29 October 2010 Internal T.I. 2010-0357241I7 - Exchangeable Debenture

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: Regarding the described exchangeable note: 1. Is there a subparagraph 20(1)(f)(ii) discount on the partial redemption in XXXXXXXXXX ? 2. Is there an interest deduction pursuant to subparagraph 20(1)(c)(i)?

Position: 1. Partially, yes. 2. Partially, yes

Reasons: 1. Most of the amount paid by the Taxpayer on the partial redemptions was paid on account of principal. The remainder was meant to compensate the Noteholder for interest that, but for the partial redemptions, would have been payable by the Taxpayer as interest on the Note. 2. The purpose test may not be met by some of the Taxpayer's uses of the proceeds from the Note.

									October 29, 2010

	XXXXXXXXXX 							HEADQUARTERS
	TAX SERVICES OFFICE					Income Tax Rulings
      Audit Division 	   						Directorate
	Attention: XXXXXXXXXX , Auditor			L. Carruthers, CA

      								2010-035724

XXXXXXXXXX
Exchangeable Notes

This is in reply to your letter of XXXXXXXXXX , wherein you requested our opinion on the application of subparagraph 20(1)(f)(ii) and subparagraph 20(1)(c)(i) of the Income Tax Act (the "Act") to the XXXXXXXXXX note (the "Note"). We acknowledge the additional information provided by the Taxpayer's representative, which you forwarded by email XXXXXXXXXX , and by facsimile XXXXXXXXXX.

On XXXXXXXXXX , XXXXXXXXXX (the "Taxpayer") issued the Note to the XXXXXXXXXX (the "Holder"). The Note is exchangeable for XXXXXXXXXX shares of XXXXXXXXXX (the "Underlying Shares"). Specifically, you requested guidance as to:

1. whether the $XXXXXXXXXX deduction regarding the Taxpayer's partial redemptions of the Note, claimed in XXXXXXXXXX personal income tax return, was deductible in accordance with subparagraph 20(1)(f)(ii) of the Act; and

2. whether the $XXXXXXXXXX interest expense claimed by the Taxpayer in XXXXXXXXXX personal income tax return was deductible in accordance with subparagraph 20(1)(c)(i) of the Act?

Our understanding of the relevant attributes of the Note and the facts of the partial redemptions is as follows:

a) Maturity date of the Note is XXXXXXXXXX ;

b) Aggregate amount for which the Note was issued for was $XXXXXXXXXX (the "Face Value");

c) As a general and continuing security, the Taxpayer granted to the Holder a continuing first security in, and delivered to the Holder, XXXXXXXXXX Underlying Shares;

d) On XXXXXXXXXX :

i) the fair market value ("FMV") of each Underlying Share was $XXXXXXXXXX ,

ii) XXXXXXXXXX Underlying Shares represented all of the Underlying Shares held by the Taxpayer, and

iii) there were approximately XXXXXXXXXX Underlying Shares issued and outstanding;

e) On XXXXXXXXXX , the Underlying Shares XXXXXXXXXX , and thereafter the XXXXXXXXXX Underlying Shares noted above became XXXXXXXXXX Underlying Shares with an effective FMV on XXXXXXXXXX , of $XXXXXXXXXX per share;

f) At maturity, and at the option of the Taxpayer, each $XXXXXXXXXX Face Value amount of the Note may be satisfied by:

i) delivery of Underlying Shares with a FMV equal to $XXXXXXXXXX ,

ii) payment of a cash amount of $XXXXXXXXXX , or

iii) any combination of i) and ii);

g) At any time after XXXXXXXXXX , the Holder may exchange, in whole or in part, the Note for Underlying Shares. Each $XXXXXXXXXX Face Value amount of the Note exchanged, may be satisfied by:

i) delivery of XXXXXXXXXX Underlying Shares (XXXXXXXXXX represents the exchange rate, and XXXXXXXXXX * XXXXXXXXXX = $XXXXXXXXXX ), or

at the option of the Taxpayer:

ii) payment of a cash amount equal to XXXXXXXXXX * the current market price per Underlying Share, or

iii) any combination of i) and ii), plus

if the exchange is in response to a notice of redemption, an additional redemption payment of:

iv) if current market price > $XXXXXXXXXX /share: Nil, or

v) if current market price < $XXXXXXXXXX /share: XXXXXXXXXX * $XXXXXXXXXX ; h) At any time after the date of issuance, the Taxpayer may redeem the Note, in whole or in part. Each $XXXXXXXXXX Face Value amount of the Note redeemed, may be satisfied by: i) a payment of a cash amount of $XXXXXXXXXX , or at the option of the Taxpayer: ii) delivery of XXXXXXXXXX Underlying Shares, iii) payment of a cash amount equal to XXXXXXXXXX * the current market price per Underlying Share, or iv) any combination of ii) and iii), plus an additional redemption payment of: v) if current market price > $XXXXXXXXXX /share: Nil, or

vi) if current market price < $XXXXXXXXXX /share: XXXXXXXXXX * $XXXXXXXXXX ;

i) In addition to any other amounts due or payable, a premium is payable in connection with the final measuring interest period preceding an exchange, a redemption, or the maturity date, equal to:

i) all cash dividends and cash distributions, having an ex-dividend date during the final measuring interest period, in respect of X Underlying Shares where X equals the Face Value amount of the Note then outstanding / XXXXXXXXXX * XXXXXXXXXX , plus

ii) the FMV of all non-cash distributions, having an ex-distribution date during the final measuring interest period, in respect of X Underlying Shares;

j) Interest is payable XXXXXXXXXX on the Note equal to:

i) XXXXXXXXXX % per annum, plus

ii) A%, XXXXXXXXXX (i.e., A is the percentage of cash distributions paid on $XXXXXXXXXX of principal), and

iii) B%, XXXXXXXXXX (i.e., B is the percentage of non-cash distributions paid on $XXXXXXXXXX of principal);

k) The proceeds of the Note were used by the Taxpayer as follows:

i) $XXXXXXXXXX was loaned to XXXXXXXXXX (the "Trust"). The Taxpayer is both an income and capital beneficiary of this fully discretionary trust. These loans were made at various times in XXXXXXXXXX following the issuance of the Note,

ii) $XXXXXXXXXX was used to repay loans previously incurred by the Taxpayer for investment purposes including loans for which the proceeds had been used to purchase XXXXXXXXXX Shares and XXXXXXXXXX Shares of XXXXXXXXXX . The XXXXXXXXXX shares were later sold XXXXXXXXXX for consideration that included a number of Underlying Shares,

iii) $XXXXXXXXXX was paid to the Holder to be held in an interest bearing collateral account against the Taxpayer's obligation to pay interest,

iv) $XXXXXXXXXX was used to pay legal fees in connection with the issuance of the Note, and

v) $XXXXXXXXXX use unknown;

l) On XXXXXXXXXX , when the current market price per Underlying Share was $XXXXXXXXXX , the Taxpayer exercised XXXXXXXXXX option to redeem $XXXXXXXXXX of the Face Value amount of the Note which resulted in the payment to the Holder of:

i) $XXXXXXXXXX in accordance with h)iii) above, and

ii) $XXXXXXXXXX in accordance with i) above; and

m) On XXXXXXXXXX , when the current market price per Underlying Share was $XXXXXXXXXX , the Taxpayer exercised XXXXXXXXXX option to redeem $XXXXXXXXXX of the Face Value amount of the Note which resulted in the payment to the Holder of:

i) $XXXXXXXXXX in accordance with h)iii) above, and

ii) $XXXXXXXXXX in accordance with i) above.

Your Question

Do the partial redemptions described above qualify for a subparagraph 20(1)(f)(ii) deduction?

Our Comments

Our views regarding the application of paragraph 20(1)(f) of the Act to exchangeable debentures was summarized at the CRA Roundtable of the 61st Annual CTF Tax Conference in 2009 as follows:

Prior to Imperial Oil Ltd. v. Canada, (Imperial Oil Ltd. v. Canada; Inco Ltd. v. Canada, 2006 DTC 6639 (SCC)) the CRA's position with respect to exchangeable debentures issued with or without an original discount was that a deduction was generally available under paragraph 20(1)(f) with respect to the original discount as well as the appreciation of the principal amount of the debenture over its face value, provided that such appreciation was inherent to the terms and conditions of the debenture.
...

In light of the decision of the Federal Court of Appeal in the Tembec case, we are now of the view that our above-mentioned position is not supportable at law. Hence, this case limits the deduction of financing costs provided for by paragraph 20(1)(f) to the original discount, granted when an obligation is issued. The appreciation of the principal amount of the debenture over its face value is not deductible under paragraph 20(1)(f). This represents a change of position and will therefore be administered on a prospective basis to debentures issued on or after January 1, 2010. In this respect, a debenture issued prior to January 1, 2010, but modified on or after that date will be considered issued on or after January 1, 2010.

The Note was issued on XXXXXXXXXX , i.e., prior to January 1, 2010, and in accordance with its terms and conditions, the principal amounts of the portions of the Note redeemed on XXXXXXXXXX , had appreciated to $XXXXXXXXXX and $XXXXXXXXXX from $XXXXXXXXXX and $XXXXXXXXXX respectively and, therefore, in our view, subparagraph 20(1)(f)(ii) of the Act applies.

However, in our view, a small portion of the $XXXXXXXXXX deduction (see calculation below which is a reproduction of that prepared by the Taxpayer's representative XXXXXXXXXX ) regarding the Taxpayer's partial redemptions of the Note, claimed in the Taxpayer's XXXXXXXXXX personal income tax return, is not deductible in accordance with subparagraph 20(1)(f)(ii) of the Act.

On 					XXXXXXXXXX
Cash payment			XXXXXXXXXX
Face Value redeemed		XXXXXXXXXX
					XXXXXXXXXX 

XXXXXXXXXX

The $XXXXXXXXXX discrepancy between the number calculated above ($XXXXXXXXXX which, in our view, is the amount that is deductible in accordance with subparagraph 20(1)(f)(ii) of the Act) and the number claimed by the Taxpayer ($XXXXXXXXXX ) is approximately equal to XXXXXXXXXX of the $XXXXXXXXXX and $XXXXXXXXXX premiums paid on the XXXXXXXXXX , partial redemptions, respectively. These amounts, in our view, were not paid on account of principal but, rather, were meant to compensate the Holder for interest that, but for the partial redemptions, would have been payable by the Taxpayer as interest on the Note and, therefore, in our view, those amounts should be prorated and deducted over the remaining term of the Note by the Taxpayer as interest pursuant to subsection 18(9.1) of the Act.

Your Question

Does the interest on the Note qualify for a subparagraph 20(1)(c)(i) deduction?

Our Comments

Interest on borrowed money is deductible for purposes of the Act if it meets all the requirements of subparagraph 20(1)(c)(i). Those requirements are that the interest must be a reasonable amount and paid pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning incoming.

The interest paid on the $XXXXXXXXXX loaned to the fully discretionary Trust for which the Taxpayer is both an income and capital beneficiary, as noted in k)i) above, is, in our view, deductible.

For interest on the $XXXXXXXXXX used to repay loans, as noted in k)ii) above, to be deductible, a link must be established to a current eligible use. To determine the current use of this $XXXXXXXXXX , the Taxpayer's representative was asked:

• What is the current use of the amount used to repay the loans not originally used to acquire XXXXXXXXXX shares, i.e., is the eligible use test still met?
• When the XXXXXXXXXX shares were sold XXXXXXXXXX , what was the other consideration? i.e., is the eligible use test still met regarding this amount?
• How many XXXXXXXXXX shares were received on the sale of XXXXXXXXXX shares XXXXXXXXXX ?

To the extent that the current uses noted above continue to be eligible uses, interest would, in our view, be deductible. We received no response to the above queries and, therefore, are unable to conclude that the entire amount of interest paid on this $XXXXXXXXXX of the Note is deductible.

The interest paid, on the $XXXXXXXXXX held in the interest bearing collateral account, as noted in k)iii) above, is, in our view, deductible.

The interest paid on the $XXXXXXXXXX used to pay legal fees incurred in connection with issuing the Note, as noted in k)iv) above, is, in our view, deductible.

No use was given for $XXXXXXXXXX of the proceeds from the Note (see k)v) above) and, therefore, we are unable to conclude that any amount of interest paid on this $XXXXXXXXXX of the Note is deductible.

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 Celine Charbonneau at (613) 957-2137. A copy would then be sent to you for delivery to the client.

R.A. Albert, CA
For Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate