4 April 1991 Internal T.I. 9027237 F - An Audit Perspective of Capital Markets

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.

Special Audits Division	Leasing and Financing
E.H. Gauthier, Director	Section
	J. Stalker
	957-9796

7-902723

Subject: Course # 1040 An Audit Perspective of Capital Markets

We enclose our package on the tax implications of certain financial products referred to in the above-noted course.  We regret that other workload has prevented an earlier response.

We will have to discuss how we will implement procedures to ensure that participants who have taken the course will receive updated or new positions.

If you have any questions or suggestions please contact Jane Stalker.

C.C. B. DarlingngDirectorFinancial Industries DivisionRulings Directorate

Attachments

cc: Mr. P. Ellison

COURSE # 1040

AN AUDIT PERSPECTIVE OF CAPITAL MARKETS

TAX IMPLICATIONS

This package is intended to highlight some of the tax issues associated with certain financial products by presenting some of Revenue Canada's public statements on such vehicles and by listing concerns of which you should be aware.

There are many problems involved in the taxation of financial instruments.  The profusion and variety of instruments available has already created tax complexity, and as new instruments evolve that complexity is only increased. There are few provisions in the Income Tax Act (Canada) which specifically deal with the more sophisticated products and there have been few Canadian tax cases on this subject.  In addition, the time frame in introducing these products to the market is usually too short to allow Revenue Canada to produce advance income tax rulings or general opinions on new financial products prior to their introduction

As emphasized later in this package, Revenue Canada has initiated a study of interest rate and foreign currency hedging transactions. The purposes of this review are to broaden our knowledge base with respect to hedging transactions and to determine what, if any, general positions can be taken, given the many techniques that appear to be involved.  This study includes options, swaps, hedges and futures.

21(1)(b)

As new positions evolve, they will be passed on to the participants of this course

Note on abbreviations

"The Act" - The Income Tax Act (Canada)

"CTF Conference" - The Canadian Tax Foundation Annual Conference

FINANCIAL PRODUCTS IN GENERAL

Tax Issues

1.     Are transactions on income or capital account? Considerations:

a)   trader or dealer recognizes all transactions on income account

b)   adventure in the nature of trade

c)   intention of taxpayer including secondary intention

d)   number and frequency of transactions

e)   length of holding time

f)   method of disposition

g)   nature of the transaction

2.     Election under subsection 39(4) for capital treatment (not available for traders or dealers in securities)

3.     Timing of reporting of gains and losses

4.     Inventory valuation

5.     Large Corporations Tax (Part I.3, sections 181 to 181.9 of the Act)

6.     General Anti - Avoidance Rule (GAAR) - section 245 of the Act

References

Interpretation Bulletins: 

IT-238R2      "Fees paid to investment counsel"

IT-341R        "Expenses of issuing or selling shares, units in a trust, interests in a partnership or syndicate and expenses           of borrowing money"

IT-479R        "Transactions in securities"

IT-459      "Adventure or concern in the nature of trade"

IT-143R2       "Meaning of eligible capital expenditures"

IT-448      "Dispositions - Changes in terms of securities"

IT-387R2       "Meaning of "identical properties"

IT-84           "Capital property owned on December 31, 1971 - Median rule (Tax-free zone)"

IT-93           "Capital property owned on December 31, 1971 - Meaning of actual   cost and amortized cost"

IT-139R        "Capital property owned on December 1, 1971 - Fair market value"

EQUITY

Tax Issues

1.     Dividend income (paragraphs 12(1)(J) and (k) of the Act)

2.     Preferred share rules (including Part IV.l and Part VI.l of the Act)

3.     Treatment of rights, warrants and options

4.     Paid-up capital

5.     Capital or income account

6.     Withholding tax on dividends (subsection 212(2) of the Act)

7.     Thin capitalization (subsections 18(4) to (8) of the Ac.)

8.     Foreign accrual property income (FAPI)

9.     Denied loss rules (subsections 112(3), (4) and (4.1) of the Act)

10.     Determination of cost base

11.     Convertible share and exchangeable share issues

12.     Share issue expense and share transfer fees (paragraphs 20(1)(e),(e.1) and (g) of the Act)

13.     Superficial losses (subparagraph 40(2)(g)(i) of the Act)

14.     Deemed dividends (eg. section 84 of the Act)

References

Interpretation Bulletins:

IT-67R2        Taxable dividends from Canadian resident corporations"

IT-133      "Stock exchange transactions - Date of disposition of shares"

IT-328R2      "Losses on shares from which dividends have been received"

IT-65           "Stock splits and consolidations"

IT-88R      "Stock dividends"

IT-115R        "Fractional interest in shares"

IT-116R2       "Rights to buy additional shares"

IT-448      "Dispositions - Changes in terms of securities"

FIXED INCOME INSTRUMENTS     

Tax Issues

1.     Paragraph 20(1)(c) issues: Does a legal obligation to pay interest exist? Is there a lender-borrower relationship?

2.     Interest income and timing of its recognition (subsection 12(3) to section 12.1 of the Act)

3.     Capital or income account

4.     Interest expense (paragraphs 20(1)(c) and (d) of the Act)

5.     Discounts (Interpretation Bulletin 114, paragraphs 18(1(f), 20(1)(c) and (f) of the Act)

6.     Premiums and Bonuses

7.     Expenses re financing (paragraphs 20(1)(e) and (e.l) of the Act)

8.     Withholding tax (paragraph 212(1)(b) and subsections 214(6) to (7.1) of the Act)

9.     Forgiveness of debt (subsection 80(1) of the Act)

10.     Denied loss (subparagraph 40(2)(g)(ii) of the Act)

11.     Prescribed debt obligations (subsection 12(9) of the Act and Section 7000 of the Regulations).

12.     Accrued bond interest (subsection 20(14) of the Act)

The following question and answer appeared in the Revenue Canada Round Table session of the 1990 CTF Conference.

Accrued Bond Interest - Deductibility  by Purchaser of Debt Obligation - Question 13

     The Queen v. Antosko 90 DTC 6111 (FCTD) (appeal to FCA filed), seems to suggest that a taxpayer who acquires a debt obligation from a vendor is entitled to a deduction under paragraph 20(14)(b) in respect of interest already accrued thereon at the time of acquisition only if it can prove that the vendor included such interest in income.  Is this the position currently being maintained by the Department?

Department's position

     The taxpayer who acquires an interest-bearing debt obligation is entitled to a deduction for a portion of the interest included in his income if the requirements in subsection 20(14) are met.  It has been and continues to be the Department's position, as stated in paragraph 6 of Interpretation Bulletin IT-410R that the transferee will be entitled to a deduction of interest pursuant to paragraph 20(14)(b) only to the extent that the interest is included in the income of the transferor of the interest-bearing obligation.  This position was supported by the Court in The Queen v. Antosko 90 DTC 6111 (FCTD) wherein it was held that paragraphs (a) and (b) of subsection 20(14) must be read together.

Revenue Canada made the following comments at the 1988 CTF Conference.

Deep Discount and Zero Coupon Bonds (p. 53:15)

     The concern is that the words "discount" and "interest" have different legal meanings.  The legal meaning of "interest" has been the object of clear judicial pronouncements in Canada and elsewhere.  In order for an amount to be interest, it must meet the following criteria:

1)        It must be compensation for the use of the principal sum or the right to the principal sum.

2)        It must be calculated on a principal sum or a right to a principal sum.

3)        It must be calculated on an accrual (day-to-day) basis.

     A true discount would not meet the third test.  Our current position is that the tax treatment for the issuer and holder of deep discount and zero coupon bonds is a question of fact to be examined in each case.  If, by reference to all the supporting documents, it is determined that the apparent discount is interest, the compound interest element is deductible only when paid.

Bonus on Early Redemption of Debt (p. 53:16)

     Usually, an amount [bonus] paid on the early redemption of a debenture is not regarded as interest because it does not accrue from day to day.  In our view, it makes no difference whether the early redemption is at the option of the holder or the issuer of the obligation.

Amounts Paid on Redemption of Bonds or Purchase of Bonds in the Open Market

     We acknowledge that the treatment of an amount paid for accrued interest on the redemption of a bond by the issuer differs from that afforded an amount paid representing accrued interest when the issuer purchases the bond on the open market.  In the first situation, the accrued interest presumably would become due on redemption, and the payment would in fact be a payment of interest and deductible to the extent allowed by paragraph 20(1)(c).  In the second situation, no interest is due at the time the bond is purchased; in fact, interest will never become due and payable.  Accordingly, no deduction under paragraph 20(1)(c) is allowed.

     The redemption of a bond held by a non-resident in the above circumstances would give rise to interest subject to withholding tax unless exempted by a specific provision of paragraph 212(1)(b).  The purchase on the open market by the issuer of a bond held by a non-resident would be deemed to be a payment of interest subject to the provisions of paragraph 212(1)(b) unless it was an excluded obligation.

[Note:  When a bond is purchased by its issuer on the open market (and assuming the issuer does not exercise advantages or special rights not available to the general public), subsection 39(3) of the Act deems the spread on the purchase to be a capital gain or loss.  However, when the issuer makes a purchase on the open market of one of its bonds which is held by a non-resident, subsection 214(7) of the Act deems the excess of the purchase price over its issue price to be interest for the purpose of Part XIII of the Act.)

The following question and answer appeared in the Revenue Canada Round Table session at the 1987 CTF Conference

Question 58 - Conversion of Debt Resulting in Disposition of Debt

     When the conversion of an interest-bearing debt to non-interest bearing debt results in a disposition of the debt, will section 80 apply, and if it does, will the fair market value or the principal amount of the new debt be taken into account in determining the amount of the forgiveness of debt?

Department's Position

      As stated in Interpretation Bulletin IT-448, it is our view that the conversion of interest-bearing debt into non-interest-bearing debt will generally represent such a significant change in the original obligation that a disposition of the debt will occur.  The interest bearing debt will be settled or extinguished on the conversion for an amount equal to the fair market value of the non-interest bearing debt at the time of the conversion.

The following question and answer appeared in the Revenue Canada Round Table session at the 1990 CTF Conference.

Foreign exchange gain or loss on a debt instrument - Question 48

     Will a debtor, who issues a debt instrument denoted in a foreign currency, be considered to have realized a foreign exchange gain or loss by virtue of subsection 39(2) of the Income Tax Act in the following circumstances:

(a)  Only the interest rate on the debt instrument is changed.  There are no other changes to the debt instrument.

(b)  Only the maturity date is changed.  There are no other changes to the debt instrument.

(c)  Both the maturity date and the interest rate are changed

(d)  The original lender assigns the debt instrument to a new lender.

Department's Position

     A debtor who has issued a debt instrument denoted in a foreign currency will make a foreign exchange gain or sustain a loss upon the settlement of the debt instrument.  If the terms of a debt instrument are changed, such changes may be considered so fundamental to the holder's economic interest that a gain may be made or a loss sustained.  In these circumstances the debt instrument has been settled and a new debt issued in substitution.  The same criteria as to whether there has been a disposition apply.  Paragraph 7 of Interpretation Bulletin 448 gives examples of changes which almost invariably give rise to a disposition (unless these changes were provided for in the original terms of the agreement).  These examples include a change from interest-bearing to interest-free or vice versa and a change in repayment schedule or maturity date.

