13 February 2004 Internal T.I. 2003-0036081I7 - Termination payment interest rate swap

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.

Principal Issues: Are termination payments under an interest rate swap deductible?

Position: Yes

Reasons: The use of underlying funds is not relevant and in this situation there was no borrowing-strictly a speculative transaction

XXXXXXXXXX  TSO						HEADQUARTERS
	Large Case Files Section					Financial Industries Division
C. Tremblay
Attention:  XXXXXXXXXX 						(613) 957-2139

									2003-003608

Interest Rate Swap Termination Payments

This is in reply to your memorandum of August 27, 2003 and further to information sent to us on November 20, 2003 regarding the termination payments made by XXXXXXXXXX to XXXXXXXXXX under an interest rate swap agreement.

Facts

On XXXXXXXXXX entered into a Forward Rate Agreement (the "Interest Rate Swap") with XXXXXXXXXX in the notational amount of US $XXXXXXXXXX exchanging a floating rate for a fixed interest rate of XXXXXXXXXX%. The interest rate swap agreement was entered into in connection with the planned issue of debt securities under a Short Form Shelf Prospectus ("Prospectus"). The Prospectus allowed XXXXXXXXXX to issue up to US $XXXXXXXXXX of debt securities over XXXXXXXXXX years. However XXXXXXXXXX changed its plans and did not issue the debt securities and as a result no longer required the interest rate swap agreement. On XXXXXXXXXX terminated US $XXXXXXXXXX and on XXXXXXXXXX terminated the balance of US $XXXXXXXXXX paying a total of CDN $XXXXXXXXXX in termination fees (collectively: the "Swap Termination Payment"). On XXXXXXXXXX issued US $XXXXXXXXXX Senior Notes fixed at XXXXXXXXXX% due in XXXXXXXXXX years and this debt issue was not hedged.

Taxpayer's Position

The taxpayer reported the $XXXXXXXXXX Swap Termination Payment as a deductible expense under subsection 9(1) of the Act basing their position on our answer given to question 11 of the 1993 Round Table at the Canada Tax Foundation Conference (the "CTF"). XXXXXXXXXX also cited the 1994 memorandum 9415947 as support for their position.

TSO Position

You feel that the facts of the case can be distinguished from the 1993 Question and answer at the CTF and the memorandum quoted by XXXXXXXXXX since there was no actual borrowing to which the particular swap could be linked. In your view, the termination payments cannot be said to be a cost of interest and on account of income. Further, in your view, the long-term swap agreement constituted a capital asset with enduring benefit.

You specifically asked us whether the termination payments are on account of income or capital and if the amounts are considered capital are the amounts deductible under paragraph 20(1)(e) of the Act? In addition is Part XIII withholding tax required on the payments?

Our Comments

The use of the underlying funds has never been considered relevant in the determination of the tax treatment of amounts payable or receivable under an interest rate swap. 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, the CRA 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).

In the situation under review, the purpose of the forward rate agreement was to hedge the interest rate from a floating rate to a fixed rate of XXXXXXXXXX% in respect to a planned issue of debt securities. Generally in such a situation, it is prudent for a borrower to hedge the debt obligation since in the event that interest rates rise the amount that would be required to pay would be offset by the amount that would be received from the hedge. Although, in this instance, XXXXXXXXXX never issued the debt obligation, XXXXXXXXXX remained contractually liable pursuant to the swap agreement and thus was exposed to pay an amount representing the difference between the fixed rate of XXXXXXXXXX% based on the XXXXXXXXXX year XXXXXXXXXX% US Treasury Security on the $XXXXXXXXXX contract and a low floating rate. The date of maturity was set at XXXXXXXXXX and the amount determined was based on the forward rate index multiplied by the notational amount payable over XXXXXXXXXX calculations. In our view, XXXXXXXXXX had entered into a speculative adventure or an adventure in the nature of trade.

The criteria generally adopted by the courts, as stated in Johnston Testers Ltd. v M.N.R., 65 DTC 5069 (Exch .Ct.), are that if the termination payment either (a) creates a capital asset of enduring or permanent character as, e.g., plant, machinery, etc.; or (b) if it is a payment in respect of a capital asset in order to go out of business, it will be categorized as a capital expenditure, but if, (c), the commutation payment does not create a capital asset even though it is made in respect of a capital asset and the business or that part of it continues after such payment, and such payment was made for the purpose of such continuing business, then the payment will be categorized as an income expenditure.

We note that the courts have held that a termination payment is deductible as a current expense in situations where the payment was made, inter alia, to eliminate an onerous annual expense and for enhancing the income-earning potential of a continuing business. See, for example, Automatic Toll Systems (Canada) Ltd. v. MNR, (1974) DTC 6060 (FCTD)). The termination payment in that case was essentially made to gain freedom from an existing obligation that had become unsatisfactory in order to carry on the business more profitably.

As a hedge, an interest rate swap would normally fix a taxpayer's overall exposure to changes in interest rates when both sides of the hedge are considered but the swap transaction itself would normally afford the taxpayer with the opportunity to "win" or "lose" depending on the movement of interest rates (or exchange rates in the case of a currency swap). If an interest rate swap agreement is not entered into for the purpose of providing a hedge, or where there is no borrowing, the taxpayer's overall exposure to changes in interest rates is potentially unlimited but the swap transaction still affords the taxpayer with the opportunity to "win" or "lose" depending on the movement of interest rates.

In the situation at hand, our understanding is that XXXXXXXXXX did not enter into the transaction with the intention of making a profit. Unlike the situation in the Federal Court Trial Division decision Salada Foods v The Queen (74 DTC 6171), XXXXXXXXXX motivation for entering into the swap transaction was to guard against rising interest rates in respect of the proposed issue of debt at a floating rate of interest. XXXXXXXXXX was reducing the potential risk that floating interest rates would rise and they were effectively locking into a fixed rate. XXXXXXXXXX actions do not appear to have been motivated initially by a desire to make money in the financial futures market and was not acting in the same manner as a trader or dealer in a swap would. However, because XXXXXXXXXX did not proceed to borrow any money, XXXXXXXXXX was left with only a speculative instrument (the Interest Rate Swap) that was losing money.

Generally, payments under an interest rate swap, including termination payments are free from withholding tax because they are not themselves payments of interest.

We have reviewed the additional information submitted to us on November 20, 2003 with reference to the fees that XXXXXXXXXX charged XXXXXXXXXX on the issue of the XXXXXXXXXX% Senior Notes due on XXXXXXXXXX. It appears that a fee in the course of borrowing was indeed paid by XXXXXXXXXX to XXXXXXXXXX along with the balance of the termination fee. If XXXXXXXXXX had been charged only the balance of the termination fee in respect of the issue of the XXXXXXXXXX % Senior Notes, then a case could be made that XXXXXXXXXX should be amortizing a portion of that second termination payment over XXXXXXXXXX years in accordance with paragraph 20(1)(e) of the Act.

In summary, it is a long standing CRA position that there is no loan involved in an interest rate swap. A swap agreement is separate from the underlying debt for which the swap is being used to hedge its exposure under that debt. The relationship between the parties to the swap is not that of lender-borrower. As a result, no debt exists on which interest could be paid.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada 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. You should make requests for this latter version from Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

For Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch