4 July 2009 Internal T.I. 9415947 - INTEREST RATE SWAP - TERMINATION PAYMENT/RECEIPT

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Whether an amount received upon a negotiated termination of an interest rate swap is on account of income or capital

Position TAKEN:

On account of income

Reasons FOR POSITION TAKEN:

Jurisprudence regarding payments paid/received upon termination of contracts

			September 7, 1994

	HAMILTON DISTRICT OFFICE	HEAD OFFICE
	Appeals Division	Rulings Directorate
P. Dunn
	Attention: Morris Haley	(613) 957-8953

			941594

XXXXXXXXXX- Notice of Objection - Interest Rate Swap Agreement

We are writing further to our (Dunn/Haley) various telephone conversations and your memorandum of June 15, 1994 concerning XXXXXXXXXX and the Notice of Objection filed with respect to its 1988 taxation year.

It is our understanding that the taxpayer has filed the notice of objection with respect to, inter alia, a gain realized during the 1988 taxation year upon the termination of an interest rate swap agreement. The taxpayer had entered into the swap agreement with a chartered bank and, pursuant to the agreement, XXXXXXXXXX would pay to the bank an amount calculated by reference to a fixed rate of interest applied to a notional principal amount and the bank would pay to XXXXXXXXXX an amount based upon a floating rate of interest applied to that same notional principal amount.

XXXXXXXXXX

treated this payment as a receipt on account of capital. The Department, however, maintains that the amount was received on account of income and has reassessed the taxpayer accordingly.

The taxpayer's representative has forwarded a submission to you in support of their position that the amount received upon termination of the swap agreement was received on account of capital and you have forwarded a copy of that submission with your referral and have requested our comments with respect thereto.

It is our understanding that the payment by the bank to XXXXXXXXXX upon the termination of the swap agreement was made pursuant to negotiations between the parties and can be considered to be a payment, as noted by the taxpayer's representative, in respect of the termination of the swap agreement.

The question of whether payments, or as in this case, receipts, for or on termination of a contract constitute an amount paid or received on account of income or capital has been considered on a number of occasions by the courts.

As noted by Lord Russell in Commissioners of Inland Revenue v. Fleming & Co. (Machinery), Ltd., 33 T.C. 57 (Ct. of Sess), at page 63,

The sum received by a commercial firm as compensation for the loss sustained by the cancellation of a trading contract or the premature termination of an agency agreement may in the recipient's hands be regarded either as a capital receipt or as a trading receipt forming part of the trading profit. It may be difficult to formulate a general principle by reference to which in all cases the correct decision will be arrived at since in each case the question comes to be one of circumstance and degree. When the rights and advantages surrendered on cancellation are such as to destroy or materially to cripple the whole structure of the recipient's profit-making apparatus, involving the serious dislocation of the normal commercial organisation and resulting perhaps in the cutting down of the staff previously required, the recipient of the compensation may properly affirm that the compensation represents the price paid for the loss or sterilisation of a capital asset and is therefore a capital and not a revenue receipt.

and,

On the other hand when the benefit surrendered on cancellation does not represent the loss of an enduring asset in circumstances such as those above mentioned(where for example the structure of the recipient's business is so fashioned as to absorb the shock as one of the normal incidents to be looked for and where it appears that the compensation received is no more than a surrogatum for the future profits surrendered(the compensation received is in use to be treated as a revenue receipt and not a capital receipt.

In determining whether a receipt by the plaintiff was on account of income or capital, Strayer J. stated the relevant principles in Canadian National Railway Company v. MNR, 88 DTC 6340 (FCTD), at 6342 and 6343:

There is much jurisprudence on the question of whether compensation paid on the occasion of the termination of some business arrangement is capital or income. To a large extent each case turns on its own facts. It appears to me that there are two aspects which a court must consider in examining such a situation retrospectively: was the purpose of the payment to replace capital or income; and, whether or not the purpose can be reliably determined, was the effect of the payment to replace capital or income? It appears to me to be a dual test because the purpose may not be discernible, or it may not be reliably discernible in the sense that parties to settlements should not, by misstating the real purpose, determine the tax consequences of the receipt of such compensation. It is therefore necessary to look at both purpose and effect.

