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: Treatment of bonus payments and extra principal.

Position: Question of fact

Reasons: depends of the particualr facts of a case as to to proper tax treatment.

			October 1, 1998

	SASKATOON TAX SERVICES OFFICE	HEADQUARTERS
B. Kerr
	Attention: Sandra McNevin	(613) 957-2744

			980386

Commodity Based Loan (“CBL”)

This is in response to your e-mail of February 11, 1998, requesting clarification of our views as expressed in file 9703377 (the “1997 letter”) and file 51396 (the “1986 letter”) concerning the tax treatment of certain amounts paid in respect of CBL’s.

You have stated that the 1986 letter indicated that all interest and the bonus payments would be fully deductible in the year paid but that the principal payments that were retroactively converted to interest arising on the early payout would not. However, the 1997 letter suggested that the bonus would fall under the provisions of paragraph 20(1)(f). You have requested our views on what treatment should be given to bonus payments relating to the commodity price adjustments and to the extra principal that will have to be paid on early termination of a CBL.

Background

From 1986-89 farmers were able to convert their existing mortgage loans into CBL’s 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.

As stated in the 1986 letter, the CBL consists of two documents, the mortgage and the commodity based loan agreement (the “CBLA”). In our view, the CBLA does not stand on its own but merely amends or suspends the terms of the mortgage. In particular, clause 2 states “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...” and clause 10 states “The mortgagor, when not in default, may prepay without penalty the whole or any part of the principal together with interest as provided in the said mortgage, less any amount paid hereunder...” It is our understanding that clause 10 was intended to require the borrower to repay the original principal in accordance with the mortgage, itself, applying all payments under the CBL as if they were originally paid pursuant to the mortgage. This has the effect of retroactively converting principal repayments under the CBL to interest payments.

Our Comments

The tax treatment on any amounts paid by a particular taxpayer depends on what in fact has been paid as well as all other relevant information relating to the particular situation. For example, if in fact a taxpayer has paid interest, paragraph 20(1)(c) may apply to allow a deduction depending on the circumstances. Where a taxpayer pays a bonus, penalty for early payout or a rate reduction payment, subsection 18(9.1) may apply to deem such amount to be interest. If the amount is paid on account of principal then paragraph 20(1)(f) may apply. Since you have not indicated whether you are currently reviewing any particular situation we can only provide general comments.

The term principal amount is defined in subsection 248(1) of the Act 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 of the following 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.

Given the structure of the CBLA we do not see how the appreciation in the principal amount over the term of the debt would constitute interest. Since the bonus payable is based on the commodity price, the provisions of subsection 18(9.1) would not apply either. 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 the total amount paid on maturity plus the total of all payments in satisfaction of principal paid over the life of the obligation. As such, a taxpayer on the cash basis could deduct in the year of maturity an amount pursuant to paragraph 20(1)(f).

With respect to the retroactive interest resulting from the early payout, we do not agree that the wording of the CBLA achieves the intended effect, since in our view clause 10 allows for such a payout "without penalty". However, in the event that you should have an actual case that does result in such action, since it is being paid in lump sum it would not appear to meet the definition of interest as it does not accrue on a day to day basis. Since you have not provided us with any factual case, we cannot determine whether the provisions of subsection 18(9.1) would deem the additional amount to be interest. However, to the extent that the additional amount does not constitute interest, our views as noted above concerning paragraph 20(1)(f) would apply.

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