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: Where property is sold and the purchaser assumes debt as partial consideration, may the vendor, in computing the "proceeds of disposition", include an amount equal to a penalty amount (early termination penalty clause) that may become payable to the lender of the assumed debt by the debtor at some future time on the happening of an event that may or may not occur.
Position: General comments.
A contingent liability that may be triggered at some future time by the then current debtor is an obligation and not property and as such is not considered as part of the sale price of property sold and should not be included in computing the proceeds of disposition.
Reasons: In the present case the early termination penalty clause provides for a penalty to be imposed on the borrower in the event of repayment of the loan before maturity. This type of arrangement is a contingency, meaning that it is intended to apply on the happening of an event (the early termination) which is not certain to occur and in fact will not occur unless the borrower chooses to repay the debt before its maturity.
Where a purchaser assumes an existing debt as part of the sale price for property acquired, no repayment on the debt has occurred and as a consequence the early termination penalty clause would not be triggered. In circumstances where the early termination penalty clause has not been triggered, no amount is exigible by the lender from the borrower under the said penalty clause.
No amount is owing in respect of the contingent penalty clause on the assumed debt and therefore, no amount relating to the contingent liability should be added to the proceeds of disposition on the pretext that it a "debt" being assumed by the purchaser.
XXXXXXXXXX 2003-004493
P. Diguer, CGA
February 24, 2004
Dear XXXXXXXXXX:
Re: Assumption of debt
We are writing in response to your letter dated October 15, 2003 in which you request our confirmation that in computing the "proceeds of disposition" on the sale of a property the vendor may include an amount equal to a penalty amount on a debt assumed by the purchaser that may become payable to the lender by the borrower at some future time on the happening of an event that may or may not occur.
In particular you describe a situation where:
1. Xco and Yco deal with each other at arm's length for purposes of the Act.
2. Xco purchased real property (the "Land") in 19x1 for $600,000. Xco paid $ 100,000 cash and borrowed $500,000 secured by a "high rate" long-term mortgage (the "Mortgage") on the Land bearing a fixed interest rate of 12%. The Land was used by Xco for the purpose of earning income in its business.
3. The Mortgage contains an early termination clause whereby if Xco pays out the Mortgage prior to maturity then Xco must pay the lender a penalty (the "Penalty"). The Penalty is calculated as the difference in the net present value of interest payments the lender would receive from the Mortgage (12%) versus current market interest rates. The Mortgage is transferable.
4. As at January 1, 19x5, the fair market value of the Land, ignoring the Mortgage, was $1,000,000.
5. As at January 1, 19x5, the principal outstanding on the Mortgage was $400,000.
6. As at January 1, 19x5, the market interest rate for mortgages comparable to the Mortgage was 7%.
7. Based on current market interest rates and number of years remaining on the Mortgage, the present value of the difference in interest rates (and prepayment penalty which is referred to herein as the "Penalty") would be $150,000 if Xco were to pay off the outstanding principal on the Mortgage on July 1, 19x5.
8. It is contemplated that, on July 1, 19x5, Xco will sell the Land to Yco. Under the sale, Yco will assume the Mortgage and pay Xco $450,000 cash. Yco will use the Land in earning income from its business.
9. In your view, the fair market value of the Mortgage at the time of the sale is actually $ 550,000 rather than $400,000. In this regard you state that
The Penalty is calculated so as to ensure that the lender is entitled to receive the net present value of the payments it would have been entitled to receive had the Mortgage run to maturity. In other words, the Penalty reflects the current premium that a purchaser would pay for the Mortgage due to the Coupon Rate being higher than the Market Rate. In this case, the premium (Penalty) is $150,000 and we therefore submit that the fair market value of the Mortgage at July 1, 2003 is $550,000.
Taking the foregoing into account, we are of the view that Xco receives consideration of $1,000,000 for the Land. Specifically, Yco is assuming the Mortgage, which has a fair market value of $550,000 and is also paying $450,000 cash.
Additionally, it is your view that a purchaser of the Land who assumed the Mortgage would take into account the $150,000 present value of the above market interest that the purchaser would pay over the remaining term of the Mortgage (i.e., the "Above Market Interest").
You ask
Briefly:
(a) That we confirm that Xco's proceeds of disposition from the sale of the Land to Yco is $1,000,0000.
(b) What is the effect of Yco assuming the Mortgage?
(c) Is Yco entitled to deduct the entire "interest" component of the Mortgage payments if it assumes the Mortgage as partial consideration for the Land?
(d) What is the adjusted cost base ("ACB") of the Land to Yco?
The situation that is described in your letter appears to involve a series of completed transactions involving specific taxpayers. Written confirmation of the tax implications inherent in particular transactions are given by this Directorate only where the transactions are proposed and are the subject matter of an advance ruling request submitted in the manner set out in Information Circular IC-70-6R5 dated May 17, 2002. Where the particular transaction is completed, the inquiry should be addressed to the relevant Tax Services Office. Although we are unable to provide any opinion in respect of the specific transactions described in your letter, we have set out some general comments which we hope are of assistance to you. However, written opinions are not advance tax rulings and, accordingly not binding on the Agency.
(a) & (b) - Xco's proceeds of disposition and effect of sale on Y co
Disposition
A "disposition" is defined in subsection 248 of the Income Tax Act (Canada) (the "Act") to include any transaction or event entitling a taxpayer to proceeds of disposition of the property. The expression "proceeds of disposition" is defined in section 54 of the Act and includes the sale price of property that has been sold. Sale price would generally include an assumption by the purchaser, under the terms of the sale agreement, of debt owing by the vendor.
Debt owing = Borrower
A debt owing by a borrower is generally not considered property of the borrower rather it is an obligation of the borrower which must be repaid.
An early termination penalty clause similar to that which you describe in your letter provides for a penalty to be imposed on the borrower under the terms of a loan agreement in the event of repayment of the loan before maturity. This type of arrangement is a contingency, meaning that it is intended to apply on the happening of an event (the early termination) which is not certain to occur and in fact will not occur unless the borrower chooses to repay the debt before its maturity.
Where a purchaser assumes an existing debt as part of the sale price for property acquired, no repayment on the debt has occurred and as a consequence the early termination penalty clause would not be triggered. Consequently, no amount is exigible by the lender from the borrower under the early termination penalty clause on the assumption of the debt in circumstances similar to those described in your letter.
Subsection 18(9.1)
An early termination penalty payment may be deductible under subsection 18(9.1) of the Act. In this regard, 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" may be deductible under paragraph 18(9.1)(d) of the Act provided the conditions set out in 18(9.1) of the Act are met. As such, if the Mortgage is repaid before its maturity such that the early termination clause were triggered the Penalty amount paid by the borrower to the lender in such a circumstance may, subject to the payment meeting the other conditions set out in subsection 18(9.1) of the Act, be deductible by the borrower.
Debt receivable = Lender
As mentioned above, a debt owing by a borrower is generally not considered property of the borrower rather it is an obligation of the borrower which must be repaid. However, an amount receivable under the terms of a loan, by a lender, is property to the lender.
Property
The expression "property" is defined in section 248 of the Act as follows:
"property" means property of any kind whatever whether real or personal or corporeal or incorporeal and, without restricting the generality of the foregoing, includes
(a) a right of any kind whatever, a share or a chose in action,
(b) unless a contrary intention is evident, money,
(c) a timber resource property, and
(d) the work in progress of a business that is a profession.
Property includes, for example, a debt receivable, land and a marketable security. Property does not however, include, for example, an obligation such as an amount owing.
Fair market value of a property (i.e. a debt receivable)
The expression "fair market value" ("FMV") is defined as:
The price (cash or equivalent) that a buyer could reasonably be expected to pay and a seller could reasonably be expected to accept, if the property/ business were for sale on the open market for a reasonable period of time, both buyer and seller being in possession of all pertinent facts, and neither being under any compulsion to act.
The determination of the FMV of a property is a question of fact.
With respect to a contingent right such as the early termination penalty clause under the terms of a debt receivable such as described above, it is our view that such a contingent right would, generally, have little if any relevance in determining the FMV of the debt receivable by the lender, in and of itself, unless it was triggered or certain to be triggered.
Accordingly, in the situation described in your letter, it is our view that:
Xco's proceeds of disposition from the sale of the Land to Yco would be the aggregate consideration received which includes the assumption of the mortgage having a principal amount of $400,000 and $450,000 cash.
Accordingly, in the situation described in your letter, it is our view that:
? the proceeds of disposition received by X co would be $850,000 which is comprised of the aggregate of the consideration received which includes the assumption of the mortgage having a principal amount of $400,000 and $450,000 cash.
? The Mortgage assumed by Y co has a principal amount of $400,000. If Y co repays the Mortgage before its maturity and makes a payment under the early termination clause, the penalty payment in such a circumstance may, subject to its meeting the other conditions set out in subsection 18(9.1) of the Act, be deductible by Yco.
(c) Deductibility of interest where Y co assumes Mortgage payable by X co
Subparagraph 20(1)(c)(ii) of the Act applies to interest on an amount payable for property acquired for the purpose of gaining or producing income. This would include situations where a taxpayer has assumed another person's indebtedness as part of the purchase price of an asset acquired by the taxpayer. The finding of the purpose of gaining or producing income is a question of fact.
In the present case, interest paid on the Mortgage by Yco would generally be deductible provided Yco uses the Land in earning income from its business.
(d) Adjusted cost base of the Land to Yco
Applying the reasoning outlined above to the present case, in our view the adjusted cost base of the Land acquired by Y co will be $850,000.
We trust our comments will be of assistance to you.
Yours truly,
Steve Tevlin
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch
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