19 September 2008 Internal T.I. 2008-0272441I7 - GUILT LOCK DERIVATIVE

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: Is the termination payment on a Guilt lock on account of capital or income, and can 20(1)(e) apply?

Position: In our view the payment reflects the underlying transaction, namely the interest on the bond which would be deductible over the term of the bond.

Reasons: The Guilt Lock is a derivative hedge tied to a government bond based on the yield for a proposed issuance of a Eurobond.

 									September 19, 2008

     Edmonton Tax Services Office				HEADQUARTERS
	Audit Division - Large Files				Income Tax Rulings
								   	Directorate
	Attention : Glen Bowe					C. Tremblay, CMA
	            Large File Case Manager			(613) 957-8979
(819) 281-6906

									2008-027244

Gilt Lock Derivative

This is in response to your memorandum of March 17, 2008 and further to information submitted on July 9, 2008 requesting our views in respect of the tax treatment of a payment made to unwind a "Gilt Lock derivative", as described herein.

The facts as we understand them:

1. XXXXXXXXXX

2. In general terms, XXXXXXXXXX purchased a Gilt Lock derivative in XXXXXXXXXX . A Gilt is a UK Government bond that trades on the open market just as Canadian Government Bonds or Treasury Bonds do. The "lock" refers to the fact that the Gilt is the basis of the derivative; it is locked to the price of the Gilt. The Gilt Lock was renewed on a regular basis until XXXXXXXXXX , when it was unwound and a payment was made to XXXXXXXXXX . The initial hedge was rolled over multiple times due to severe problems in the UK credit market that made it impractical to issue the Eurobond as intended. By the time the market had recovered, XXXXXXXXXX had approved the acquisition of XXXXXXXXXX . So the intended Eurobond financing increased from £XXXXXXXXXX to £XXXXXXXXXX pounds to cover both the debt repayment and the new acquisition.

3. Specifically, the Board of Directors of XXXXXXXXXX approved the issuance of a £XXXXXXXXXX Eurobond on XXXXXXXXXX . The hedge transaction, the XXXXXXXXXX Gilt Lock, was entered into on XXXXXXXXXX . The £XXXXXXXXXX Eurobond was not issued due to unreceptive market conditions. On XXXXXXXXXX , the Board of Directors of XXXXXXXXXX rescinded the resolution to issue the £XXXXXXXXXX Eurobond. On XXXXXXXXXX issued a £XXXXXXXXXX Eurobond that was to mature on XXXXXXXXXX . The Guilt Lock was wound up on XXXXXXXXXX and XXXXXXXXXX was required to pay XXXXXXXXXX . The Canadian dollar equivalent of the payment is $XXXXXXXXXX .

4. XXXXXXXXXX has treated the payment as a deduction under paragraph 20(1)(e) of the Act and amortized the amount over XXXXXXXXXX years.

5. The risk hedged appears to be the interest rate risk and price risk. It does not appear to include a currency risk.

Our Comments:

We understand the tax return would have been statute-barred on XXXXXXXXXX , and you have issued reassessments disallowing the deduction claimed under paragraph 20(1)(e) of the Act and allowed a capital loss for the Gilt lock termination payment in XXXXXXXXXX . Accordingly, we will not provide a full analysis of all the different options that you have identified as possible tax treatment.

Over the last fifteen years or so, there has been a dramatic development in the number of types of derivative hedging arrangements and in the sophistication of such transactions.