     Provided the assignment of the debt by the original lender to a new lender does not constitute a novation [FN*: Note:  A novation occurs when an original obligation is discharged by agreement of the parties and a new obligation with new consideration is undertaken, usually, but not necessarily, on the same terms, with a different creditor or debtor.  In contrast an assignment may not necessarily release the original debtor from the contract.]and provided none of the terms of the debt instrument are varied such an assignment should not trigger the realization of a foreign exchange gain or loss.

     Whether a foreign exchange gain or loss is realized by virtue of the changes noted above will depend on the facts of the particular situation. Degree of change and relative importance in the circumstances would also be considered for example.

References

Interpretation Bulletins:

IT-396R        "Interest Income"

IT-114      "Discount, premiums and bonuses on debt obligations"

IT-52R4        "Income bonds and income debentures"

IT-265R2       "Payments of income and capital combined"

IT-360R2       "Interest payable in a foreign currency"

IT-361R2       "Exemption from tax on interest payments to non-residents

IT-410R        "Debt obligations - Accrued interest on transfer"

IT-448      "Dispositions - Changes in terms of securities"

CONVERTIBLE BONDS/DEBENTURES     

Convertible bonds and debentures ordinarily offer investors the right to convert the bonds or debentures of an issuer into a specific number of common shares of the same corporation at a given price within a specified time. Essentially the investor has a call on common shares at a predetermined price (Convertible shares are also frequently encountered).

Tax Issues

1.     Interest deductibility

2.     Debt or equity

3      Rollover available under section 51 of the Act if capital property

4      Proceeds to issuer

5      Forgiveness of debt (section 80 of the Act)

6      Discounts, premiums and bonuses

7.     Preferred share rules

See Interpretation Bulletin IT-114.

The following question and answer appeared in the Revenue Canada Round Table session at the 1990 CTF Conference.

Question 12 - Interest Deduction

     A corporation issues a debenture with a five-year term on which interest at a specified rate per annum is compounded semi-annually.  Simple interest and compound interest are payable in cash at maturity.  The debenture and accrued but unpaid interest are convertible into common shares at the option of the holder.  The conversion ratio is based on the fair market value of the common shares at the date of issue of the debenture.  The debenture is not redeemable at the option of the issuer.

     Assuming that the debenture meets the purpose test of paragraph 20(1)(c), what are the Department's views as to the availability of deductions for simple and compound interest under paragraphs 20(1)(c) and 20(1)(d) respectively?

Department's Position

     Provided that the facts of a particular case establish that a lender and borrower relationship exists, that there is a legal obligation to pay interest and that the issuer has no means, whether direct or indirect, to force conversion of the debenture, the borrower would be entitled to deduct simple interest on a paid or payable basis under paragraph 20(1)(c) and compound interest when it is paid under paragraph 20(1)(d).

EXCHANGEABLE DEBENTURES

Exchangeable debentures are similar to convertible debentures; however, exchangeable debentures are exchangeable into securities issued by another corporation, instead of those of the issuer of the debentures.  As a result a tax-free rollover under section 51 of the Act is not available since more than one corporation is involved.  (Exchangeable shares are also frequently encountered).

Tax Issues

1.     Interest deductibility

2      Debt or equity

3.     Proceeds to issuer

4      Forgiveness of debt

5.     Discounts, premiums and bonuses

6      Preferred share rules

See Interpretation Bulletin IT-114.

TREASURY BILLS

A note that bears no interest (within the legal definition of that term), such as a treasury bill ("T-bill"), constitutes a prescribed debt obligation pursuant to subsection 12(9) of the Act and paragraph 7000(1)(a) of the Regulations.  Consequently, an amount determined pursuant to paragraph 7000(2)(a) of the Regulations would be deemed to accrue on the note as interest income to its holder.   (Usually this is a simple calculation - the difference between the maturity or face amount of the T-bill and the discounted price at which it was bought.  That is, the discount on the bill would be deemed to accrue as interest on a compound basis over its life.)

Note that it may be possible for a capital gain or loss to arise at the time of disposition of a T-bill (assuming the investor is not a trader).  The aggregate of all amounts of interest included in income prior to the disposition is included in computing the cost of the T-bill by virtue of subsection 52(1) of the Act.  As a result, a capital gain or loss could arise on disposition to the extent that proceeds of disposition exceed or are less than the adjusted cost base of the T-bill.  Generally, capital gains and losses will only occur when there is a variation ln interest rates on capital markets.

Effective after 1988, subsection 201(6) of the Regulations requires investment dealers and financial institutions to make an information return in respect of the disposition by an individual of a debt obligation in bearer form.  This requires the reporting of proceeds of disposition, rather than the amount of interest earned by the individual, since often the investment dealer or financial institution will not know the amount of the discount at which the debt obligation was originally sold

STRIPPED BONDS

Tax Issues

1.     Deemed interest income accrual on prescribed debt obligations (subsection 12(9) of the Act and section 7000 of the Income Tax Regulations).

2      Withholding tax on deemed interest (subsections 214(6) to (7.1) of  the Act.)

The following question and answer appeared in the Revenue Canada Round Table session at the 1984 CTF Conference.

0.14 Stripped Coupon Bonds

     Although subsection 12(9) of the Act and regulation 7000 would apply to stripped coupon bonds (that is, bonds sold at a discount because the coupons have been removed), it does not apply to the coupons that are discounted and sold separately.  What is the tax treatment for the purchaser of the discounted interest coupons?

Department's Position

     Where a bond is stripped of its coupons, and the bond residue and the detached coupons are sold separately at a discount, it is the position of the Department that the accrual rules contained in subsection 12(9) of the Act and regulation 7000 are applicable to both the bond residue and the detached coupons.

