11 December 1998 Internal T.I. E9828647 - PARAGRAPH 18(1)(A)

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 certain swap transactions were entered into for the purpose of producing income.

Position:

Question of fact as to whether paragraph 18(1)(a) applies - Case referred to Industry Specialist for a review of the facts, industry practice and comparison to terms of commercial swap transactions.

Reasons: See above.

		December 11, 1998

	HEADQUARTERS	HEADQUARTERS
	Industry Specialist Services	Michael Cooke
613) 957-3498
	Attention:  John Luck
		982864

Paragraph 18(1)(a) of the Income Tax Act ("Act")

As we discussed (Cooke/Luck) on December 2, 1998 we are transferring the attached referral that we received from XXXXXXXXXX TSO dated October 29, 1998 for your action. The issue that we had been asked to consider was whether outlays or expenses made or incurred by XXXXXXXXXX on the swap transactions between XXXXXXXXXX and its parent corporation (XXXXXXXXXX ) were made or incurred for the purpose of earning income from the business or property (i.e., would paragraph 18(1)(a) of the Act apply to disallow any deduction)?

We indicated in our discussion that as the determination of whether the swaps contracts in question were entered into for the purpose of earning income from the business or property is a question of fact it would be appropriate that the XXXXXXXXXX TSO deal directly with a financial industry and/or financial product specialist on this matter (i.e., the determination will require specific knowledge of the taxpayer’s business operations as well as general industry information). Notwithstanding, we do have some comments that we trust will be of use in the determination of this matter.

Comments

It appears from the XXXXXXXXXX TSO’s memorandum that they are primarily concerned with the fact that the swap contracts had initially been entered into by XXXXXXXXXX for the purpose of providing an interest rate hedge against XXXXXXXXXX mortgage portfolio and that once XXXXXXXXXX mortgage portfolio was transferred to XXXXXXXXXX the swap contracts could no longer be viewed as being made (or held) for purpose of earning income from XXXXXXXXXX business or property. In this regard, we would like to point out that swap contracts do not have to be entered into or held for the purpose of hedging interest rate or currency exposures to be considered as being made for the purpose of earning income.

As a hedge, an interest rate swap would normally fix a taxpayer’s overall exposure to changes in interest rates when both sides of the hedge are considered but the swap transaction itself would normally afford the taxpayer with the opportunity to “win” or “lose” depending on the movement of interest rates (or exchange rates in the case of a currency swap). If an interest rate swap agreement is not entered into for the purpose of providing a hedge, the taxpayer’s overall exposure to changes in interest rates is potentially unlimited but the swap transaction should still afford the taxpayer with the opportunity to “win” or “lose” depending on the movement of interest rates.

As noted above, the determination as to whether an expense or outlay is made or incurred for the purpose of earning income will depend on a complete analysis of all the facts and circumstances of a particular situation. In Mark Resources v. The Queen, 93 DTC 1004 (TCC) the court in finding that interest expense was not deductible since it was not incurred for the purpose of earning income stated:

“The absorption of business losses of a foreign subsidiary is unquestionably a legitimate objective. Its overall purpose is to increase the net worth of the corporate group as a whole. This is a commendable business purpose and any chief executive who failed to try and do so would not be doing his or her job. It is not, however, a purpose that falls within paragraph 20(1)(c) as a “purpose of earning income”.”

In Hickman Motors Limited v. The Queen, 97 DTC 5363 (SCC) the court had to determine whether depreciable property acquired by a corporation (“Hickman”) on the winding up of its subsidiary pursuant to subsection 88(1) of the Act were acquired for the purpose of producing income for capital cost allowance (“CCA”) purposes (the assets acquired by Hickman were sold by it only five days later to a related corporation). Since the facts in Hickman clearly supported that Hickman was carrying on a business the court focused its attention on answering the “purpose of income” question and in doing so considered the Exchequer Court’s decision in Bolus-Revelas-Bolus Ltd. v. MNR, 71 DTC 5153 [In Bolus the taxpayer operated a business and purchased two amusement park rides that were never erected or operated and never produced any income] and commented as follows:

“Bolus-Revelas-Bolus Ltd. stands for the following proposition: where property does not produce income, courts will ascertain objectively whether the taxpayer acquired property for the purpose of producing income; where there is no such objective purpose CCA deduction will not be allowed. However, while Bolus-Revelas-Bolus Ltd. seems analogous to the instant case, it is clearly distinguishable because, as will be shown below, here the property did produce income. Absent extraordinary circumstances, if a business owns an item of property that produces income, then presumably its purpose is indeed to produce income.”

Presumably, since XXXXXXXXXX also carries on a business the key issue that must be resolved is when viewed objectively did XXXXXXXXXX enter into the interest rate swap contracts for the purpose of earning income? Since the swap contracts in question are between related parties it is important to consider whether the terms and conditions of those particular swap contracts are similar or common to the terms and conditions that would otherwise be commercially available in the marketplace. This will require not only an examination of the particular swap contracts in question but a comparison with “normal” commercial terms and conditions.

Even if it is determined that XXXXXXXXXX swap contracts have normal commercial terms and conditions it is also fair to question why XXXXXXXXXX would agree to terminate its swap contracts (and incur termination fees) as soon as XXXXXXXXXX started receiving net payments from XXXXXXXXXX (i.e. XXXXXXXXXX swap position is “in-the money”). As noted above, while the determination as to whether XXXXXXXXXX entered into the swap contracts for the purpose of earning income remains a question of fact we would seriously question whether this was the case if it can be established that such contracts are consistently terminated by XXXXXXXXXX as soon as they become “in the money”.

In this regard, while under “normal” circumstances an arm’s length party holding an “in the money” position in a swap contract would not agree to terminate the swap contract early, even where they agreed to do so, we would expect that they would receive some form of compensation from the “out of the money” party. Therefore, it is also fair to question the amount of the termination fees charged to XXXXXXXXXX by XXXXXXXXXX. Similarly, while we can understand that a party holding an “out of the money” position in a swap contract (i.e. XXXXXXXXXX in this case) may want to terminate such a contract early we would again question why the party holding the “in the money” position (i.e., XXXXXXXXXX) would ever agree to pay a termination fee.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department’s mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Jackie Page at 613 957-0682. The severed copy will be sent to you for delivery to the client.

We trust that the above comments will be of assistance. If appropriate, after a detailed review of the facts has been completed we are prepared to reconsider the application of paragraph 18(1)(a) and any other provision that may be relevant and if you require further information or would like to discuss the above please do not hesitate to contact either F. Lee Workman at (613) 957-3497 or Michael Cooke at (613) 957-3498.

F. Lee Workman
Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy & Legislation Branch

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