29 August 2011 Internal T.I. 2009-0336671I7 - Derivative

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.

Principal Issues: 1. Is the swap transaction a derivative or a loan? 2. What is the method to report the zero-coupon swap?

Position: 1.Derivative 2. Realized Basis in XXXXXXXXXX years.

Reasons: 1. Original Loan has been repaid; there is only an obligation left with respect to cash flows based on fixed and variable interest rates. 2. There is an exchange of cash flows with no realization until the exchange occurs which is XXXXXXXXXX years later.

								August 29, 2011

Toronto District Office					Headquarters
Azeez Sankar							C. Tremblay
International Audit						(819) 281-6906
(416) 954-9316

								2009-033667

Timing of the Deductibility of Swap Payments

This is in response to your e-mail of April 21, 2011 and is further to your memorandum of August 11, 2009, wherein you had requested our views on whether the arrangements set out below constituted interest-bearing loans. We also acknowledge a telephone conversation from Sandra Mallory and a further e-mail of April 28, 2011, to which all the recent submissions and documentations were attached.

We had verbally advised you nearly a year ago that, in our view, the legal form of the transactions must be respected and, in this case, the legal form is that of two interest rate swaps and not a loan. After discussions with the taxpayer and submissions by both the taxpayer and their representatives, you now only seek clarification on the approach to be taken in determining the tax treatment of the XXXXXXXXXX year zero-coupon swap. (You no longer seek our views on the coupon swap).

The following facts as we understand them are relevant to the determination of the tax treatment of a number of transactions (the “Swap Transactions”) between XXXXXXXXXX (“FCo”) and XXXXXXXXXX (“BCo”). BCo is resident in XXXXXXXXXX , and is a controlled foreign affiliate of XXXXXXXXXX (“ACo”). FCo and XXXXXXXXXX (“DCo”) are both subsidiaries of XXXXXXXXXX (“Parentco”). FCo specializes in derivative transactions outside Parentco’s core XXXXXXXXXX business.

1. The Swap Transactions mean the transactions described in a 5-page memorandum (the “Memorandum”) dated XXXXXXXXXX , from FCo to BCo, the subject of which is described as “Interest Rate Swap Transactions”. The Memorandum refers to a number of documents that are relevant to the determination of the terms of the Swap Transactions.

2. The Swap Transactions were entered into at the same time as an agreement, in XXXXXXXXXX , pursuant to which, XXXXXXXXXX (“CCo”), issued and sold to DCo, debentures totaling US $XXXXXXXXXX bearing a rate of interest equal to the US 6-month LIBOR rate prevailing during the term of the debenture. The contemplated date of maturity of the debenture was XXXXXXXXXX .

3. The transactions in the Memorandum are set out within the framework of two interest rate swaps, each of which has to remain in force as long as the other is in force. The first swap is a “zero-coupon” swap and the second swap is a “coupon” swap.

4. The debenture issued by CCo ceased to exist in XXXXXXXXXX as it was repaid.

In the “zero-coupon” swap, no amount is paid by the counterparties until the contract terminates, subject to the non-occurrence of certain defined events. This swap had a term of approximately XXXXXXXXXX years, with the first arm of the swap payable by BCo, compounding every 6 months, at a fixed rate of interest of XXXXXXXXXX %, on a notional principal of $XXXXXXXXXX US, and with the second arm of the swap payable by FCo, compounding every 6 months, at the prevailing US 6-month LIBOR rate, on a notional principal of $XXXXXXXXXX US. At the end of XXXXXXXXXX years, the difference in the amounts accumulated in each arm of the swap is paid by the counterparty owing the greater amount.

In the “coupon” swap, the first arm of the swap payable by FCo, is computed and paid every 6 months at XXXXXXXXXX %, on a notional principal of $XXXXXXXXXX US, with the second arm of the swap payable by BCo, compounding every 6 months, at the prevailing US 6-month LIBOR rate, on a notional principal of $XXXXXXXXXX US, but payable every XXXXXXXXXX years.

FCo paid a $XXXXXXXXXX US fee on inception for the cancellation right. If LIBOR was above the fixed rate of XXXXXXXXXX % over the terms of the swaps, then FCo could terminate the swap. If LIBOR remained below the fixed rate of XXXXXXXXXX % in XXXXXXXXXX , BCo would have a net obligation to FCo on the zero-coupon swap. LIBOR rates have remained generally low to the point where BCo has a huge obligation to FCo, estimated to be worth over $XXXXXXXXXX US in XXXXXXXXXX .

The TSO’s View:

In your initial request, you considered the arrangement to be interest-bearing loans but you now agree with us that the form of the particular arrangements is two swap contracts. You are now only concerned with the timing in the zero-coupon swap. You, Sandra Mallory and the Industry Specialist, Doug Watson, met with the taxpayer’s representatives. In explaining his views to them, Doug Watson stated: “that similar to all derivatives, a swap is an agreement to exchange cash flows. In my view, there has been no fulfillment of the contract or realization until there is an exchange of cash. No expense has been incurred and no income is earned until there is an exchange. The calculation of an amount that must be paid in the future does not represent an expense that is incurred in the current year. Quite simply, no goods were acquired; no services consumed, and; there is no event that had an impact on taxable income for the year. With regard to the zero coupon swap, there is no income or expense until the contract is realized in year XXXXXXXXXX , unless it is terminated earlier.

The accounting treatment for the swap essentially recognizes the termination value of the swap. As such amounts are only payable in the event of termination, they are clearly contingent on that event and fit into paragraph 18(1)(e). It is also arguable that the calculation of amounts due in the future must be recognized for accounting purposes as a reserve. As such, it also fits into paragraph 18(1)(e).”

Accordingly, in your view, the Swap Transactions should be recognized on a realizable basis thus recognition of income and losses would have to be deferred to XXXXXXXXXX .

Taxpayer’s Views:

The taxpayer’s position is that these are two swaps that must be considered in isolation and, for tax purposes, the difference in amounts payable and receivable under each swap, for each year, must be recognized in full, as current income or a current loss, pursuant to section 9 of the Act.

In the submission by XXXXXXXXXX , the taxpayer’s representative argues that the requirements of the swap contracts create receivables and liabilities that must be recognized in taxable income in the current years. In their view, the net result of the calculations creates an amount that is deductible pursuant to section 9 of the Act. With reliance on Canderel (98 DTC 6100), they argue that the accounting result represents a “truer picture of income for tax purposes”. They further argue that the calculation of future income and expenses represents true rights and obligations that must be recognized as income and expenses for tax purposes. In addition, it is their view that the liabilities are not contingent within the meaning of paragraph 18(1)(e) of the Act.

The taxpayer further argues that a taxpayer is free to adopt any method which is not inconsistent with (i) the provisions of the Income Tax Act; (ii) established case law principles, or rules of law and (iii) well-accepted business principles. The taxpayer states that there are no cases or rules of law which precludes the method used by BCo and once the taxpayer has chosen its method of profit computation, the onus is on the Minister to prove there exists a more accurate method which should be used. They argue that the method used was consistent with GAAP and well-accepted business principles.

XXXXXXXXXX also prepared a submission analysing three alternatives for accounting for the swap payments and receipts and conclude that the fair value basis as the preferred method and is the best basis of well-accepted business principles.

Our Comments:

The CRA’s views on the appropriate treatment for tax purposes of interest rate swaps are set out in its response to question # 60 at the 1984 Canadian Tax Conference (“CTF”) and again in response to question # 11 at the 1993 CTF. In summary, ‘all amounts payable or receivable pursuant to an interest rate swap agreement will be considered to be on account of income and will be included in or deductible from the income of the taxpayer pursuant to section 9 of the Act’. However, it should be noted that the Act does not recognize unearned income under section 9 of the Act. Accrual basis and fair value accounting for swaps contradicts the realization principle that has been established by case law for income recognition. The provisions of the Act further support the realization principle, in that any reported accrued losses would constitute reserves and contingent liabilities that would be prohibited from deduction under paragraph 18(1)(e) of the Act.

Accordingly, it has been CRA’s longstanding view that the realization principle is required. Further, in our view, the application of the realization principle to the calculation of profits under subsection 9(1) would eliminate any amounts to which paragraph 18(1)(e) of the Act would apply. However, if for some reason that has not been presented to us up to this point, accrued losses from accrual basis or fair value accounting for swaps remain after the calculation of profits under subsection 9(1) of the Act, in our view, paragraph 18(1)(e) of the Act would apply to deny a deduction for such amounts.

Professor B.J. Arnold, stated in Timing and Income Taxation: The Principles of Income Measurement for Tax Purposes (1983), at p. 333:

"One of the basic principles of income taxation is that appreciation or depreciation in the value of property is not taken into account in the computation of income until such appreciation or depreciation has been realized, usually by a means of sale."