With respect to purpose, the essential question is to determine what the compensation(whether paid pursuant to a contract, a court award of damages, or otherwise(is intended to replace. (See e.g. London and Thames Haven Oil Wharves Ltd. v. Attwooll (1967) 2 All E.R. 124 (CA); followed in H.M. v. Manley, 85 DTC 5150 (FCA).) In some cases the contract providing for compensation may be clear. The measure employed for calculating compensation is not always determinative: potential lost income may be taken into account in calculating a capital sum to be paid. Nor on the other hand does the fact that an amount is paid as damages for breach of a contract necessarily make it a capital sum and not income. On the contrary it appears to me that whatever the source of the legal right to the compensation, be it the contract or the law of damages, the substantive issue is: what is this amount intended to replace?

The court then quoted from C.I.R. v. Fleming, supra, and, with reference to the principles provided in that case, noted that,

to apply such criteria it is necessary to make value judgments as to the severity of the impact on the taxpayer of the termination of certain business activities in respect of which compensation has been paid.

These principles were applied in other court cases, for example, Schofield Oil Ltd. v. HMQ, 89 DTC 5128 (FCTD), and Pe Ben Industries Company Limited v. HMQ, 88 DTC 6347 (FCTD).

With respect to the case at hand, we would agree that the termination payment resulted in the loss of an asset of XXXXXXXXXX which was used in its profit-making activities. We do not, however, agree with the contention of the taxpayer's representative that this resulted in the loss of an "enduring" asset for, as we understand, the contract was for a term of five years and was terminable at any time by either party. As noted by Strayer J. in dismissing the appeal by Canadian National Railway, supra:

This can hardly be seen as the destruction NAR's whole "profit-making apparatus" or even "the serious dislocation of the normal commercial organization" of NAR, to use the terms employed by Lord Russell in the Fleming case. Considering the contractual arrangements themselves, their termination was hardly the destruction of an "enduring asset". The contracts which NAR had with Bechtel and with Pe Ben were trading contracts of a relatively short duration. At most they would have run for five years and were terminable at any time.

These comments would seem to be directly applicable to the case at hand.

The taxpayer's representative also maintains that this interest rate swap agreement constituted a hedge of the interest in respect of the long-term capital borrowings of the taxpayer and, in accordance with the Department's position that any gain or loss realized on the hedge instrument is characterized in accordance with the nature of the underlying transaction that is the subject of the hedge, concludes that the gain realized by the taxpayer in this case should be accorded capital treatment. Although we would agree that the representative has accurately summarized the Department's position in this regard, we also note the representative's statement that,

the interest rate swap was entered into by XXXXXXXXXX to hedge its floating interest rate exposure in a significant portion of its capital borrowings.

It is clear from this statement that it is the interest on the debt and not the foreign currency denominated debt itself which is the subject of the hedge in the present case. As noted in the response to a question posed at the Revenue Canada Round Table of the 1993 Conference of the Canadian Tax Foundation, the Department considers that,

All amounts payable or receivable pursuant to an interest rate swap agreement will be considered to be on account of income and will be included in or deductible from the income of the taxpayer pursuant to section 9 of the Act

and,

The use of any underlying funds is no longer relevant in determining the treatment for income tax purposes of the amounts payable or receivable pursuant to an interest rate swap agreement.

We note with reference to that response that the use of the underlying funds has never been considered relevant in the determination of the tax treatment of amounts payable or receivable under an interest rate swap and that particular segment of the Department's response was intended to clarify that the deductibility of payments made pursuant to the swap was not dependent upon the deductibility, which is contingent upon the use of the borrowed funds, of the interest on that underlying debt.

XXXXXXXXXX

In this case however, the determination of whether or not the debt constitutes a significant portion of the long-term capital of XXXXXXXXXX would not seem to be germane to the resolution of the present question as the debt, notwithstanding that it is denominated in a foreign currency, is not the transaction which is being hedged with this swap agreement.

We would, accordingly, agree with your conclusions that the amount received by XXXXXXXXXX upon, and in consideration of, the termination of the interest rate swap agreement should be considered to have been received by the corporation on account of income and not on account of capital.

We trust that this is the information which you require.

for Director
Financial Industries Division
Rulings Directorate
Policy and Legislation Branch

.../cont'd