DEEP DISCOUNT BONDS

Tax Implications

An issuer may offer investors a substantial or "deep" discount on the stated redemption value of a bond to compensate for the loss (or reduction) of annual interest payments.  A deduction to the issuer for the discount may be available under paragraph 20(1)(f) of the Act, where interest is stipulated to be payable on the bond.  For the discount to be fully deductible under subparagraph 20(1)(f)(i) the amount for which the obligation is issued must not be less than 97% of the principal amount and the yield on the obligation cannot exceed 4/3 of the interest stipulated to be payable.  In any other case, 3/4 of the discount will be deductible provided interest is stipulated to be payable on the obligation.

No general statement can be made about the appropriate tax treatment for investors, which depends on the circumstances.

SECURITIES LENDING/REPURCHASE AGREEMENTS

Tax Implications

New legislation provides deeming rules for securities lending arrangements and specifies the tax consequences for related payments.  See section 260 of the Act.

Repurchase agreements (REPOs) are similar to securities lending arrangements and accordingly will be subject to section 260 if the definition of a "securities lending arrangement" under subsection 260(1) of the Act is met.

See the Explanatory Technical Notes to Bill C-28 from June 20, 1989 (p.94 97) attached, and the Explanatory Notes to the Draft Income Tax Amendments from July 1990 (p.351-2), which made minor changes to Bill 5-28, attached

INTEREST RATE SWAPS

Tax Implications

A.  Types of payments

The types of payments that can arise under an interest rate swap include:

1.   periodic payment/receipt

2.   arrangement fees

3.   up-front compensation fees

4.   spread to the intermediary financial institution

5.   commission or finder's fees

6.   payments to buy down the rate

7.   payments to unwind the swap such as assignment in the secondary market, early termination or default

B.  Tax Issues

1.   Income account or capital account

2.   Timing of reporting

3.   Withholding tax

C.  Revenue Canada's Position

1.   Periodic Payments

     The periodic payment refers to the payment exchanged or the net payment/receipt called for under the terms of the swap.

     This payment is includable/deductible under section 9 of the Act.

     If the payee is a non-resident, Part XIII is not considered to apply to the swap on the basis that the periodic payment is not interest and provided that the payments are matched. If instead the resident payor in the swap receives payments from the nonresident in advance of its payment, the later payment by the Canadian participant would be considered to contain an interest element which would be subject to withholding tax

2.  Other fees

     Other fees paid to the other participant in the swap or to an intermediary are generally deductible provided they are reasonable in amount.

     The following comments appeared in the 1984 Revenue Canada Round Table session of the CTF Conference. (p.826)

Interest Rate Swaps

     Where a Canadian corporation (Canco) with debt enters into an agreement with an arms's length financial intermediary to pay to that entity an amount based on a fixed/floating rate in exchange for an amount calculated by reference to a fixed/variable raye, our views are as follows:

1)        Provided that interest payable by Canco on its debt is deductible for income tax purposes, amounts payable by Canco to the intermediary or receivable from the intermediary pursuant to the agreement are considered to be on income account.

2)        Where the intermediary is a nonresident, no Pare XIII tax is exigible with respect to payments made by Canco to the intermediary if such payments are made at the same time and for the same period as the payments made by the intermediary to Canco

3)        Fees paid to the intermediary in respect of the swap transaction are generally deductible provided they are reasonable in amount.

NOTE

21(1)(b)

SHORT SALES

Tax Implications

A short sale is a sale of stocks, bonds, foreign exchange or commodities that the seller does not own, made in anticipation of a fall in prices.  The gain or loss resulting from the difference between the proceeds from the short sale received by the seller and the cost of the securities which the seller must remit to cover the sale is considered to be on income account.

See Interpretation Bulletin IT-479R "Transactions in securities".

FUTURES

Tax Issues

1.     Capital account or income account

2.     Calculation of profit or loss

3.     Timing

In general, any gain or loss is on income account.  Traders or dealers and financial institutions must use income treatment.  A speculator may use either capital or income treatment, provided the treatment is consistent from year to year.  (This administrative concession for speculators is stated in Interpretation Bulletin IT-346R).

The Department looks at commodity straddles as a single, composite transaction so that profit or loss from the transaction would be recognized only in the year that the last portion of the straddle is closed out.

However, the Special Audits Division in Head Office has advised us that the Department's position with regard to the reassessing policy for commodity straddles has been modified, when the straddle is used primarily to reduce taxes on a personal income tax return by a taxpayer who is not a trader.  The Department will no longer recognize the unrealized loss (if any) as at the year end, on the basis that the transaction was not entered into to earn or produce income pursuant to paragraph 18(1)(a) of the Act.

See Interpretation Bulletin IT-346R "Commodity futures and certain commodities".

From the Revenue Canada Round Table session of the 1989 CTF Conference:

Commodity Straddles

Question 30 The Friedberg Case [Friedberg v. The Queen 89 DTC 5115 (FCTD)]

     Having regard to the decision of the Federal Court in Friedberg, is the department reconsidering its position with respect to straddles, hedge transactions, and other commodity or securities operations? Will notices of objection in such cases be held in abeyance pending the outcome of any appeal in Friedberg?

Department's Position

     The department is appealing the decision of the Federal Court-Trial Division in the Friedberg case and is not reconsidering its assessing practices with respect to commodity straddle transactions at the present time.  Any notices of objection involving such transactions will continue to be held in abeyance until the matter is resolved.

(Note:  The appeal in the Friedberg case has not been heard as of February 8, 1991)

OPTIONS

Tax Implications

A.      Issues

1.       Income account or capital account.

     Income or capital treatment is a question of fact.  Generally an option transaction is on income account in view of its speculative nature (particularly in the case of naked options) and the absence of any income until disposal.  However, capital treatment may be considered if the option is clearly designed to hedge capital transaction or where the taxpayer has elected capital treatment.

2.        Timing of reporting of gains and losses.

3.        Inventory valuation if a trader is involved.

B. Income Account
Call options
	Holder (Purchaser)	Writer (Vendor)
Exercised	Premium fn *  added to security cost	Premium is income in year exercised by holder
Expires	Premium deducted in year of expiry	Premium is income in year of expiry
Close Out	Premium paid is netted against premium recieved in year of close out.	Premium is netted with cost of offsetting position
Put options
	Holder (Purchaser)	Writer (Vendor)
Exercised	Premium deducted from proceeds of security	Premium is income in year exercised
Expires	Premium is deducted year of expiry	Premium is income in in year of expiry
Close out	Premium paid netted against premium received in year of Close out	Premium paid netted with cost of offsetting  position

C. Capital account  (See Section 49 of the Act) fn **
Call options
	Holder (Purchaser)	Writer (vendor)
Exercised	Premium added to cost of shares	Premium is capital gain at time of writing call fn ***
Expires	Premium is capital loss in year of expiry	No tax consequences
Close out	Net gain or loss in year of close out	Premium is capital loss in year of close out
Put options
	Holder (Purchaser)	Writer (Vendor)
Exercised	Premium deducted from proceeds	Capital gain at time of writing put fn ***
Expires	Premium is capital loss	No tax consequences
Close out	Net gain or loss in year of close out	Premium is capital loss in year of close out

See Interpretation Bulletins IT-479R "Transactions in Securities" and IT-96R4 "Options granted by Corporations to acquire shares, bonds or debentures".

NOTE

21(1)(B)

FORWARD FOREIGN EXCHANGE AGREEMENTS

Tax Implications

A.        Types of payments

1.   Gain/loss on foreign exchange transaction .

2.   Premium or discount if hedge 3.   Other fees

B.      Tax Issues

1.   Capital account or income account

2.   Timing of realization of gain/loss

C.      Revenue Canada's position

     The general rules in section 9 of the Act apply to forward contracts of traders or dealers or speculators, so that any gain or loss would be on income account.

      The timing of the realization of gains and losses is discussed in Interpretation Bulletin 346R on the similar topic of commodity futures.  As an administrative policy, Revenue Canada will allow a speculator to choose to report futures either on income or capital account, provided such reporting is followed consistently from year to year.

     If the forward contract is intended as a hedge, the forward contract is considered separately from the underlying transaction that is being hedged, although its nature as capital or income is characterized by the underlying transaction.

     A hedge premium or cost is not considered as a separate item for tax purposes.  Instead it is viewed as inherent in the determination of any gain on loss on the forward contract.  The characterization of this gain or loss as on account of income or capital will depend on the nature of the underlying transaction.

The following question and answer appeared in the Revenue Canada Round Table session of the 1984 CTF Conference.

Question 63 Hedge Cost

     The exchange rate payable on a forward contract in foreign exchange in many cases is slightly higher than the spot rate for the foreign currency on the day that the forward is negotiated.  On the subsequent day when the forward contract is closed out, this differential may represent a net cost to the Canadian participant, depending upon the exchange rate on that day. What is the Department's position as to the treatment of this so-called hedge cost?

Department's Position

     The Department's position as regards a "hedge cost" or "hedge premium" is not to treat such a cost as a separate item for income tax purposes.  Instead, it is viewed as inherent in the determination of any gain or loss on the forward contract, which gain or loss can only be determined at the time of contract fulfillment and is equal to the difference between the payment made under the contract and the Canadian-dollar value of the consideration received therefore where such consideration is translated to Canadian dollars at the spot rate in effect on the date of delivery.  The characterization of this gain or loss as on account of income or capital will depend on the underlying use of the funds that gave rise to the liability that the forward contract is designed to hedge.

NOTE

21(1)(b)

CURRENCY SWAPS

Tax Implications

A.        Types of payments.

     See "Interest Rate Swaps - Tax Implications".

B.        Tax Issues

1.      Payments - Income account or capital account

2.      Foreign Exchange Gain or Loss  Income account or capital account

3.      Timing of realization of gain/loss

4.      Withholding tax

C.      Revenue Canada's Position

1.        Periodic Payments

     The Canadian dollar equivalent of the interest payments exchanged are considered to be on income account, and accordingly includable/deductible under section 9 of the Act.  Withholding tax may be exigible under section 212 of the Act.

2.        Foreign Exchange Gain or Loss

     The tax treatment of any net foreign exchange gain or loss resulting from a mismatching of payments, including the timing of its recognition, is discussed in Interpretation Bulletin IT-95R.

3.        Other Fees

     Other fees paid to the other participant in the swap or to an intermediary are generally deductible provided they are reasonable in amount.

D.        References

     See Interpretation Bulletin IT-95R "Foreign exchange gains and losses"

The following comments were made at the 1984 CTF Conference. (pp 826-827)

CURRENCY SWAPS

As it has been our experience that there are a considerable number of variations to the "basic" interest and currency swap arrangements, we have provided only some general comments with respect to these transactions...,

A Canadian corporation (Canco) with debt denominated in a foreign currency (currency "X") on which interest is deductible enters into bona fide agreements to

•     borrow funds denominated in other foreign currency (currency "Y");

•     swap those funds for an equivalent amount of funds denominated in currency X with a financial intermediary;

•     pay to and receive from that intermediary amounts sufficient to meet the periodic interest payments due on one another's respective obligations;

•     reswap the currencies at the same amounts initially swapped on a see redemption date; and

•     repay the currency Y debt on the redemption date.

Our views of the above are as follows:

1)     The Canadian-dollar equivalence of the amounts payable by Canco to the intermediary or receivable by Canco from the intermediary in respect of periodic interest payments as described above are considered to be on income account.

2)     The Canadian-dollar equivalent of the increase paid or payable on the currency Y debt is deductible by Canco in computing its income in accordance with the provisions of paragraph 20(1)(c) of the Income Tax Act.

3)     Provided the terms of the currency Y debt conform to the requirements specified in subparagraph 212(1)(b)(vii) of the Act, the interest payments made by Canco on that debt are not subject to tax under Part XIII of the Act.

4)     Any gain or loss arising on the repayment of the currency Y debt as a result of any fluctuation in the value of the Canadian dollar vis-à-vis currency Y will be offset by a matching gain or loss arising on the repayment of currency Y by the financial intermediary to Canco.

NOTE

21(1)(b)

AUCTION PREFERRED SHARES

In very simple terms, auction preferred shares are cumulative preferred shares which are issued with a set dividend, generally paid quarterly, for the first five years.  The shares are redeemable at par plus unpaid dividends at any time after five years. Beginning with the first dividend in the sixth year, the dividend is determined using one of three methods undertaken in the following order,

1)     Direct negotiation between the company and its shareholders;

2)     Dealer bid procedure where bids are obtained from investment dealers; and

3)     Auction procedure where bids can come from existing holders as well as new investors.

Tax issues

1.     The auction preferred shares are taxable preferred shares. Accordingly, Part VI.1 tax on the dividend must be remitted pursuant to subsection 191.1(1).

2.     A failed auction could precipitate a redemption of the shares. Generally, a failed auction is unlikely and it is thus arguable that the shares would not be term preferred shares as defined in section 248.  As a result subsection 112(2.1) would not prevent the deductibility of the dividends.  However, if the likelihood of a failed auction is less remote, paragraph (i) of the definition of a term preferred share as set out under subsection 248(1) may apply, with the result that a holder of auction preferred shares that is a specified financial institution would not be able to deduce dividends on those shares.

ASSET SECURITIZATION

In a securitization a vendor corporation sells assets (usually accounts receivable) at a discount to a special purpose entity that, in turn, issues debt securities to investors, collaterized by the receivables.  The vendor obtains immediate proceeds for its receivables and off-balance sheet financing.  The cost of the discount to the vendor is usually based on the cost of commercial paper.  The purchaser receives the discount plus various other fees.  Recourse to the vendor in the event of uncollectability is generally limited to a deferred portion of the purchase price.  The receivables are sold on a continuous basis over an agreed period, ordinarily, at least five years.  The proceeds of collected receivables are used to pay the discount and fees to the purchaser and the net collection amount is invested in new receivables.  On termination of the program, the list of receivables becomes fixed and no other purchases are made.

Tax issues

The key tax issue in an asset securitization is whether the arrangement is a purchase and sale or instead a loan collateralized by the securitized assets.  This is a question of fact.  The other tax issues listed below depend on this characterization.

1.     Purchase and sale v. loan

2.     Deductibility of fees

3.     Withholding tax (application of subparagraph 212(1)(b)(vii) of the Act) if the purchaser is a non-resident.

4.     Deductibility of discount

5.     Applicability of reserves for doubtful debts and bad debts (paragraphs 20(1)(1) and 20(1)(p) of the Act)

REVERSE PERLS  (Reverse Principal Exchange Rate Linked Securities)

A Reverse Perl is an arrangement whereby a Canadian corporation borrows a target number of Canadian dollars denominated in a foreign currency (e.g. Japanese yen), repayable in 5 years.  The amount to be repaid by the borrower is determined by formula.  The formula is such that if the yen appreciates relative to the dollar the amount of yen to be repaid will be less than that borrowed.  If the dollar appreciates relative to the yen then the yen to be repaid will be greater than the amount borrowed.  We are advised that as the currency exchange risk is basically borne by the lender, given the (former) market expectation that the yen will appreciate relative to the dollar, the borrower is willing to pay a premium interest race.

By utilizing the futures market the borrower is essentially able to ensure a gain independent of which currency performs better.

Tax Implications

The following comments were made by a representative of Revenue Canada at the 1989 Corporate Management Tax Conference (p.8:11):

Another form of loan arrangement involves a trade-off between the interest rate and the principal repayable on security.  For example, a borrower may pay an above-market rate of interest corresponding with a strong likelihood that the amount repayable on maturity will be less than the amount originally borrowed.  In this situation, we are not satisfied that the amounts stipulated to be interest are in fact interest.

21(1)(b)

PARTICIPATING LOANS

The following comments were made by a representative of Revenue Canada at the 1989 Corporate Management Tax Conference (p.8:9):

(attached)     

Attachment — REVENUE CANADA PANEL

A payment made by a landlord to a tenant to cancel a lease between them is generally deductible by the landlord under either paragraph 20(1)(z) or paragraph 20(1)(z.1) of the Act.

Application of Paragraph 12(1)(x) to the Tenant

Paragraph 12(1)(x) is generally applicable to all inducement payments received by a tenant, subject to the exceptions in subparagraphs 12(1)(x)(v) to (viii).  We are frequently asked whether paragraph 12(1)(x) is applicable to interest-free loans provided as inducements.  Paragraph 12(1)(x) is not generally applicable provided that the loan is unconditionally repayable. It is possible that section 245, the general anti-avoidance rule (GAAR), could apply to certain abusive transactions involving interest-free loans and the landlord's restriction on the purposes for which the tenant may actually use the loan proceeds.

Another common question we are asked is whether paragraph 12(1)(x) applies to lease cancellation payments or whether such payments are excluded from paragraph 12(1)(x) by virtue of subparagraph 12(1)(x)(viii).  From our experience, whether all or any portion of a lease cancellation payment is a payment by the landlord for an interest in the tenant's property for the purposes of subparagraph 12(1)(x)(viii) is a question of fact.  We have taken the position that if the payment results in an acquisition by the landlord of an interest in the tenant's property, the amount of the payment would be considered to be proceeds of disposition to the tenant of a leasehold interest and would not be subject to paragraph 12(1)(x).

Participating Loans

The department's concern in respect of participating loans is to determine whether such loan arrangements effect a distribution of profits or are an expense of doing business.  A distribution of profits should be on a tax-paid rather than a tax-deductible basis.

No clear dividing line exists in law to distinguish debt payments from equity payments.  As a general rule, the department takes the view that a lender's return on debt does not depend on the profitability of the borrower, whereas an investor's return on equity does depend on profitability.  On this view of the matter, most participating loan arrangements qualify as equity rather than debt.

Some taxpayers have represented the view that participation payments are deductible under paragraph 20(1)(c), which authorizes a deduction for amounts paid or payable pursuant to a legal obligation to pay interest.  It is, however, doubtful that most participation payments qualify as interest.  On the basis of the Miller case," a payment must satisfy all three of the following criteria to qualify as interest:

1)     it must be calculated on a daily accrual basis;  16 Miller v. The Queen, 85 DTC 5354 (FCTDl.

2)     it must be calculated on a principal sum or a right to a principal sum

3)     it must represent compensation for the use of the principal sum or the right to the principal sum.

To be referable to a principal sum, amounts are usually determined by applying a percentage to that principal.  In our view, an amount that is determined on the basis of other criteria (such as cash flow, revenue, or net profit) is not referable to a principal sum.

fn 17 While it is possible to create formulas under which amounts calculated on the basis of those other criteria are expressed as a percentage of the principal sum, the mere expression of such an amount in this manner does not necessarily qualify the amount as interest.

This is not to say that participation payments can never qualify as interest.  As noted earlier, the question centres around the distinction between debt and equity payments.  We have issued favourable rulings for participation payments that exhibited debt rather than equity characteristics.

For example, one ruling involved a loan granted at a commercial interest rate.  Both parties to the transaction anticipated that the borrower would not generate sufficient cash flow to make the required interest payments during the first few years of the loan; consequently, the parties agreed that interest would be paid only when the borrower had sufficient funds to make such payments.  This was accomplished by the borrower's agreeing to pay the lender 50 percent of his net cash flow, subject to an overall cumulative limit equal to 14 percent of the amount borrowed.  As evidence that the arrangement represented a debt (rather than an equity) investment, the taxpayer pointed to the overall cap on the payments to be made by the borrower.  The taxpayer argued that, since this limit represented a commercial rate of interest, the transaction was not an equity investment.  This argument was accepted by the department and we agreed to so rule.

In accordance with this position, the department will consider a participation payment to be interest provided that

   1)      the payment is limited to a stated percentage of the principal;

  2)      the limiting percentage reflects commercial interest rates prevailing between arm's-length parties at the time the loan is entered into; and

  3)      no other facts indicate the presence of an equity investment.

The relevant commercial interest rates will be those reflecting ordinary credit risks involved in a debt investment.  Accordingly, the limiting percentage may reflect any increased credit risk arising as a result of the credit rating of the borrower.  The limiting percentage may also reflect the risk that the lender may not receive all of the anticipated payments owing to insufficient profits in any one year.  An inordinate rate may well indicate that the "lender' is assuming risks that are more in keeping with an equity investment.

The department is prepared to issue favourable rulings on participation payments that can reasonably be considered to be interest payments according to the above criteria.

Some taxpayers have represented the view that participation payments are deductible under paragraph 20(1)(e), which authorizes a deduction for expenses incurred in the course of borrowing money used for an income-earning purpose.  The department, however, takes the view that paragraph 20(1 )(e) does not authorize a deduction for payments made as compensation for the use of money.  In our view, this interpretation is consistent with the taxation policy underlying paragraph 20(1)(e), namely, the provision of a deduction for incidental expenditures incurred in the course of effecting a borrowing.

The decision in Yonge-Eglinton [FNl8.: MNR v. Yonfge-Eglington Building Ltd.  74 DTC 6180 (FCA). ] dealt with commitment fees, which do not represent compensation for the use of borrowed funds.  As noted in that decision, the commitment fees were payable whether or not the taxpayer actually borrowed money and whether or not any unpaid principal balance existed.  Accordingly, Yonge-Eglinton does not conflict with our view of paragraph 20(1)(e).

Another form of loan arrangement involves a trade-off between the interest rate and the principal repayable on maturity.  For example, a borrower may pay an above-market rate of interest corresponding with a strong likelihood that the amount repayable on maturity will be less than the amount originally borrowed. In this situation, we are not satisfied that the amounts stipulated to be interest are in fact interest.

This brief review of the income tax consequences of some participating loan arrangements has not been exhaustive.  However, it does highlight some of the difficulties that can arise in the context of such transactions.  The Department of Finance is currently reviewing the provisions of the Act dealing with financing charges.  Finance officials are aware of the issues described above and will no doubt include them in the discussion paper on interest expense to be released later this year.

Capitalization of Soft Costs: Buildings Under Construction

Introduction

There are a number of tax issues relating to the capitalization of soft costs for buildings under construction.  With tax reform extending the current rules (which are found in subsection 18(3.1) of the Act) to all buildings, including those being constructed by a principal business corporation, [19] there has been a renewed interest in the department's interpretation of these provisions.

As a starting point, it is important to note that the rules relating to the capitalization of soft costs apply only to the construction renovation, or

GOLD LOANS

The following question and answer appeared in the Revenue Canada Round Table session of the 1989 CTF Conference.

Question 22 - Loans of Gold

     The department stated at the 1988 Round Table that it considers that a loan for consumption - that is, one in which the actual specific asset is not to be returned - results in a disposition of the asset by the lender and an acquisition by the borrower.  As the lender receives a promise to return a like amount at some future date, his proceeds should be equal to the value of that promise. This appears to represent a basic change in assessing practice that warrants further explanation.

(a)     As the loan is repaid, we assume that Revenue Canada considers gold to have been disposed of by the borrower to the lender at its then fair market value, so that each of the borrower and lender has a gain or loss with respect to the payable/receivable established with the original loan.  In the case of a borrower that is in the business of mining and selling gold, we assume that this gain or loss will be on ordinary income account but will not constitute income or loss from the production of metal, and thus will not enter into the computation of resource profits under Regulation 1204.  If the lender is a bank, we assume this gain or loss will be on ordinary income account.

(b)     If the borrower repays the loan by delivery out of its own Canadian production, we assume it is the fair market value of the gold at the date of repayment that is to be taken into account in determining the borrower's resource profits under Regulation 1204.

Please confirm (or revise as appropriate) these understandings.

Department's Position

     We confirm your understanding of (a) and (b) described above, but wish to add that we do not consider recognition of a gain or loss by the borrower to be restricted to repayment of the loan.  In our view, the liability must be valued at the borrower's year-end and any gain or loss indicated by so valuing the debt reflected in the borrower's income for that year.  In our opinion, this situation is analogous to situations involving foreign currency conversions.

Revenue Canada made the following comments at the 1988 Round Table. (p.53:8)

Loans of Gold and Other Commodities

The Department considers that a loan for consumption - that is, one in which the actual specific asset is not to be returned - results in a disposition of the asset by the lender and an acquisition by the borrower.  As the lender receives a promise to return a like amount at some future date, his proceeds should be equal to the value of that promise.  On the date on which the loan is settled, there will be a disposition of the promise and an acquisition of the commodity, at the value of the commodity on that date.

We have considered the lending of securities in a few circumstance involving large investors.  It appears that these loans are also loans for consumption and accordingly involve dispositions and acquisitions.  The Department of Finance has been advised of our position regarding these specific transactions.

[Note: See legislation on security lending which was enacted subsequent to these comments in "Securities Lending" Section.]

INTEREST DEDUCTIBILITY

Following the judgement by the Supreme Court of Canada in The Queen v Bronfman Trust 87 DTC 5059, a Notice of Ways and Means Motion was tabled in the House of Commons on June 2, 1987 to minimize uncertainty concerning borrowings.  This Notice of Ways and Means proposed legislation that would confirm Revenue Canada's administrative treatment that applies to the deductibility of interest on borrowings before 1989.  In subsequent announcements, this proposal was extended to borrowings made in 1989, 1990, and 1991, pending the completion of Finance's discussion paper on interest.

Attached are:

1)     Notice of Ways and Means Notion to Amend the Income Tax Act re: interest deductibility.

2)     Revenue Canada's Panel Discussion on the Notice of Ways and Means at the 1987 Corporate Management Tax Conference (p.10:10 to 10:25).

3)     The Round Table questions referred to on p.l0:11 of the Panel Discussion which continue to reflect our practice.

Attachment — Notice of Ways nd Means Motion to Amend the Income Tax Act

That it is expedient to amend the Income Tax Act and to provide:

(1)     That, for the purposes of the rules relating to the deduction of interest on money borrowed before 1992, a definition of the expression "borrowed money used for the purpose of earning income from a business or property" be introduced to include

(a)      any borrowed money used by

(i)     a corporation to pay dividends not exceeding its accumulated profits determined immediately before the dividends were paid, or

(ii)     a partnership to make distributions of profits not exceeding its accumulated profits determined immediately before the distributions were made

     to the extent that the accumulated profits were used by the corp- oration or partnership for a qualifying purpose that is, to earn income and not to acquire property the income from which is exempt or to acquire a life insurance policy);

(b)      any borrowed money used by

(i)     a corporation to return capital to its shareholders by way of a redemption, acquisition, cancellation of any shares, reduction of capital or otherwise, or

(ii)     a partnership to make a distribution of capital

     to the extent that such capital was used by the corporation or partnership for a qualifying purpose;

(c)     any borrowed money used to make a loan described in section 80.4 of the Act;

(d)     any borrowed money used by a person or partnership who is a shareholder of a Canadian corporation to make a loan to the corporation, or to its Canadian subsidiary, or to make a payment under a guarantee given in respect of a loan made to the corporation or subsidiary, where

(i)     the proceeds of the loan are used by the borrowing corporation or by its Canadian subsidiary in carrying on its business to gain or produce income from a business property that will be subject to Part I tax In Canada

(ii)     the borrowing corporation is unable by reason of its own financial position to obtain financing on comparable terms without the guarantee of the person or partnership, and

(iii)      the deduction of interest on the borrowed money or the loan would not result in an artificial or undue reduction of the income of the person or partnership or the borrowing corporation; and

(e)     any borrowed money used by a person or partnership who is a member of a Canadian partnership to make a loan to the partnership, or to make a payment under a guarantee given in respect of a loan to the partnership, where

(i)       the proceeds of the loan are used by the Canadian partnership in carrying on its business to gain or produce income from a business or property that will be subject to Part I tax in Canada,

(ii)      the Canadian partnership is unable by reason of its own financial position to obtain financing on comparable terms without the guarantee of the person or partnership, and

(iii)      the deduction of interest on the borrowed money or the loan would not result in an artificial or undue reduction of the income of the person or partnership or the Canadian partnership.

(2)     That any interest paid or payable in a year on money borrowed before 1992 in respect of the acquisition of property by a person or partnership that is not deductible because the property was not acquired to gain or produce income from a business or property be deductible to the extent of the borrower's income for the year from the property.