A "Gilt Lock derivative" in the UK is similar to a treasury lock derivative in Canada that an issuer of a corporate bond or debenture would consider. Companies planning to issue fixed-rate debt are exposed to the risk of interest rate movements until the issue is priced. During that waiting period, issuers can choose to hedge the yield on the bond or treasury security on which the debt will be priced. A form of hedge is the Gilt Lock which enables issuers to secure current market rates for future fixed-rate funding. As the name implies, a Gilt Lock is used to "lock-in" the forward rate of a specific bond to a specified date in the future. The lock hedges only the underlying bond yield. To put a lock into place, the hedger selects an appropriate bond, sets the hedge maturity date (matched to the date when the issue is expected to come to market or the private placement is circled) and agrees to a lock rate. At the expiry date, the bond is settled. If interest rates rise during the hedge period, the cost of the company's debt issue will be higher. However, the bond will be higher than the lock rate, and the cash payment from the intermediary will help offset the costs of financing. If interest rates fall during the hedge period, the rate on the new financing will be lower, but the bond will be lower than the lock rate. This triggers a cash payment to the intermediary which brings the hedged yield up to the company's original target. For large debt issues, companies frequently set locks in increments, minimizing the odds of locking-in at a temporary market high point. Hedging one-third to one-half of the principal amount of a proposed debt issue at a time eliminates rate risk on a significant portion of the debt. In a Gilt Lock, the contract fulfillment occurs when a counterparty pays the other counterparty. There are no up-front costs, it can be unwound or terminated at any time, and until the bond is issued, no payments are required but should the bond not be issued and cancelled, the lock remains.

In our view, the Gilt Lock is not a cost of financing; it is a derivative hedge against the yield on the proposed bond to be issued. The purchase of the derivative is aimed at reducing the interest on the bond. It is not incurred in the course of borrowing money as required under subparagraph 20(1)(e)(ii) of the Act, thus, in our view, the derivative termination payment does not qualify for the five year amortization.

We examined the words "in the course of borrowing" because the taxpayer representative, XXXXXXXXXX , argued that the decisions in MacMillan Bloedel (90 DTC 6219) and Yonge-Eglinton (74 DTC 6180) are on point. We disagree. In the Macmillan -Bloedel decision, the judge stated:

"... when one carefully analyzes the situation, there are, from a business and accounting view, two transactions. There was a loan obtained by the plaintiff in the United States. When the funds became available, there was another transaction: the obtaining of Canadian funds. The loss on the second transaction was, in my view, an expense incurred in the course of borrowing the U.S. funds.

Mr. Culver, in his evidence in chief, described the foreign exchange loss as a "cost", but seemed unwilling to characterize that cost as an expense. I so characterize it; and deductible under the subparagraph of the statute. Quite apart from accounting techniques or principles, it seems to fall clearly within subparagraph 20(l)(e)(ii)."

The CRA considers that the decision reached by the Federal Court in the MacMillan Bloedel case is limited to the particular facts of that situation. At the 1994 Round Table, we stated: "We are not prepared to adopt as a general position that foreign currency gains or losses that arise as the consequence of the sale of a currency pursuant to the exercise of a forward contract would be an expense incurred in the year in the course of borrowing money for purposes of paragraph 20(1)(e). In particular we have difficulty characterizing a gain as an expense incurred in the course of borrowing money."

In the Yonge-Eglinton case, however, the Minister had disallowed amounts claimed as expenses by a borrower of money which, under the terms of the contract with the lender, it was required to pay over and above its payments of interest on the money borrowed. Those amounts were calculated as one per cent of its gross rental income in each year in which it showed a net profit from the operation of a building, for a period of twenty-five years. Judge Thurlow, speaking for the majority of the court, found that the annual payments were not bonuses in the sense used in clause (iii) of paragraph 11(1)(cb) but were simply a part of the consideration for a commitment to lend money on certain terms when and if called upon to do so. The payments were thus held to be deductible under clause 11(1)(cb)(ii) under the old Act (now subparagraph 20(1)(e)(ii) of the present Act).

We also looked at other cases for guidance. In the Riviera Hotel Company Ltd. v MNR decision (72 DTC 6142), the deduction was denied because the payment was not made in the course of borrowing money from the first lender but it was made in the course of repaying that money.

Neonex International Ltd. v the Queen (78 DTC 6339) is also of interest. In Neonex International Ltd, decided in 1978 by the Federal Court of Appeal, it was held that a bond paid to an insurance company in order to obtain discharge from a debt and borrow a larger amount from another lender was not deductible under subparagraph 20(1)(e)(ii) of the Act. The expense was not regarded as "incurred in the year... in the course of borrowing money", but as resulting from the payment of money borrowed from a prior lender. Accordingly, it did not fall squarely within the conditions of the exempting subparagraph 20(1)(e)(ii) of the Act. In denying the deduction, the court relied on the decision in Riviera Hotel Co Ltd.

The Supreme Court in Shell Canada (99 DTC 5699) confirmed, and created powerful authority for, the proposition that the character of a gain on a hedging contract should be the same as the character of the underlying transaction being hedged. In the case at hand, the underlying transaction is the bond issue and what is being hedged is the interest component or yield on that bond.

Case law exists to support the view that the concept of an "expense incurred in the course of borrowing money" is very broad: see Young-Eglinton 74 DTC 6180 (F.C.A.); MacMillan Bloedel 90 DTC 6219 (F.C.-T.D.), and Sherway Centre 98 DTC 6121 (F.C.A.). However, in Sherway Centre and Yonge-Eglinton, the issue was the deductibility of a commitment fee paid to the lender as a service for the lender making the credit facility available, which is not the issue in the case at hand. In addition, as noted above, the CRA considers the decision of the Federal Court in MacMillan Bloedel is limited to the particular facts of that situation.

As emphasized by the preamble to subsection 20(1) of the Act, there must be a clear connection between the amount to be deducted and the source of the borrowing.

In the case at hand, there are two transactions: the first, a hedge to fix a yield on a bond and the second, an issuance of a bond (i.e., the borrowing).

As such, in our view, the $XXXXXXXXXX Gilt lock termination fee paid by XXXXXXXXXX , if looked at in isolation within the context of the Agreement, was not an expense incurred by it in the course of borrowing money, incurring indebtedness or rescheduling or restructuring debt as described in subparagraphs 20(1)(e)(ii), (ii.1) and (ii.2) of the Act. Accordingly, in our view, paragraph 20(1)(e) of the Act does not apply to permit a deduction by XXXXXXXXXX for the payment.

Paragraph 16 of IT-341R4, Expenses of issuing shares, units in a trust, interests in a partnership or syndicate and expenses of borrowing money, lists expenses that the CRA considers to be incurred in the course of borrowing money. Although this is not an all exhaustive list, it does give some guidance as to the type of expenditure that we feel is contemplated under subparagraph 20(1)(e)(ii) of the Act, being in the nature of a fee paid for services provided in the course of borrowing money.

The CRA position is to treat a "hedge cost" or "hedge premium" as inherent in the determination of any gain or loss on the derivative contract, which gain or loss can only be determined at the time of contract fulfillment, and is equal to the difference between the payment made under the contract and the Canadian-dollar value of the consideration received therefor, where such consideration is translated to Canadian dollars at the spot rate in effect on the date of delivery. The characterization of this gain or loss as on account of income or capital will depend on the underlying use of funds that gave rise to the liability that the derivative is designed to hedge.

We do not agree with your view that the hedge transaction is on account of capital; although we agree that the underlying item and the use of the bond is capital (to finance an acquisition) and the interest is generally a capital item, but would be deductible under paragraph 20(1)(c) of the Act. The hedge follows the underlying transaction which in this case is to fix an interest rate to a particular bond that will be issued in the near future. Further, in our view, it cannot be said that the hedge is a discount similar to a paragraph 20(1)(f) expense. XXXXXXXXXX did not issue the derivative; they issued the corporate bond and attempted to hedge the yield on that bond. Moreover, XXXXXXXXXX attempted to fix the yield on the entire debt obligation, not only during the period before it was issued.

Canadian Banks (see for example, the Bank of Montreal web site) have indicated in press releases, that from a federal tax standpoint, current hedge accounting allows the company to recognize the cost or benefit over the life of the underlying debt. That statement, in our view, is valid as the lock hedges the yield which represents the interest on the obligation; thus, for CRA to recognize the gain or allow the loss over the life of the obligation makes economic sense and is in keeping with our position on characterizing the hedge with the underlying transaction. In the case at hand, the bond has a maturity of XXXXXXXXXX years, thus the cost should be spread over that term.

In the case at hand, XXXXXXXXXX repurchased on XXXXXXXXXX for cash up to $XXXXXXXXXX of its outstanding pound sterling XXXXXXXXXX note that was due in XXXXXXXXXX . Since we are trying to match the expense in question over the entire term and the remaining outstanding amount of the bond, an adjustment to increase the expense would be required in XXXXXXXXXX to reflect that fact.

R. Albert, CA
for Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch