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:

T\P converted a conventional mortgage into a consumer based loan arrangement ("CBL") with Farm Credit Corporation. Purpose was to give t\p reduced interest rate. However, the closing principal balance in each year, after applying the semi-annual payments of principal and interest, was adjusted to reflect a increase\decrease in the commodity index for the commodity in which the farmer deals. Semi-annual interest payments were calculated on the revised opening principal. However, after 10 years the t\p still owes the same principal balance as was outstanding when the CBL was entered into. Can the payments of principal which were "lost" due to the negative affect of the commodity index be considered interest?

Position:

Not interest. However, may be deductible pursuant to paragraph 20(1)(f).

Reasons:

Additional amounts do not meet accepted definition of interest. Definition of principal amount in subsection 248 refers to maximum amount payable with respect to debt obligation. Under the CBL that is the face value at time of maturity plus all payments on account of principal that were made over life of obligation. As such taxpayer will have paid principal payments in excess of amount for which obligation was issued.

			April 17, 1997

	SASKATOON TSO	HEADQUARTERS
S. J. Tevlin
	Attention:  Shawna Murphy		(613) 957-2746

			7-970337

Early Payout of Consumer Based Loans ("CBL")

We are writing in response to your letter dated February 4, 1997 wherein you requested our opinion regarding the treatment of certain amounts under a CBL. In this regard we offer the following comments.

Background

In the mid 1980's farmers were able to convert their existing mortgage loans into CBLs through the Farm Credit Corporation ("FCC"). The program was to consist of mortgages with basic interest at a rate of six percent and a principal repayment obligation tied to the farmer's commodity prices. Each loan had a ten year term. Principal repayments were to be based on a twenty year amortization and interest was reduced from the FCC "10-year lending rate" at the time to 6% per annum. The principal balance of the loan increased or decreased each year according to the change in price of one or two of the major commodities produced on the borrower's farm as compared with the average price of that commodity or those commodities for the prior year.

In your example the farmer obtained a CBL in 1986 for a the principal amount of $137,000. Over the next 10 years, the farmer paid a total of $140,000 to FCC, of which $65,000 was on account of interest and $75,000 was on account of principal. The farmer deducted for income tax purposes the interest as it was paid. Now, as a result of unfavourable commodity results, the farmer must pay a principal amount that includes the amounts that were paid as to principal since 1986. As such, the new principal balance is $137,000.

Our comments

The substance of the problem which you have presented to us is whether an increase ("indexed amount") in the amounts owing by the farmer under the CBL, that were determined by reference to a particular commodity index, qualify as interest or are part of the principal amount of the debt.

As noted in the Rulings Directorate letter (the "Letter") dated December 1986, to Farm Credit Corporation ("FCC"), "if the borrower maintains the CBL in good standing throughout its ten year life, the borrower will have paid some principal together with interest at a rate reduced below that otherwise payable under the Mortgage (i.e., 6% in the case of a fully-indexed CBL). At maturity, the principal balance outstanding under the CBL may either be greater than, less than or equal to the original funds borrowed under the CBL (i.e., the principal balance under the borrower's previous conventional FCC mortgage which was "transferred" to the CBL) due to the combined effect of the principal instalment repayments and the indexing of the principal balance outstanding from year-to-year."

As noted in the Letter, this is confirmed in the terms and conditions of the Mortgage and CBL side agreement which were quite specific with respect to the payment of principal and interest:

"Provided that the aforesaid instalments are to be applied first in payment of the interest due from time to time, calculated at the aforementioned rate of interest, and the balance to be applied in reduction of the principal sum, subject however to the provisions hereinafter contained."

In particular the provisions were set forth in the principle clauses as follows:

"2.Notwithstanding the rate of interest in the said Mortgage provided, when there is no default under the said Mortgage, the interest payable and to be paid by the Mortgagor shall be, where mortgage payments are fully adjusted to fluctuations in the average commodity price or index, 6% per annum calculated half yearly, not in advance, or where mortgage payments are not so fully adjusted to such fluctuations, _ % per annum calculated half yearly, not in advance.

5. The average commodity price or index shall be used to calculate the percentage increase or decrease, as the case may be, from the base average commodity price or index immediately preceding. The said percentage increase or decrease shall then be used to reflect the relevant corresponding adjustment in the principal balance hereunder then outstanding. Where mortgage payments are not fully adjusted to fluctuations in the average commodity price or index, one half of such percentage increase or decrease is applied to the principal balance hereunder then outstanding.

6. The balance adjusted as aforesaid shall be the basis for calculating the amount of subsequent instalments together with the relevant interest thereon over the amortization period remaining.

10.The Mortgagor, when not in default, may prepay without any penalty the whole or any part of the principal together with interest as provided in the said Mortgage, less any amount paid hereunder. Where the Mortgagor prepays any part of the principal, such partial prepayment shall first be applied to the balance outstanding under the said Mortgage and then adjusted to reflect an amount applicable under this Agreement.

12.Nothing in the Agreement shall require the Mortgagor to pay a sum total exceeding the sum total required under the said Mortgage at the end of the term thereof; Provided, however, that on the maturity date of the said Mortgage, if not in default, the amount owing shall be the lesser of:

(i)the principal amount outstanding under this Agreement; and

(ii)the aggregate sum of the principal outstanding under the said Mortgage together with the amount represented by the excess of the instalment otherwise payable pursuant to and during the term of the said Mortgage over the payments actually made pursuant to this Agreement with interest accumulated on such excess."

In subsection 248(1) of the Act, principal amount is defined as meaning "the amount, that under the terms of the obligation or any agreement relating thereto, is the maximum amount payable on account of the obligation by the issuer thereof, otherwise than as or on account of interest..."

On the basis of jurisprudence, it is the Department's view that a payment must satisfy all three criteria to qualify as interest:

(a) it must be calculated on a daily basis;

(b) it must be calculated on a principal sum or right to use a principal sum; and

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

As implied in the definition of principal, interest is different from principal. One of the requirements for an amount to be interest is that it must be referrable to a principal in money. Without that structure, an obligation to pay money cannot be deemed an obligation to pay interest. Given the structure of the Mortgage\CBL, we cannot see how this relationship exists. Pursuant to the terms of the Mortgage\CBL agreement, the only amount that appreciates or depreciates is the amount of the debt or the principal itself. As a matter of fact, any appreciation could be lost before the end of the ten year term. In our view, the appreciation in the principal amount over the term of the debt would not be interest.

However, we are of the opinion that where it can be said that the taxpayer has paid an amount on account of principal in excess of the amount for which the obligation was issued, then paragraph 20(1)(f) would apply. It is our view that for purposes of paragraph 20(1)(f) the principal amount under the terms of the CBL is total amount paid on maturity plus the total of all payments in satisfaction of principal paid over the life of the obligation. As such, under the CBL a taxpayer on the cash basis could deduct in the year of maturity an amount pursuant to paragraph 20(1)(f).

We trust our comments will be of assistance to you. We apologize for the delay in responding to your enquiry.

for Director
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch