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: Because of the open market purchase and the application of 39(3):1. Does section 80 apply? 2. Is there an apportionment between principal and interest? 3. Is the interest income deducted in prior years now subject to income?
Position: 1. No, 2. No 3.YES
Reasons: 1. 39(3) is the more specific section 2. Wording of subsection 39(3) postamble. 3. Interest no longer payable.
April 20, 2009
Large Case Files Headquarters
Anna Stamatopoulos
Tax Auditor C. Tremblay
Toronto Centre TSO (819) 281-2916
2008-030251Liquid Yield Option Notes ("LYONs) repurchased on the open market
This is in reply to your enquiry of October 21, 2008 wherein you ask us to confirm the following:
1. Since the LYONs were repurchased in the open market, subsections 39(3) and 39(2) of the Act would apply and section 80 of the Act would not apply.
2. Due to the fact that the company repurchased the LYONs in the open market there would be no apportionment of the repurchase price between principal and interest.
3. The simple interest that was previously deducted on the LYONs for tax purposes is no longer payable. On reversing this liability, there would be an income inclusion under subsection 9(1) of the Act.
Facts:
1) XXXXXXXXXX is a Canadian public holding company with shares listed on the XXXXXXXXXX stock exchanges. XXXXXXXXXX holds shares in various subsidiaries with operations in the XXXXXXXXXX .
In XXXXXXXXXX issued LYONs with a principal amount at maturity of US$XXXXXXXXXX , payable XXXXXXXXXX received gross proceeds of US$XXXXXXXXXX for the LYONs at an issue price per LYON of US$XXXXXXXXXX will not pay interest on the LYONs prior to maturity. On XXXXXXXXXX , the maturity date, each holder will receive US$XXXXXXXXXX per LYON. The company may elect to pay the principal amount at maturity of the LYONs or the repurchase price that is payable in certain circumstances, in cash or subordinate voting shares, or any combination thereof. The issue price of the LYONs represented a yield to maturity of XXXXXXXXXX %, computed on a XXXXXXXXXX basis commencing XXXXXXXXXX . The original issue discount of US$XXXXXXXXXX therefore represents the total simple and compound interest on the LYONs which is accrued over XXXXXXXXXX years at the XXXXXXXXXX % yield to maturity, commencing on XXXXXXXXXX , on the basis of a XXXXXXXXXX -day year consisting of XXXXXXXXXX months and compounded XXXXXXXXXX . The LYONs include features such as convertibility at the option of the holder and redemption at specified dates and prices at the option of XXXXXXXXXX . In general, redemption/repurchase prices are based on the accreted value of the LYONs (issue price + accrued original discount on specified date).
2) It has already been determined that pursuant to paragraph 20(1)(c) of the Act, XXXXXXXXXX can deduct simple interest as it accrues, however, it can only deduct the compound interest when paid, pursuant to paragraph 20(1)(d). Upon maturity, XXXXXXXXXX can deduct the compound interest calculated at that time.
3) In XXXXXXXXXX , the company repurchased a total of XXXXXXXXXX LYONs in the open market at various prices and at different times for a total of US$XXXXXXXXXX .
Generally, LYONs are convertible obligations issued at a substantial discount and can be converted into shares of the issuer. LYONs are unsecured general obligations of the issuer. As such, they rank equally with other senior unsecured indebtedness of the corporation. If held to maturity, a holder will receive a compound return based on the original outlay, i.e., a multiple of what was originally invested. The original outlay compounds to the amount to be received at maturity, with the difference representing interest payments. However, holders do not receive interest payments during the period and the issuer does not make any interest payments. If the security is kept to maturity by the holder, the issuer will have ended up issuing low-cost, zero-coupon debt without having to pay interest on an annual basis. Each LYON is convertible at the holder's option into a special class of shares. The conversion can be done at any time and the conversion rate is set on the day the deal is done. At various times, the holder has the option of putting the security back to the lender and, in that situation, the holder will receive the original outlay plus accrued interest. The issuer has the option to pay in either cash or shares. Even though it does not make interest payments on the convertible debentures, the issuer gets an interest deduction for the simple interest during the life of the convertible debenture and gets to deduct the remainder when the debenture matures. Holders are required to include in income an amount representing accrued notional interest.
1. Application of section 80?
In our view, the provisions of subsection 39(3) of the Act allow for a capital gain or capital loss where a taxpayer purchases in the open market any obligation earlier issued by the taxpayer and these provisions would apply in these current circumstances. The provisions do not apply to the extent a gain or loss is otherwise recognized as income or loss; that is, it does not affect transactions which are income transactions under the general rules for distinguishing income from a capital gain. Thus, a taxpayer reporting on income account should not receive the benefits under subsection 39(3) of the Act. Subsection 248(27) of the Act clarifies that the open market purchase of any portion of an obligation under subsection 39(3) of the Act is treated on the same basis as the purchase of the entire obligation. Further, the definition in subsection 80(1) of the Act of "forgiven amount", at paragraph (d) of the formula calculating B, clarifies that any portion of a debt extinguished under circumstances to which subsection 39(3) of the Act applies is not subject to the application of subsection 80(1) of the Act. Subsection 39(3) of the Act overrides any of the more general provisions. Accordingly, in our view, section 80 would not apply in the situation described.
Although Interpretation Bulletin IT-95R does not reflect this, it is our long-standing view that subsection 39(2) of the Act applies to foreign exchange gains and losses other than in an open market transaction. In the latter case, subsection 39(3) of the Act applies to all gains or losses, including foreign exchange gains or losses arising therefrom as the words in subsection 39(3) of the Act clearly expressed Parliament's intention that in reference to open market purchases by the issuer, that specific provision of subsection 39(3) of the Act overrides any other more general provision. As we apply the principles in Gaynor on a consistent basis to the provisions of the Act, the amounts relevant to the calculation in subsection 39(3) of the Act must be expressed in Canadian dollars. Prior to Gaynor, we opined that it was likely that each of subsections 39(2) and 39(3) of the Act would apply to the open market purchase of a US dollar denominated debt. However, after the Federal Court of Appeal decision, it is clear that where a provision of the Act, e.g. subsection 39(3) of the Act, refers to an amount from which a gain or loss is calculated, the amounts relevant to determining the gain or loss must be translated to Canadian dollars so that in effect, the subsection 39(3) of the Act amount includes the foreign exchange gain or loss from the open market purchase.
2. Principal and Interest Apportionment?
In a May 16, 2008 submission addressed to you, XXXXXXXXXX states that apportionment of the payment is provided for in subsection 39(3) as "Subsection 39(3) of the Act operates to deem XXXXXXXXXX to have realized a capital gain in its XXXXXXXXXX taxation year for each such repurchase in an amount equal to the excess of the original principal amount (i.e., the amount for which the LYONs were issued) over the purchase price paid by XXXXXXXXXX in the open market repurchase to the extent that such amount would not otherwise be deductible in computing XXXXXXXXXX income for the year or any other taxation year computed in the manner stipulated in subsection 39(3). Plainly, to the extent any portion of the amount paid by XXXXXXXXXX on repurchase of the LYONS is deductible (for example, as a payment of interest pursuant to paragraph 20(1)(c) of the Act) it is not included in computing the deemed capital gain pursuant to subsection 39(3)." XXXXXXXXXX is referring to the application of the subsection 39(3) postamble. In our view, the postamble of subsection 39(3) and its reference to the reading of section 3 of the Act is more broadly based and, as previously noted above under our comments concerning section 80, the provision does not apply to the extent a gain or loss is otherwise recognized as income or loss such that a taxpayer reporting on income account should not receive the benefits under subsection 39(3) of the Act. Accordingly, we agree with your views that subsection 39(3) does not provide for an apportionment between principal and interest upon a repurchase on the open market.
3. Reversing Liability - Income Inclusion?
The accrued interest is no longer payable as a result of the open market purchase. We therefore agree that on the repurchase of the LYONs, the interest obligation no longer exists and an income inclusion would result on the reversal of the liability.
For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
R. Albert, CA
for Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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