29 January 1990 Ministerial Correspondence 56704 F - Interest Rate Cap

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.

Dear Sirs:

Interest Rate Cap

This is in reply to your letter of October 11, 1988 wherein you requested our comments as to the income tax implications to a bank with respect to its participation as vendor or purchaser of an interest rate protection agreement.  We apologize for the delay.

The type of interest rate protection agreement which you made reference to in your letter and which we are commenting on is an interest rate cap ("Cap").  Under a Cap arrangement a borrower is able to fix an upper limit with respect to funds that he has borrowed at a floating rate of interest.  This would be accomplished by the bank committing itself to pay an amount to the borrower in respect of the borrowed funds calculated on the basis of the excess of the market interest rate over a specified interest rate.  For an up-front fee the bank, for a specified period extending beyond one year, would agree to limit the borrower's cost of funds with respect to the borrowed funds to a specified rate.

The bank may accumulate a number of these contracts and for an up-front fee purchase a Cap with respect to a notional amount from another financial institution.

We emphasis that our comments that follow are intended to be general and may not be appropriate with respect to specific facts of a particular Cap.

In our view, the portion of the up-front fee received by the bank from the borrower that is attributable to the taxation year in which a Cap is sold should be included in the bank's income from business for that year pursuant to section 9 of the Income Tax Act ("Act"); and the portion of the fee attributable to subsequent taxation years should be included in the Bank's income from business under subparagraph 12(1)(a)(i) of the Act as an amount received by the taxpayer in the year in the course of a business that may be regarded as not having been earned in the year.

To the extent such fee is included in income pursuant to subparagraph 12(1)(a)(i) of the Act, the bank should be entitled to claim a reasonable reserve pursuant to subparagraph 20(1)(m)(ii) of the Act.

Similarly only that portion of the up-front fee paid by the bank to another financial institution that is attributable to the taxation year in which a Cap is acquired may be deducted in computing the bank's income from business for that year pursuant to section 9 of the Act.  Pursuant to subparagraph 18(9)(a)(i) of the Act no deduction may be made in the initial year in respect of the remaining portion of the fee which may be viewed as consideration for services to be rendered after the end of that year.  Such amount would be deductible in a subsequent year pursuant to paragraph 18(9)(b) of the Act.

The amounts paid by the bank in a year to the borrower under a Cap due to interest rate fluctuations would be deductible as a business expense for that year by the bank pursuant to section 9 of the Act and amounts received by the bank in a year from another financial institution under a Cap due to interest rate fluctuations would be included in income from business for that year pursuant to section 9 of the Act.

We trust these comments will be of assistance.

F. Lee WorkmanChiefFinancial Industries DivisionRulings Directorate