24 April 1998 External T.I. 9802565 - PENALTY PAYMENT IN RESPECT OF BORROWING

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:

If funds are borrowed from A to pay B does 18(9.1) apply to the prepayment penalty charged by A ?

Position:

Generally, Yes. Provided there is performance of obligation

Reasons: Performance of Obligation and interpretation of subsection 18(9.1)

		                                                 980256
XXXXXXXXXX                                              	C. Tremblay

Attention: XXXXXXXXXX

April 24, 1998

Re: Subsection 18(9.1) of the Act

This is with respect to your letter of February 2, 1998 concerning the above.

It is a question of fact whether a payment can reasonably be considered to be made in respect of the extension of the terms or in substitution or conversion of a debt obligation. In our view, where there has been full payment of that obligation, the provisions of subsection 18(9.1) of the Act will normally apply. Accordingly, a prepayment penalty incurred by a taxpayer who borrows money from one arm’s length party to pay a pre-existing debt owing to another arm’s party would generally be deductible pursuant to subsection 18(9.1) of the Act over what would have been the remaining term of the obligation. However, in our view, if the terms of the original obligation have been modified or extended with the same or different person such that the transaction would constitute a rescheduling or restructuring of a debt obligation, the provision of subparagraph 20(1)(e)(ii.2) of the Act may apply in respect of the borrowing.

Generally the penalty or bonus payment made by the borrower is compensation required by the lender for interest forgone over the entire term of the obligation and should therefore be deducted over the period during which the obligation is outstanding or would have remained outstanding but for the prepayment. Pursuant to clause 18(9.1)(f)(ii)(B) of the Act, such deduction will be available to the extent that the property or property substituted therefor is used by the borrower in that year for the purpose of earning income therefrom or for the purpose of earning income from a business.

We confirm that provided the taxpayer has used the new loan to repay money previously borrowed, the new loan would be deemed to have been used for the same purpose as the previous borrowing. Accordingly, the interest on the new loan would be deductible in the same manner that it was deductible on the borrowing it replaced. We further confirm that generally interest on money borrowed to pay the prepayment penalty is deductible provided the previous borrowing was used for the purposes of earning income from the business.

We trust our comments will be of assistance to you

Yours truly,

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