23 November 2005 External T.I. 2005-0156071E5 - deductibility of prepayments under s. 18(9.1)

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: Explanation of position in paragraph 7 of IT-104R3 requested.

Position: Prepayments are to be prorated over the remaining term of the debt obligation.

Reasons: Prepayments can reasonably be considered to relate to the whole term of the debt obligation.

									2005-015607
XXXXXXXXXX  								R. Albert
(613) 957-2100
November 23, 2005

Dear XXXXXXXXXX:

This letter is in reply to your October 25, 2005 correspondence concerning the application of subsection 18(9.1) of the Income Tax Act (the "Act").

You describe a hypothetical situation wherein a taxpayer borrowed money (the 'mortgage') in January 2004 to acquire an income producing property. The mortgage is to expire in December 2008 and interest thereon is and will be deductible each year in the ordinary course. The taxpayer retains the income producing property but prepays the mortgage in 2006 and must pay a prepayment penalty at that time equal to 6 months of interest. You have requested that we provide you with an explanation for the position, as described in paragraph 7 of Interpretation Bulletin IT-104R3 ("IT-104R3"), that such prepayments are to be prorated over the remaining term of the debt obligation.

Our Comments

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 70-6R5, dated May 17, 2002. Questions concerning completed transactions should be addressed to the local taxation service office. We are, however, prepared to provide the following comments which may be of assistance.

Canada Revenue Agency's longstanding view on the application of subsection 18(9.1) of the Act was originally reflected in paragraph 10 of Interpretation Bulletin 104R2, issued May 28, 1993, and, as you noted, is currently reflected in paragraph 7 of IT-104R3 which reads, in part: "Subsection 18(9.1) applies in certain cases to a penalty or bonus payable by reason of the repayment before maturity of all or part of the principal on an outstanding debt obligation. It may also apply to a fee or penalty paid to reduce the rate of interest payable on such an obligation. These amounts are considered prepaid interest and, provided the other requirements of paragraph 20(1)(c) are satisfied, are deductible in computing a taxpayer's income from business or property over the period that the interest rate is to be reduced, or over the period that would have been (but for the prepayment) the remaining life of the debt obligation."

We also make reference to file 2003-0023137 issued by this Directorate on September 30, 2003 wherein we state:

"...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.

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....

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."

The mid-amble of subsection 18(9.1) of the Act, in part, states: "the payment shall, to the extent that it can reasonably be considered to relate to,...an amount that, but for the ...repayment described in (d) [i.e., ...the repayment by the taxpayer of all or part of the principal amount of the debt obligation before its maturity], 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...". In our view, a prepayment penalty can 'reasonably be considered to relate to' interest that would have been paid for all the years that the obligation would have been outstanding if it had not been repaid earlier. It follows that a penalty paid on the early redemption of a debt obligation equivalent to the interest that would have been paid over a 6-month period, is reasonably considered to relate to and be deductible over the whole term of the debt obligation as compensation required by the creditor for the interest forgone over the whole term rather than just 6 months, even though the amount paid may be equivalent in dollar amounts to the interest payments of a 6-month period.

We trust that these comments will be of assistance.

Yours truly,

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