the resulting obligations are typically netted, such that there is one payment, either from the swap counterparty to Finco or from Finco to the swap counterparty.
In its financial statements prepared in accordance with generally accepted accounting principles, the net payments ("Swap Payments") or net receipts ("Swap Receipts") from the settlement of the Interest Rate Swaps are treated as an increase/reduction of interest expense. Although it is not indicated in the Request, we understand that, in computing its taxable income, Finco does not add/ deduct, as the case may be, on the T2-Schedule 1 the Swap Payments or Swap Receipts such that the interest expense reported in its financial statements is also the amount reported by Finco for tax purposes.
Finco's XXXXXXXXXX Leasing Business is its principal business. You indicate in the Request that if Finco excludes the Swap Payments or Swap Receipts, as the case may be, from its "gross revenue" it "would satisfy the criteria under paragraph 1100(16)(a) of the Regulations in that not less than 90% of its gross revenues would be from leasing activities.
You ask
Are Swap Payments or Swap Receipts, as the case may be, included in the "gross revenue" of Finco from a principal business that is leasing for purposes of paragraph 1100(16)(a) of the Regulations?
Analysis
Leasing Properties
Subsection 1100(15) of the Regulations limits the amount of capital cost allowance ("CCA") that can be claimed on leasing property owned by a taxpayer, with certain exceptions, in order to prevent a taxpayer from creating or increasing a loss to shelter non-leasing income. Regulation 1100(15) does not apply, by virtue of Regulation 1100(16), to a corporation whose principal business is renting or leasing of leasing property including property that would be leasing property were it not excluded under subsections 1100(18) [certain properties acquired before May, 1976], 1100(19) [non-arm's length and 55(3)(b) acquisitions] or 1100(20) [replacement property] of the Regulations, or the renting or leasing of such property combined with the sale and service of property of the same general type and description. Such a corporation will qualify for exclusion if its gross revenue for the year from such a principal business was not less than 90% of its gross revenue from all sources.
With respect to the expression "gross revenue", the Canada Customs and Revenue Agency ("CCRA") has stated in paragraph 10(c) of Interpretation Bulletin IT-443 as follows:
10. The term "gross revenue" is defined in subsection 248(1). The Department considers that for purposes of Regulation 1100(16)(a) "gross revenue" from the principal business referred to therein includes: (a) gross revenue from renting or leasing of property described in that Regulation or from the servicing of property of the same general type and description as well as royalty income from all such property; (b) proceeds from the sale of property described in that Regulation or property of the same general type and description; (c) interest and other financing charges incidental to the taxpayer's activities set out in (a) and (b) above, other than a money-lending business, and earned in the course of selling or leasing property.
(Our emphasis added)
A corporation must meet the requirements of paragraph 1100(16)(a) of the Regulations for each taxation year in respect of which it claims to be exempted from the CCA limitation. Whether the revenues from specific activities of a corporation can be considered part of gross revenues from the principal business of leasing for a particular taxation year in respect of which the corporation claims to be exempted from the CCA limitation is a question of fact.
Hedging
Interest rate swap
An interest rate swap agreement is a contract between two parties to exchange interest (coupon) payments on a specified notional principal amount for a specific term. No principal is exchanged, only interest flows. In a generic interest rate swap one party pays a fixed rate and the other party pays a floating rate. This exchange allows for conversion of variable rate funding to fixed rate exposure or fixed rate funding to variable rate exposure. The fixed swap rate is a market rate that approximates investment grade fixed rate borrowing levels. The floating rate is a short-term market rate based on a specific money market index (i.e., LIBOR).
Exchange of payments occurs at preset payment dates over a specified term (i.e., semi-annual payments for five years). Exchanges reflect differences between the fixed rate and each period's floating rate. The fixed and floating payments usually are netted and the counterparty owing the difference pays the net amount on the payment date.
Parties to an interest rate swap take on potential credit exposure to one another.
Tax treatment of interest rate swap
The CCRA is of the view that a borrowing and a financial derivative such as an interest rate swap 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. Additionally, CCRA has stated that the relationship between the parties is not that of lender-borrower. No debt exists on which interest could be paid.
The CCRA's views on the appropriate treatment for tax purposes of interest rate swaps are set out in its response to question # 60 at the 1984 Canadian Tax Conference ("CTF") and again in response to question # 11 at the 1993 CTF (see also ATR-4 dated November 29, 1985) and remain unchanged. In this regard, CCRA indicated the following at the 1993 CTF:
1993 CTF
Question # 11.
...
Department's Position
All amounts payable or receivable pursuant to an interest rate swap agreement will be considered to be on account of income and will be included in or deductible from the income of the taxpayer pursuant to section 9 of the Act.
The use of any underlying borrowed funds is no longer relevant in determining the treatment for income tax purposes of the amounts payable or receivable pursuant to the interest rate swap agreement.
(our emphasis added)
Turning to the case at hand, we have been provided with only limited information. In order provide a comprehensive opinion in respect of the specific situation described in the Request we would require additional information.
For example,
? We have not been provided with any information concerning the amount of income in the relevant taxation years from the Finco's two businesses; (a) XXXXXXXXXX Leasing Business and (b) Financing Business.
In particular, it may be necessary to determine what the proportion of the aggregate amount of the net payments or net receipts to Finco from the settlement of the Interest Rate Swaps is attributable to each of its two businesses. In this regard, while it appears that the XXXXXXXXXX Leasing Business may be a leasing activity to which subsection 1100(16) of the Regulations may apply, its Financing Business would not, in our view, be a such an activity nor would it be considered to be a business of selling or servicing of property of the same general type and description.
? It is not evident from your Request whether Finco is a "financial institution" referred to in the definition of "restricted financial institutions" in subsection 248(1) or subsection 142.2(1) of the Income Tax Act (Canada) (the "Act").
? The aggregate amount of the Swap Payments by Finco and the Swap Receipts to Finco for each relevant year as well as the proportion of this amount that is attributable to each of its two businesses have not been provided.
In this regard, it is not evident from your Request that any of the funds obtained by Finco on the issuance of its Debts are used for its XXXXXXXXXX Business. If substantially all the Interest Rate Swaps were prompted by Debts incurred to obtain funds for its Financing Business, the Swap Payments and the Swap Receipts would not be relevant to the determination of Finco's gross revenue from its principal business of XXXXXXXXXX Leasing, regardless of our conclusion in this matter. However, they are, as indicated below, relevant to the determination of Finco's gross revenue from all sources.
? In computing its taxable income, what provision of the Act is Finco relying on as authority for the increase/ reduction of its interest expense to reflect the Swap Payments or the Swap Receipts, as the case may be?
Owing to the limited information our opinion in respect of the specific situation described in your Request may not be comprehensive. Nevertheless, we hope that it is of assistance to you.
Conclusion
As mentioned above in the CCRA's view, 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.
Accordingly, it is our opinion that no portion of the Swap Payments or the Swap Receipts, as the case may be, can be considered in the determination of, for purposes of the 90% test in paragraph 1100(16)(a) of the Regulations, gross revenue from the principal business of Finco. However, Finco's Swap Payments or the Swap Receipts, as the case may be, would, for purposes of the 90% test in paragraph 1100(16)(a) of the Regulations, be included in the determination of its gross revenue for the year from all sources.
We are not aware of any provision in the Act that would support Finco's current practice of increasing/reducing its interest expense to reflect the net payments or net receipts from the settlement of the Interest Rate Swaps.
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
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