The courts have consistently applied the realization principle developed by case law to determine the timing of recognizing profits for the purpose of subsection 9(1) of the Act in preference to well-accepted business principles, which include but are not limited to the formal codification found in GAAP.

The Supreme Court of Canada (“SCC”) has stressed the importance of the realization principle. In Jake Friesen v. The Queen, 95 DTC 5551 (“Friesen”), Iacobucci and Gonthier, JJ, in their dissenting opinion, held that the write-down of the value of land held as an adventure in the nature of trade is a violation of the realization principle as follows:

The importance of [the realization] principle is reflected in the fact that, whenever the Income Tax Act permits deemed dispositions at fair market value without actual realizations, it does so narrowly and in a highly circumscribed manner: for example, when a taxpayer ceases to be a Canadian resident (s. 48 (now repealed)), or upon death (s. 70), or upon change of control (s. 111). Exceptions from the realization principle are thus clearly stipulated and explicitly codified, unlike the exception upon which the appellant seeks to rely. For the most part, the Act does not recognize "unrealized" or "paper" gains or losses: Krishna, supra, at pp 278-79.

(Although the majority of the SCC in Friesen held that the taxpayer was entitled to write down his inventory, their decision was based on the view that subsection 10(1) of the Act, which is a statutory exception to the realization principle, applied to the taxpayer.)

This principle was followed in IKEA Limited v. Canada, 98 DTC 6092 (S.C.C.). Iacobucci, J. after referring to a quotation from Kenneth B.S. Robertson, Limited v. MNR (1944), 2 DTC 655 wrote,

“The ultimate effect of this (realization) principle is clear: amounts received or realized by a taxpayer, free of conditions or restrictions upon their use, are taxable in the year realized, subject to any contrary provision of the Act or the rule of law.”

Those cases support the realization principle for reporting of income or losses on swaps.

Further, in Robertson, Thorson J., in referring to the opinion of Mr. Justice Brandeis in a U.S case (Brown v. Helvering) stated:

“In my judgment, the language used by him...lays down an important test as to whether an amount received by a taxpayer has the quality of income. Is his right to it absolute and under no restriction, contractual or otherwise, as to its disposition, use or enjoyment?”

In the case at hand, a gain could only be realized and a loss could only be incurred upon the termination of the swaps at the specified termination date. Only on the termination date would the taxpayer have the absolute right to receive, or the legal obligation to pay, the cash settlement. Only on the termination date could the cash settlement amount be ascertained. Gains and losses computed at any point prior to the termination date under either accrual basis or fair value accounting are irrelevant to the computation of profit for any given year. The gains were not receivable and do not have the quality of income since BCo does not have the absolute right or entitlement to receive such an amount from the counterparty. Likewise, the losses were un-incurred losses that were not due and payable since BCo does not have the legal obligation to pay that amount to the counterparty.

As such, un-incurred losses recognized under either accrual basis accounting or fair value accounting are, for tax purposes, contrary to the realization principle, and, further, would be non-deductible reserves or contingent liabilities that would be prohibited from deduction under paragraph 18(1)(e) of the Act.

The taxpayer’s representatives argue that there are no contingent liabilities in this case and point to both the McLarty v the Queen 2008 DTC 6354 (“McLarty”) and the Wawang Forest Products v the Queen 2001 DTC 5212 (“Wawang”) decisions for support. However, neither McLarty nor Wawang involve swap transactions that are settled with cash. Our arguments give emphasis to the realization principle and, in our view, no amounts under the zero-coupon swap were due until the aggregate of the obligations were to be exchanged at maturity, in XXXXXXXXXX , on a net basis.

We note that in the full annual report of ACo for XXXXXXXXXX , the corporation does refer to the swaps as contingent. At page XXXXXXXXXX of this full annual report, at the beginning of the page, there is a section entitled “XXXXXXXXXX ” and, below that heading, it is stated “XXXXXXXXXX ”

XXXXXXXXXX

In summary, in our view, the realization principle is applicable to determine the timing of recognition of gains and losses on swaps that have been accorded income treatment under subsection 9(1) of the Act. Accordingly, in our view, for tax purposes, the reporting of the income on the zero-coupon swap should be at the termination of the swap in XXXXXXXXXX .

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. 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 electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Mrs. Celine Charbonneau at (613) 957-2137. A copy will be sent to you for delivery to the client.

R. Albert, CA
for Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch