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 amounts paid by the taxpayer under various interest rate swap agreements need to be deducted in computing the taxpayer's resource profits
Position: Yes
Reasons: The payments were made in the course of carrying on its resource business and are not related to a source of income that does not include a resource activity
January 20, 2010
XXXXXXXXXX Resources Industry Section
Large File Case Manager T. Harris
XXXXXXXXXX Tax Services Office (613) 957-8284
2009-034857XXXXXXXXXX (the "Company")
Interest Rate Swaps and Resource Profits
We are writing further to your email request of September 1, 2009 wherein you requested our opinion as to whether certain payments incurred by the Company as a result of interest rate swaps entered into by several of its predecessor corporations would be deducted in computing the Company's "resource profits" under subsection 1204(1.1) of the Income Tax Regulations (the "Regulations"). We also acknowledge receipt of a copy of a submission dated XXXXXXXXXX from XXXXXXXXXX (the "Representative") regarding this matter (the "Submission").
Our understanding of the facts relevant to this situation is as follows:
1. On XXXXXXXXXX , XXXXXXXXXX acquired control of XXXXXXXXXX . Prior to its acquisition by XXXXXXXXXX , XXXXXXXXXX had entered into various LIBOR interest swap agreements (the "Swap Contracts"), that had the effect of reducing XXXXXXXXXX interest rate exposure. XXXXXXXXXX , another subsidiary of XXXXXXXXXX , had entered into similar Swap Contracts.
2. XXXXXXXXXX
3. XXXXXXXXXX
4. XXXXXXXXXX
5. XXXXXXXXXX , XXXXXXXXXX and the Company, as their successor, continued to make payments under the Swap Contracts up to their termination date as specified therein, notwithstanding that the debts to which the Swap Contracts related had been repaid prior to that time. This decision was made, in part, to avoid any cancellation penalty on the early termination of the Swap Contracts.
6. We have not been provided with details of the particular borrowings to which the various Swap Contracts relate. However, you have advised that the debts were incurred by each of XXXXXXXXXX and XXXXXXXXXX in the ordinary course of operating their respective XXXXXXXXXX business, that the Swap Contracts were subsequently entered into to hedge the borrowers interest rate exposure and that when the debt was paid off by the particular corporation, the Swap Contracts were not terminated. Consequently, the rights and obligations under the Swap Contracts passed to the Company as a result of the XXXXXXXXXX amalgamations. Thus the Company continued to make any required payments under the Swap Contracts until their settlement dates.
Audit's Position
The TSO Audit group ("Audit") is of the view that the payments arising under the Swap Contracts would have to be deducted in the calculation of the Company's "resource profits" pursuant to paragraph 1204(1.1)(a) of the Income Tax Regulations (the "Regulations").
Audit believes that unlike most investments, a swap contract, by itself, does not produce income or loss. The Swap Contracts produce a stream of payments and/or receipts with reference to the difference between the swap interest rate and the interest rate of the underlying debt obligation. The entering into the Swap Contracts would not represent a separate activity from the Company's business operations unless the Company were to enter into the contracts for speculative purposes.
As the debts to which the Swap Contracts related were incurred by XXXXXXXXXX and XXXXXXXXXX to fund their XXXXXXXXXX operations and the Swap Contracts were entered into to hedge the interest rate exposure relating to these borrowings, Audit believes that these Swap Contracts were entered into in the ordinary course of carrying on the particular corporation's XXXXXXXXXX business, which involves a resource activity. Consequently, Audit is of the opinion that the payments arising from the interest rate difference between the Swap Contracts and the related debt would not be of the nature described in either of the exceptions described subparagraphs 1204(1.1)(a)(iv) or (v) of the Regulations and must, therefore, be deducted in the calculation of the Company's "resource profits" pursuant to paragraph 1204(1.1)(a) of the Regulations.
Representative's Position
In the Submission, the Representative sets out its position relating to the impact that the payments under the Swap Contracts should have on the calculation of the Company's resource allowance. A substantial portion of the Submission describes the legislative history of the resource allowance and sets out the Representative's view concerning the manner in which certain jurisprudence, including Echo Bay Mines Ltd. v. Canada 92 DTC 6437 (FC-TD), The Queen v. Gulf Canada Ltd. 92 DTC 6123 (FCA), Shell Canada Ltd v The Queen [SCC] [1999] 3 S.C.R. 622 and Ontario v. Placer Dome Canada Ltd. 2006 DTC 6532 (SCC), should be interpreted for the purposes of determining a taxpayer's "gross resource profits" pursuant to subsection 1204(1) of the Regulations.
With respect to the impact of the payments under the Swap Contracts on the calculation of the Company's "resource profits" pursuant to paragraph 1204(1.1)(a) of the Regulations, the Representative submits that the Swap Contracts represent property, any income or loss from which must be reported in the manner outlined in sections 3, 4 and 9 of the Income Tax Act (the "Act"). Pursuant to subsection 4(1) of the Act, a taxpayer's income from each source must be "computed in accordance with this Act on the assumption that the taxpayer had.....no income or loss except from that source...and was allowed no deductions in computing the taxpayer's income...except such deductions as may reasonably be regarded as wholly applicable to that source". The Representative argues that the Swap Contracts constitute a separate source of income that is distinct from the Company's XXXXXXXXXX business (which business is the subject of the resource profit calculation). The Submission indicates that this position is based on the simple premise that "the Swap Contracts could have resulted in an income inclusion or an income loss and must be treated as property and source of income. As such, he argues that the payments under the Swap Contracts would not be deducted in computing the Company's resource profits by virtue of the exceptions in subparagraphs 1204(1.1)(a)(iv) and (v).
As Audit's proposed reassessment only relates to whether the payments arising under the Swap Contracts should be deducted in the calculation of the Company's "resource profits" pursuant to paragraph 1204(1.1)(a) of the Regulations, we will limit our comments to our opinion as to whether the Swap Contracts constitute a separate source of income that is distinct from the Company's XXXXXXXXXX business as suggested by the Representative.
Based on our understanding of the facts of this situation and the provisions of paragraph 1204(1.1)(a) of the Regulations, we agree with Audit's view that the payments made by the Company under the Swap Contracts should be deducted in the determination of the Company's "resource profits" for the relevant taxation year.
The Representative is relying on several published CRA documents, including 4M09660, 9415947, 2003-0030597, 2003-0036081 and 2004-0080911I7, to support his position that the Swap Contracts represent a separate source of income to the Company. While we agree that these documents may support the Representative's statement that the CRA's position is that a derivative agreement, such as a swap, is a contractual arrangement which is separate from any associated asset or liability for which it may be designed, we do not agree with his contention that they support his position that the Swap Contracts represent a separate source of income to the Company. In general, the comments in these documents were made in the context of whether any income or loss arising from such derivatives should be on income or capital account or whether such income or loss arising on an interest rate swap can be considered to represent interest income or expense, as the case may be. In this regard, we note that document 2003-0030597 referred to by the Representative, which involves the issue of whether the net payments or net receipts from the settlement of interest rate swaps should be considered in the determination of the taxpayer's "gross revenue" from a principal business that is leasing as described in subsection 1100(16) of the Regulations, includes the following statements under the heading Incomplete Information:
In particular, it may be necessary to determine what the proportion of the aggregate amount of the net payments or net receipts to Finco from the settlement of the Interest Rate Swaps is attributable to each of its two businesses.
.....
In this regard, it is not evident from your Request that any of the funds obtained by Finco on the issuance of its Debts are used for its XXXXXXXXXX Business. If substantially all the Interest Rate Swaps were prompted by Debts incurred to obtain funds for its Financing Business, the Swap Payments and the Swap Receipts would not be relevant to the determination of Finco's gross revenue from its principal business of XXXXXXXXXX Leasing, regardless of our conclusion in this matter. However, they are, as indicated below, relevant to the determination of Finco's gross revenue from all sources.
We have reviewed the XXXXXXXXXX reports of XXXXXXXXXX , which is the indirect parent company of the Company, and found the following comments that are relevant to this issue:
XXXXXXXXXX
On page XXXXXXXXXX under the heading XXXXXXXXXX it states:
XXXXXXXXXX
On page XXXXXXXXXX under the heading XXXXXXXXXX :
XXXXXXXXXX
XXXXXXXXXX
Similar comments appeared under the same headings.
XXXXXXXXXX
At page XXXXXXXXXX it states:
XXXXXXXXXX
Given that the financial statements for XXXXXXXXXX , which include the consolidated operations of the Company, state that it "XXXXXXXXXX", it is our view that the Swap Contracts do not constitute a separate source of income of the Company. Where such derivative contracts are entered into in the ordinary course of carrying on a taxpayer's business, and not for purely speculative reasons, it is our view that any amounts received or amounts paid under such contracts will be sourced to that business for the purposes, inter alia, of sections 3, 4 and 9 of the Act. We believe that this is the approach that has generally been followed by the Courts as evidenced by the decisions in cases such as:
Tip Top Tailors Limited (57 DTC 1232) [SCC];
Dominion Steel and Coal Corporation Limited (57 DTC 147) [Tax Appeal Board];
Atlantic Sugar Refineries, Limited (49 DTC 602) [SCC]; and
Echo Bay Mines Ltd. v. Canada 92 DTC 6437 [FC-TD].
It is our understanding that the Company and/or its predeccesors entered into these Swap Contracts to hedge the interest rate risk associated with certain long-term financings that were incurred in carrying on the XXXXXXXXXX business of the particular party. In addition, for financial statement purposes, any payments or receipts under the Swap Contracts have been treated as an inclusion or reduction of interest expense. In our view, these factors indicate that the Swap Contracts were entered into in the ordinary course of carrying on the party's XXXXXXXXXX business and should, therefore, be sourced to that business for purposes of the Act, including section 3 and 9 of the Act.
The Representative has suggested that the various citations in the Submission to comments of the Supreme Court in its decisions in Shell Canada Ltd. v. The Queen 99 DTC 5669 [SCC] and Stewart v The Queen 2002 DTC 6969 "XXXXXXXXXX " However, we have been unable to identify any comments in either of these decisions that support the Representative's position. In our view, the comments in paragraphs 62 to 77 of the Shell decision indicate that the Court merely addressed the principles to be followed in determining whether a gain realised on a derivative contract was on income or capital account; there were no comments to the effect that the foreign exchange contracts represented a separate source of income. We do, however, acknowledge that for purposes of the Act, a capital gain or loss does represent a separate source of income, even where it is realised on the disposition of an asset used in the taxpayer's business. Similarly, we do not find any comments in the Stewart decision to support the Representative's position. In paragraph 5 of this decision, the Court states:
It is undisputed that the concept of a "source of income" is fundamental to the Canadian tax system; however, any test which assesses the existence of a source must be firmly based on the words and scheme of the Act. As such, in order to determine whether a particular activity constitutes a source of income, the taxpayer must show that he or she intends to carry on that activity in pursuit of profit and support that intention with evidence. [Underlining added]
In view of XXXXXXXXXX , but to manage its exposure to interest-rate volatility, it is our opinion that these contracts, on their own, do not constitute an activity carried on in pursuit of profit, but are ancillary to the Company's business operations. This is also supported by the fact that for financial statement purposes the payments under the Swap Contracts were treated as increases or decreases to interest expense.
Resource Profits
Subsection 1204(1.1) of the Regulations reads, in part, as follows:
...."resource profits" of a taxpayer for a taxation year means the amount, if any, by which the taxpayer's gross resource profits for the year exceeds the total of
(a) all amounts deducted in computing the taxpayer's income for the year other than
...
(iv) an amount deducted in computing the taxpayer's income for the year from a business, or other source, that does not include any resource activity of the taxpayer, and
(v) an amount deducted in computing the taxpayer's income for the year, to the extent that the amount
(A) relates to an activity
(I) that is not a resource activity of the taxpayer, and
(II) that is
(1) the production, processing, manufacturing, distribution, marketing, transportation or sale of any property,
(2) carried out for the purpose of earning income from property, or
(3) the rendering of a service by the taxpayer to another person for the purpose of earning income of the taxpayer, and
(B) does not relate to a resource activity of the taxpayer, ...
It is our understanding that the payments under the Swap Contracts have been "deducted in computing the taxpayer's income for the year" for the purposes of paragraph 1204(1.1)(a) of the Regulations. Consequently, it is necessary to determine whether either of the exceptions described in subparagraphs 1204(1.1)(a)(iv) or (v) of the Regulations are applicable with respect to these payments. In order for either of these exceptions to preclude a reduction in thedetermination of the Company's "resource profits" for a deduction in respect of the payments under the Swap Contracts, such payments would have to be either a deduction
- in computing the Company's income "from a business, or other source, that does not include any resource activity of" the Company; or
- that "does not relate to a resource activity of" the Company.
Based on the information that has been provided to us, the only business activity of the Company involves XXXXXXXXXX from Canadian resource properties. As discussed above, since the Company does not acquire derivative instruments for speculative trading purposes, it is our view that the payments made by the Company under the Swap Contracts can only be sourced to its XXXXXXXXXX business. In addition, the XXXXXXXXXX from Canadian resource properties is an activity encompassed by paragraph XXXXXXXXXX of the definition of the term "resource activity" in subsection 1206(1) of the Regulations. Furthermore, paragraphs (f), (g) and (i) of the "resource activity" definition expressly expand the meaning of "production" to include "exploration and development activities", activities that are "ancillary to, or in support of" a qualifying "production" activity and activities undertaken "as a consequence of" such a "production" activity (notwithstanding that the production activity may have ceased). In our view, the fact that the borrowings were incurred by the predecessor companies in the ordinary course of operating their XXXXXXXXXX businesses and that the Swap Contracts were subsequently entered into to hedge the borrowers interest rate exposure on these borrowings indicates that these activities were "ancillary to, or in support of" their XXXXXXXXXX operations for the purposes of paragraph (g) of the "resource activity" definition. Therefore, it is our opinion that neither of the exceptions in subparagraphs 1204(1.1)(a)(iv) or (v) of the Regulations would exclude a deduction for the payments made by the Company under the Swap Contracts in computing its "resource profits".
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. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
If we can be of further assistance with regard to this matter, please contact the writer.
for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Planning Branch
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