“Cost of Funding Requirements” and “Return on Funding Requirements”
Inclusion of an amount under IFE or IFR
An amount may be included under paragraph (e) of variable A and paragraph (a) of variable B of the definition of IFE only if all conditions set out in those paragraphs are satisfied (collectively, the “Cost of Funding Requirements”). An amount may similarly be included under paragraph (d) of variable A and paragraph (a) of variable B of the definition of IFR only if all conditions specified in those paragraphs are satisfied (collectively, the “Return on Funding Requirements”).
Economic perspective of the taxpayer applied in determining whether A(e) or B(a) return
In computing IFE, the Cost of Funding Requirements are applied from the perspective of the taxpayer incurring the cost of funding. Where those requirements are satisfied, amounts paid or payable (or losses, whether on income or capital account) are included under paragraph (e) of variable A of the definition of IFE. …
The netting of amounts under paragraph (e) of variable A and paragraph (a) of variable B of the definition of IFE is intended to reflect the real economic cost of funding deductible for a particular tax year in respect of all borrowings and other financings, where each such borrowing or other financing is specifically linked to the procurement of funding by the taxpayer (or a non arm’s length person or partnership) for use in its business or to fund an investment activity intended to earn income.
“Cost of funding” under A(e) and B(a) references time value of money and financing amounts which are not otherwise referenced
[Regarding] [t]he phrase “cost of funding” is used in paragraph (e) of variable A and paragraph (a) of variable B of the IFE definition … the explanatory notes suggest that it contemplates any amount that can reasonably be considered compensation for the time value of money. … [and] that the Cost of Funding Requirements are intended to capture in IFE certain amounts that can reasonably be considered to be part of the cost of funding with respect to a borrowing or other financing, but that are not otherwise included under another paragraph of the IFE definition (for example, an amount that is legally considered interest and included under paragraph (a) of variable A of the IFE definition).
Potential inclusion of derivative returns in IFR
Differences in IFE and IFR
… [P]aragraph (e) of variable A and paragraph (a) of variable B of the definition of IFE permit a taxpayer entering into a borrowing or other financing to transact separately for various elements of that borrowing or other financing and to enter into one or more derivative contracts with different counterparties to hedge different portions of its risks. Provided the resulting amounts can all reasonably be considered to affect the taxpayer’s cost of funding in respect of the borrowing or other financing, they are included in computing the taxpayer’s IFE.
Paragraph (d) of variable A and paragraph (a) of variable B of the definition of IFR similarly permit a taxpayer providing a loan or other financing to enter into one or more derivative contracts with different counterparties to hedge the various risks associated with that transaction and to include in computing its IFR amounts received or receivable, amounts paid or payable, and gains and losses that increase or reduce its return in respect of the underlying loan or other financing.
Certain derivative agreements may themselves constitute an “other financing”. Examples include certain monetisation or other finance-based derivative transactions that include a material financing or funding component, such as certain prepaid forward contracts, and securities lending agreements and sale and repurchase agreements, whether or not such agreements constitute “securities lending arrangements” for the purposes of section 260. In such cases, transfers of property for cash may occur in the course of the procurement of funding (in the case of IFE) or the provision of funding (in the case of IFR), on terms and conditions under which the payment or receipt can reasonably be considered to form part of the taxpayer’s cost of funding or return in respect of a loan or other financing.
Amounts arising from derivative contracts that do not have this character are, however, included in IFR only where they can reasonably be linked to, and affect the return on, an identified loan or other financing.
More generally, where an agreement or arrangement does not itself constitute a borrowing or other financing (for purposes of IFE), or a loan or other financing (for purposes of IFR), it must be sufficiently linked to an identified borrowing or other financing, or an identified loan or other financing, as applicable. In this context, the agreement or arrangement must be entered into for the purpose of eliminating or mitigating a relevant risk (such as currency, interest rate, or payment risk) associated with that borrowing or other financing or loan or other financing.
The required linkage would not, for example, typically exist in the case of traders entering into speculative derivative transactions in the ordinary course of a securities or derivatives trading business (such as cash settled or physically-settled swap agreements, forward rate agreements, futures, or options),
Example 3 (showing asymmetric result between borrower and hedging counterparty)
- A Canadian-resident corporation (ACo) borrows in US dollars from a Canadian bank at a floating rate of interest in U.S. dollars, and enters into a derivative agreement at arm's length with a resident corporation, CCo, to hedge its interest rate risk.
- The derivative hedging arrangement with CCo is sufficiently linked to CCo's borrowing from the bank so that the amounts paid under the derivative increase CCo's cost of funding in respect of its borrowing so as to be included in IFE under A(e) - or, in the case of receipts by Aco under the derivative, are included as a reduction in the cost of borrowing under B(a) of the IFE definition provided, in either case, the other Cost of Funding Requirements are satisfied,.
- As the amounts received by CCo from ACo under the derivative do not increase and are not in respect of the return on a loan or other financing owing to or provided by CCo or a non-arm's length person or partnership, such amounts are not included in computing CCo's IFR under A(d) thereof and, similarly, any amounts paid by CCo to ACo under the derivative would not be included in CCo's IFR under B(a) thereof.
