16 December 1988 Income Tax Severed Letter 7-3381 - [IT-96R4, paragraphs 1 and 2 (allocation of issue price between debentures and warrants) IT-114, paragraphs 3 and 24 (deductibility of discount considered to be the equivalent of interest)]

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.

December 16, 1988

HEAD OFFICE Financial Industries Division B. Dwyer 957-2744

Subject: IT-96R4 , paragraphs 1 and 2 (allocation of issue price between debentures and warrants) IT-114 , paragraphs 3 and 24 (deductibility of discount considered to be the equivalent of interest)

This memorandum is in response to your memorandum dated October 18, 1988, in which you asked for our comments on the above-noted matters.

Interpretation Bulletin IT-96R4

Our understanding of the facts related to your question on Interpretation Bulletin IT-96R4 is as follows:

XXXX

You have asked us to clarify paragraph 2 of IT-96R4 , which reads as follows:

2. For all issues of securities prior to August 19, 1983 and for issues in respect of which a prospectus was issued to the public on or before that date, the allocation in I [sic] above [the allocation of the issue price and issue expenses between an option and a security issued concurrently with the option] need not apply where the option was not one of the main reasons for issuing the security and therefore was not of significant value. In a case where the option was attached to

(a) a bond or debenture and the total issue price was at or below the principal amount of the bond or debenture, or (b) a preferred share and the total issue price was at or below the redemption price of the preferred share,

no part of the issue price was viewed as being applicable to the option.

The first sentence of paragraph 2 applies generally to securities issued prior to August 19, 1983 and for issues in respect of which a prospectus was issued to the public on or before that date. You interpret this sentence as exempting the taxpayer from the allocation requirement if the Department can prove that the option was not one of the main reasons for issuing the security. This interpretation is generally correct. We would prefer to say, however, that the conditions described in this sentence must be proven to the satisfaction of the Department rather than that the Department must prove them. Depending on the circumstances, an allocation can be a disadvantage to a purchaser or to the issuer of the securities and related warrants.

The second sentence of paragraph 2 applies only to non-severable ("attached") options. It gives two examples of instances in which the Department used to be of the view that the condition outlined in the first sentence was usually met. These examples to not relieve a taxpayer from proving that the option was not one of main reasons for issuing the security. Given that the warrants issued XXXX may be traded separately from the debentures, the examples set out in the second sentence do not apply to the case at hand. Consequently, an allocation of both the issue price and the issue expenses is required unless the first sentence applies.

The use of the past tense in paragraph 2 does reflect a change in departmental policy effective August 19, 1983. The policy reflected in paragraph 2 was set out in paragraph 3 of former Interpretation Bulletin IT- 96R3. The Department decided that the attempt to clarify its administrative practice regarding allocations was impractical due to the diverse circumstances under which shares with options could be issued. In many cases, the coupling of an option to a security issue acted as a sweetener to improve the marketability of the issue (notwithstanding that the issue price may not have exceeded the principal amount/redemption price of the bond, debenture or preferred share). The very presence of the option therefore indicated that it had some value, necessitating an allocation to reflect the economic reality of the transaction. Paragraph 3 of former Interpretation Bulletin IT-96R3 was cancelled by a Special Release dated August 19, 1983, subject to the grandfathering treatment reflected by the opening words of paragraph 2 in the current IT.

Interpretation Bulletin IT-114

Your question on Interpretation Bulletin IT-114 also arises in connection with the above-noted issue of debentures and warrants. We understand that the following additional facts are relevant:

XXXX

considers that the discount is equivalent to interest in accordance with paragraphs 3 and 24 of Interpretation Bulletin IT-114 .

You have asked us to assume that the discount is to be regarded as interest. We assume that this means the entire discount is to be regarded as interest (i.e. that no portion of the discount exceeds the discount necessary to bring the effective return up to XXXX.

Before dealing with your question, we should point out that Interpretation Bulletin IT-114 is currently under review. As announced during the 1988 Revenue Canada Round Table, the Department is concerned that a true discount does not accrue on a daily basis and consequently may not qualify as interest. No decision has yet been reached in this regard. Until the Department formally announces a change in its published position on this issue, however, paragraph 3 of IT-114 will continue to be applied. Our response, therefore, is based on the current wording of IT-114 .

You are concerned that the interest becomes payable only at the maturity date. This is not the case, however. Your confusion probably arises from the two senses of the adjective "payable". The Random House College Dictionary (revised edition, 1975) ascribes two different meanings to "payable":

1. to be paid; due: a loan payable in 30 days.

2. capable of or liable to being paid.

The dictionary also ascribes two different meanings to the word "due":

1. immediately owed: This bill is due.

2. owing or owed, irrespective of whether the time of payment has arrived.

For purposes of paragraph 20(1)(c) and the Act generally, "payable" means "liable to being paid" (i.e. now or at a future time). In contrast, the word "due" conveys the sense of being "immediately owed" (the first meaning of "due" noted above).

Interest on the bonds in question is not (immediately) due until maturity. Nevertheless XXXX is under a legal obligation throughout the term of the bonds to make the interest payment, even though performance of this obligation is deferred until maturity of the bonds. Any interest paid on maturity will have accrued during the various years during which the notes were outstanding and will be payable in respect of the year in which it accrued. Since paragraph 20(1)(c) authorizes an accrual-basis taxpayer to deduct simple interest solely during the year in respect of which it is payable, simple interest must be deducted in the year of accrual. It cannot be deducted in a subsequent year, even if paid during that subsequent year [refer to M.N.R. v Mid-West Abrasive Company of Canada Limited, 73 D.T.C. 5429 (F.C.T.D.)].

When discount is regarded as equivalent to interest, the Department takes the position that the discount must be deducted under the simple-compound method. This method assumes a built-in rate of return. A constant rate of simple interest is applied to the principal throughout the term on the basis that interest accrued to the end of each year remains outstanding and earns compound interest through the remainder of the term. Since paragraph 20(1)(d) of the Act allows a deduction for compound interest solely when it is paid, a substantial portion of the discount will be deductible only on payment. Consequently, the straight-line amortization claimed by XXXX is not acceptable for income tax purposes.

During its review of Interpretation Bulletin IT-114 , the Department will be considering whether to accept the straight-line or actuarial methods of deducting discount that qualifies as interest. We are unable to estimate when a decision may be made in this regard, however.

We trust that this letter will assist you with your audit. If you have any questions, please do not hesitate to contact us.

A/Chief Leasing & Financing Section Financial Industries Division Rulings Directorate