26 October 2005 External T.I. 2005-0152201E5 - Positions in IT-114

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: Whether positions in paragraphs 11 and 16 of cancelled IT-114 are still valid

Position: General comments given

Reasons: N/A

XXXXXXXXXX 2005-015220
G. Moore
October 26, 2005

Dear XXXXXXXXXX:

Re: Interpretation Bulletin IT-114

This is in response to your recent enquiry about Interpretation Bulletin IT-114, Discounts, premiums and bonuses on debt obligations.

You have asked specifically about paragraphs 11 and 16 of the above-mentioned bulletin and whether the positions contained therein are still valid.

Our Comments

Paragraph 11, which was applicable to traders and dealers, generally provided that where the purchasing of debt obligations to resell or to hold until maturity either forms part of the taxpayer's ordinary business or constitutes a business in itself, the amount of any realized discount is included in computing the taxpayer's income. Similarly, the amount of any premiums was deducted in computing the taxpayer's income. Paragraph 16 of IT-114 related to investors and generally provided that if a taxpayer's activities can be classified as those of an investor, the amount of any realized discount or bonus is treated as a capital gain. Conversely, the amount of any premium was treated as a capital loss either at the maturity of the obligation or at the date of disposition thereof.

Issue premiums normally arise as a result of the establishment of the rate of interest on a debt obligation prior to its issue such that the rate so determined, exceeds the market interest rate for similar instruments at the time of its issue. Accordingly, the issuer is able to require the payment of a premium over and above the repayment obligation or face amount of the debt obligation. In economic terms, such an issue premium serves to adjust the interest yield to reflect the market yield currently being offered on similar instruments.

The courts have enunciated the general principle that money received for capital purposes constitutes a capital receipt. In this regard see Lomax (H. M. Inspector of Taxes) v. Peter Dixon and Sons Ltd, [1943] TR 221. CRA's view, as set out in paragraph 29 of Interpretation Bulletin IT-114, was that provided the issuer is not in the business of lending money, the amount of a premium on the issue of an obligation is not regarded as income. In effect, CRA generally considered a premium on the issue of an obligation in situations where the issuer is not in the business of lending money to be a payment on account of the capital of the issuer and as such was treated as a non-taxable receipt.

IT-114 was issued in 1973 and was never intended to cover the wide array of financial products currently available in the marketplace. With this in mind the Bulletin was cancelled on June 10, 1994. Some of the main concerns with the Bulletin relate to paragraph 3, and whether a discount is in fact interest, and paragraph 29, where it states "...in any other case the amount of a premium is not regarded as income". In response to question # 20 at the 1994 Association de Planification fiscale et financière (APFF) Conference Round Table, CRA explained that:

"Interpretation Bulletin IT-114, issued in 1973, was cancelled in full because it did not reflect significant changes to the Income Tax Act and was no longer a useful guide to the taxation of discounts, premiums and bonuses relating to a multiplicity of financial products that have changed considerably."

For example, the bulletin was issued before the introduction of the rules concerning prescribed debt obligations. The comments in the bulletin in respect of debts issued at a discount (treasury bonds) or with a bonus on maturity were no longer relevant taking these rules into account. The bulletin also contemplated obligations with a premium on issue by reason of a small variation between the interest rates on the obligations and prevailing market rates at the time of their issue. The comments relating to this type of premium were not considered appropriate for new types of financial transactions (e.g. weak currency borrowings).

Paragraph 38 of Interpretation Bulletin IT-533, Interest deductibility and related issues, states:

"Where debts are issued with a stated interest rate greater than prevailing market rates, the debt issuer will receive greater than 100% of the principal amount of the debt issue, i.e., a premium. Where the borrowed money constitutes stock-in-trade for some taxpayers in the financing business (e.g. money-lenders), the premium amount will be included in computing income under section 9. For other taxpayers it will generally be considered a non-taxable capital receipt. Where the premium arises because the debt was deliberately priced to give rise to a premium, the interest expense otherwise deductible will not be considered reasonable and will be reduced (with reference to the amount of the premium) over the life of the debt. Since the issue premium serves to adjust the overall yield to reflect the market yield currently being offered on similar instruments, it is the CCRA's position that the stipulated interest rate on the debt is in excess of a reasonable amount as determined for the purposes of paragraph 20(1)(c)."

We trust that these comments will be of assistance.

Yours truly,

Steve Tevlin
for Director
Financial and Exempt Entities Division
Income Tax Rulings Directorate
Policy and Planning Branch