2006 Ruling 2006-0196691R3 - 18(9.1): Deductibility of a "Penalty".

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 a payment made by a taxpayer as a penalty because of the repayment of the principal amount of a debt obligation before its maturity is deductible under subsection 18(9.1).

Position: Yes

Reasons:		The repayment will be in respect of the principal amount of the debt obligation that was an amount payable for property acquired by the taxpayer and the property or property substituted therefore is used by the taxpayer in the year for the purpose of gaining or producing income therefrom.

XXXXXXXXXX 								2006-019669

XXXXXXXXXX, 2006

Dear XXXXXXXXXX

Re Advance Income Tax Ruling
XXXXXXXXXX

This is in reply to your letters of XXXXXXXXXX, wherein you request an advance income tax ruling on behalf of the above-named taxpayer. We also acknowledge additional documents provided on XXXXXXXXXX, and additional information during our various telephone conversations (XXXXXXXXXX) in connection with your ruling request.

We understand that, to the best of your knowledge and that of the taxpayer involved, none of the issues involved in this ruling request is:

(a) dealt with in an earlier return of the taxpayer or a related person;

(b) being considered by a tax services office or a taxation centre in connection with a previously filed tax return of the taxpayer or a related person;

(c) under objection by the taxpayer or a related person;

(d) before the courts, or if a judgment has been issued, the time limit for appeal to a higher court has expired, and

(e) the subject of a previous ruling issued to the taxpayer or a related person by the Income Tax Rulings Directorate.

DEFINITIONS:

In this letter, the following terms or expressions have the meanings specified:

(a) "Act" means the Income Tax Act, RSC 1985 (5th supp.), c.1, as amended to the date hereof, and, unless otherwise indicated, all statutory references are to the Act;

(b) "adjusted cost base" has the meaning assigned by section 54;

(c) "affiliated persons" has the meaning assigned by subsection 251.1(1) ;

(d) "arm's length" has the meaning assigned by subsection 251(1);

(e) "B Group" means all corporations and other entities in the XXXXXXXXXX group, as more particularly described in paragraph 2(i) hereof;

(f) "Cash Consideration" has the meaning assigned by paragraph 5(i) hereof;

(g) "controlled foreign affiliate" has the meaning assigned by subsection 95(1);

(h) "CRA" means Canada Revenue Agency;

(i) "E Group" means all corporations and other entities in the XXXXXXXXXX group, as more particularly described in paragraph 2(ii) hereof;

(j) "foreign affiliate" has the meaning assigned by subsection 95(1);

(k) "GAAR" means the general anti-avoidance rule;

(l) "Parent" means XXXXXXXXXX, and is more fully described in paragraph 1 hereof;

(m) "Parent Notes" means collectively the Parent Senior Notes and the Parent Subordinated Senior Notes described in (n) and (o) below;

(n) "Parent Senior Notes" means the notes issued by Parent described in paragraph 3(ii)(a) hereof;

(o) "Parent Subordinated Senior Notes" means the notes issued by Parent described in paragraph 3(ii)(b) hereof;

(p) "Penalty" means the purchase price of the Parent Senior Notes and the Parent Subordinated Senior Notes (excluding accrued interest), as the case may be, in excess of their principal amount as referred in paragraph 15 hereof;

(q) "public corporation" has the meaning assigned by subsection 89(1);

(r) XXXXXXXXXX;

(s) "Revolving Facility" has the meaning assigned by paragraph 3(i)(a) hereof;

(t) "taxable Canadian corporation" has the meaning assigned by subsection 89(1);

(u) "Term A Loan Facility" has the meaning assigned by paragraph 3(i)(b) hereof;

(v) "Term B Loan Facility" has the meaning assigned by paragraph 3(i)(c) hereof;

(w) U.S. means the United States of America;

(x) "US Debts" means collectively the Parent Senior Notes and the Parent Subordinated Senior Notes, the Term A Loan Facility and Term B Loan Facility as referred in paragraph 3 hereof;

(y) "US Holding Co" means XXXXXXXXXX, and is more fully described in paragraph 2 hereof;

(z) "US LLC" means a limited liability company formed in the U.S. under the laws of the State of XXXXXXXXXX as referred in paragraph 11 hereof and is considered to be a corporation for the purposes of the Act; and

(aa) "US Pubco"; means XXXXXXXXXX, and is more fully described in paragraph 6 hereof.

Unless otherwise indicated in this letter, all dollar amounts referred to herein are in Canadian dollars.

Our understanding of the facts, proposed transactions, other representations and the purpose of the proposed transactions are as follows:

FACTS

1. Parent is governed by the XXXXXXXXXX and is a public corporation and a taxable Canadian corporation whose shares are listed on a prescribed stock exchange within the meaning of the Act. XXXXXXXXXX.

Parent is serviced by the XXXXXXXXXX Tax Services Office and files its income tax return at the XXXXXXXXXX Taxation Centre.

2. US Holdco is a XXXXXXXXXX corporation that is a resident of the U.S. and a non-resident of Canada for the purposes of the Act. US Holdco, a wholly-owned subsidiary of Parent, is a management holding corporation XXXXXXXXXX

XXXXXXXXXX.

All corporations in B Group and E Group are resident of the U.S. and non-resident of Canada for the purposes of the Act. US Holdco and the corporations in B Group and E Group are foreign affiliates and controlled foreign affiliates of Parent. The taxation year of US Holdco and other foreign affiliates of Parent end on the XXXXXXXXXX.

For the purposes of subsection 93(2), the exempt dividends received by Parent on the shares of US Holdco or shares for which such were substituted are approximately $XXXXXXXXXX.

US Holdco shares held by Parent constitute capital property as defined under section 54.

3. XXXXXXXXXX The purchase price of E Group, together with the payments of expenses and repayment of existing debts at the time of the acquisition, has been financed by Parent through:

(i) Debt financing consisting of secured first rank credit facilities of US$XXXXXXXXXX broken down as follows:

(a) a XXXXXXXXXX-year revolving variable-rate facility of US$XXXXXXXXXX (the "Revolving Facility");

(b) a XXXXXXXXXX-year variable-rate loan facility of US$XXXXXXXXXX (the "Term A Loan Facility"); and

(c) a XXXXXXXXXX-year variable-rate loan facility of US$XXXXXXXXXX (the "Term B Loan Facility").

(ii) A US$XXXXXXXXXX Parent Notes offering consisting of:

(a) US$XXXXXXXXXX of unsecured senior notes bearing interest at XXXXXXXXXX% and maturing on XXXXXXXXXX (the "Parent Senior Notes"), and

(b) US$XXXXXXXXXX of unsecured senior subordinated notes bearing interest at XXXXXXXXXX% and maturing on XXXXXXXXXX (the "Parent Subordinated Senior Notes").

(iii) The issue of XXXXXXXXXX new Class A subordinate voting shares for gross proceeds of US$XXXXXXXXXX.

The Term A Loan Facility, Term B Loan Facility, Parent Senior Notes and the Parent Subordinated Senior Notes (the "US Debts") can reasonably be considered to have been issued or incurred in relation to the acquisition of shares of US Holdco by Parent.

4. By reason of Parent not being required to repay more than XXXXXXXXXX% of the principal amount of the Parent Senior Notes and the Parent Subordinated Senior Notes within XXXXXXXXXX years of the date of their issue, the prospectus relating to the Parent Notes represented to the holders that interest paid or credited on the Parent Notes to non-resident holders will not be subject to Canadian withholding tax pursuant to subparagraph 212(1)(b)(vii).

5. On XXXXXXXXXX, Parent and US Pubco concluded a letter of intent in order to proceed with the definitive agreements pursuant to which US Pubco agreed to acquire from Parent all of the outstanding shares of US Holdco on terms and conditions set forth therein. Following the completion of the proposed transactions, Parent will receive from US Pubco for all of its shares of US Holdco:

(i) cash in the amount of US$XXXXXXXXXX (reduced by the debt assumed by US Pubco), subject to adjustments in respect of the working capital of US Holdco as more fully described in the definitive agreements (the "Cash Consideration"); and

(ii) XXXXXXXXXX common shares of the capital stock of US Pubco.

The parties also agreed that:

(i) Parent will have the right to elect XXXXXXXXXX of the XXXXXXXXXX board representatives to the Board of Directors of US Pubco;

(ii) Parent will be represented on the audit, compensation, executive and nominating a governance committees;

(iii) For so long as Parent owns at least XXXXXXXXXX% of the common shares of US Pubco, Parent will have a pre-emptive right on future issuances allowing it to maintain the same percentage of US Pubco common shares that it held prior to any issuance.

The parties contemplate to close the above transactions in XXXXXXXXXX.

6. US Pubco is a XXXXXXXXXX corporation that is a resident of the U.S. and a non-resident of Canada for the purposes of the Act. US Pubco is a widely held corporation whose common shares are listed on the XXXXXXXXXX Stock Exchange. XXXXXXXXXX.

ADDITIONAL INFORMATION

7. If all the conditions precedent to the definitive agreements are satisfied, an internal reorganization of US Holdco and its subsidiaries will be carried out prior to the proposed transactions described below in order to simplify the corporate structure and to facilitate the merger of US Holdco with US Pubco.

8. As at XXXXXXXXXX, the principal amounts of the Term A Loan Facility, the Term B Loan Facility, the Parent Senior Notes and the Parent Subordinated Senior Notes payable by Parent are the following:

U. S. $

(i) The Term A Loan Facility		XXXXXXXXXX 

(ii) The Term B Loan Facility		XXXXXXXXXX 

(iii) The Parent Senior Notes		   XXXXXXXXXX 

(iv) The Parent Subordinated Senior Notes		   XXXXXXXXXX 

The U.S. dollar-Canadian dollar exchange rate at the issuance of the above US Debts was US$1 equals CA$1.3292.

9. If the proposed transactions occur, Parent will be obliged to make an offer to purchase all the Parent Senior Notes and the Parent Subordinated Senior Notes at a pre-determined purchase price, plus accrued interest.

As part of the transaction between Parent and US Pubco described in paragraph 14 below, US Pubco contemplates to assume the Parent Subordinated Senior Notes. In this case, the Cash Consideration payable by US Pubco to Parent will be reduced by the amount of the Parent Subordinated Senior Notes assumed by US Pubco including any accrued interest.

PROPOSED TRANSACTIONS

10. If all the conditions precedent to the definitive agreements are satisfied, the following transactions will occur in the order presented below (unless otherwise indicated). It is expected that Parent and US Pubco will perform the transaction described in paragraph 14 below in XXXXXXXXXX. Parent cannot predict if it will realize a capital gain or a capital loss on this transaction since a portion of the proceeds of disposition is dependent on the fair market value of the XXXXXXXXXX common shares of US Pubco received as a consideration. Accordingly, the proposed transaction described in paragraphs 12 and 13 below are two proposals for achieving the disposition of all the shares of US Holdco to US Pubco. The two proposals are not alternatives but are specific courses of action dependent if an unrealized capital gain or capital loss is attributable to the shares of US Holdco immediately before the disposition.

11. Parent will form a new XXXXXXXXXX limited liability company ("US LLC") and will subscribe for XXXXXXXXXX units of the capital of US LLC for a nominal amount.

The limited liability agreement of US LLC will provide that each unit is entitled to one vote, to share rateably in dividends as and when declared by the board of directors and to share rateably in the assets of US LLC on its liquidation.

12. If an unrealized capital loss is attributable to the shares of US Holdco immediately before the transaction described in paragraph 14 below, Parent will transfer all of its shares of US Holdco to US LLC for no consideration and the transaction described in paragraph 14 below will be completed in the period ending XXXXXXXXXX days following such transfer.

Parent will sustain a capital loss on the disposition of its shares of US Holdco to US LLC. Parent will use such capital loss to offset its foreign currency gain realized on the settlement or extinguishment of the Term A Loan Facility, Term B Loan Facility, Parent Senior Note and the Parent Subordinated Senior Notes described in paragraphs 14 (if the Parent Subordinated Senior Notes are assumed by US Pubco) or 15 below.

13. If an unrealized capital gain is attributable to the shares of US Holdco immediately before the transaction described in paragraph 14 below, Parent will transfer all of its shares of US Holdco to US LLC in exchange for XXXXXXXXXX units of the capital of US LLC. This transaction will occur under subsection 85.1(3). US LLC will not dispose of the shares of US Holdco to a person (other than a foreign affiliate of Parent) with whom Parent is dealing at arm's length as part of the series of transactions or events that includes the proposed transactions described herein.

14. Parent will sell to US Pubco all of its units of US LLC in exchange for the Cash Consideration and XXXXXXXXXX common shares of US Pubco. As part of this transaction, US Pubco may assume the Parent Subordinated Senior Notes. In this case, the Cash Consideration payable by US Pubco to Parent will be reduced by the principal amount of the Parent Subordinated Senior Notes plus any accrued interest. Parent will be fully discharged of any obligations in connection with the Parent Subordinated Senior Notes and will not have to pay the corresponding Penalty. As a result or immediately after the transaction, US Pubco will become a foreign affiliate of Parent and US LLC will cease to be a person affiliated with Parent.

This disposition of units of US LLC will occur under subsection 85.1(3). US Pubco will not dispose of the shares of US LLC to a person (other than a foreign affiliate of Parent) with whom Parent is dealing at arm's length as part of the series of transactions or events that includes the proposed transactions described herein.

15. Parent will use the Cash Consideration received from the sale described in paragraph 14 above to purchase the Parent Senior Notes and the Parent Subordinated Senior Notes (if it is not assumed by US Pubco). Parent may also reimburse its Term A Loan Facility and Term B Loan Facility.

The Penalty for the repayment of the Parent Senior Notes or the Parent Subordinated Senior Notes are estimated at US$XXXXXXXXXX and US$XXXXXXXXXX respectively. Each Penalty will be computed as a function of the future interest that would have been payable on the Parent Notes had they not been re-purchased prior to maturity.

PURPOSES OF THE PROPOSED TRANSACTIONS

16. XXXXXXXXXX The purposes of the proposed transactions is to restructure the shareholding of Parent in US Holdco such that Parent will be able to defer the capital gain (if any) on the disposition of its shares of US Holdco or to realize capital loss attributable to it, in which case, such capital loss will be used to offset the capital gain triggered on the settlement of its US Debts.

RULINGS GIVEN

17. Based on the statement of facts and additional information, the proposed transactions and the purposes thereof, all as described herein, we confirm the following:

A. For a taxation year ending after the time of the payment of the amount of the "Penalty" as described in the definition and in paragraph 15 of the Proposed Transactions, the amount of the Penalty relating to that taxation year will pursuant to paragraphs 18(9.1)(e) and (f), be deemed to have been paid by Parent and received by the holders as interest on the Parent Senior Notes or the Parent Subordinated Senior Notes, as the case may be, and to have been paid or payable by Parent in that year as interest on the Parent Senior Notes or the Parent Subordinated Senior Notes, as the case may be, to the extent that the common shares of US Pubco or any other property substituted therefore is used by Parent in the year for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business. For this purpose, the amount of the Penalty is limited to the proportion of the Penalty paid that:

(a) the fair market value of the XXXXXXXXXX common shares of US Pubco at the time of the purchase of the Parent Senior Notes or the Parent Subordinated Senior Notes, as the case may be,

is of

(b) the principal amount of the Parent Senior Notes or the Parent Subordinated Senior Notes, as the case may be, purchased before maturity.

B. The amounts referred to in Ruling A above that shall be deemed to have been paid by Parent to a non-resident holder who deals at arm's length with Parent will be interest payable on a debt obligation for purposes of subparagraph 212(1)(b)(vii).

C. Since US LLC is considered to be a corporation for the purposes of the Act, the comments contained in Interpretation Bulletin IT-392 regarding the meaning of the term "share" for the purposes of the Foreign Accrual Property Income provisions of the Act would apply for the purposes of subsection 85.1(3). Therefore, that subsection will apply to the transfer of the shares of US Holdco to US LLC described in paragraph 13 above, and to the transfer of the units of US LLC to US Pubco described in paragraph 14 above.

D. Paragraph 85.1(3) will not apply to the disposition of the shares of US Holdco described in paragraph 12 above with the result that Parent will be deemed to have received proceeds of disposition equal to the fair market value of US Holdco shares pursuant to paragraph 69(1)(b).

E. Subsection 93(2) will apply to reduce Parent's loss, if any, arising on the disposition of US Holdco shares by the exempt dividends (approximately $XXXXXXXXXX) received by Parent on the US Holdco shares or shares for which such shares were substituted.

F. Parent's loss, if any, resulting from the disposition of its US Holdco shares as described in paragraph 12, will not be deemed to be nil because of subsections 40(3.3) and (3.4).

G. Subsection 245(2) will not be applicable as a result of the proposed transactions, in and by themselves, to redetermine the tax consequences confirmed in the rulings given.

The above rulings are subject to the limitations and qualifications set out in Information Circular 70-6R5 dated May 17, 2002 and are binding on CRA provided that the Proposed Transactions are completed by XXXXXXXXXX. The above rulings are based on the law as it presently reads and do not take into account any proposed amendments to the Act and the Regulations which, if enacted into law, could have an effect on the rulings provided herein.

OPINION

Provided that the proposed subsection 93(2) is enacted as proposed in February 27, 2004 draft legislation, the amount of the reduction of Parent's loss described in Ruling E above will be reduced by the capital gain determined under paragraph 39(2)(a) for the taxation year that includes the disposition of US Holdco shares by Parent in respect of the settlement or extinguishment of the US Debts which can be considered to have been issued or incurred in relation to the acquisition of the US Holdco shares by Parent.

COMMENTS

Nothing in this ruling should be construed as implying that the CRA has agreed to, reviewed or has made any determination in respect of:

(a) the adjusted cost base of the US Holdco shares to US LLC received as a result of the transfer by Parent of all of its shares of US Holdco to US LLC for no consideration, as described in paragraph 12 above,

(b) the fair market value or adjusted cost base of any property or the paid-up capital of any shares referred to herein, and

(c) any tax consequences relating to the facts and proposed transactions described herein other than those specifically described in the rulings given above.

An invoice for our fees in connection with this ruling request will be forwarded to you under separate cover.

Yours truly,

for Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch