26 May 2009 Internal T.I. 2008-0301051I7 - Make-Whole Amount

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: Are the make-whole amounts deductible as interest?

Position: YES

Reasons: Consistent with prior opinions

							May 26, 2009

XXXXXXXXXX 						Headquarters
Large File Case Manager				Claude Tremblay, CMA
XXXXXXXXXX 						(819)281-6906
Large Case Senior Auditor
XXXXXXXXXX  TSO

							2008-030105

Make-Whole Amount on XXXXXXXXXX ("Canco") Notes

This is in reply to your memorandum of November 12, 2008 and additional information sent to us on March 19, 2009 by XXXXXXXXXX , requesting our opinion on the deductibility of the penalties and interest (the "Make-Whole Amount") on the payment of the Senior Notes (the "Notes") before maturity. We also acknowledge several telephone conversations with XXXXXXXXXX on this file and the comments below are generally a summary of those conversations.

Facts:

In XXXXXXXXXX , due to financial problems experienced by its XXXXXXXXXX parent that came to light earlier that year, Canco was required to refinance. Notes that were issued initially in XXXXXXXXXX were repaid in XXXXXXXXXX by funding from the XXXXXXXXXX ("the Plan") because the Plan wanted the security that the Notes held. Under XXXXXXXXXX in the terms of the Notes, there was a Make-Whole Amount if early payment was made. The Make-Whole Amount was equal to the discounted value of the remaining scheduled payments, essentially compensating the Noteholders for the interest rate spread between the coupon rate on the Notes and the market interest rates when the Notes were issued. The Notes were repaid by funds received from the Plan. The Make-Whole Amount was calculated and new notes were issued (the "New Notes").

Your questions:

1. Are the Make-Whole Amounts deductible and, if so, when and how much? Why would Canco settle the Notes when the interest rate is less than on the New Notes and Canco would have to pay out over $XXXXXXXXXX in penalties plus interest?

2. Is the interest expense on the New Notes deductible? Canco accrued the interest amounts in the accounts and initially added back those amounts for tax purposes on Schedule 1. Canco is now requesting that it be allowed to deduct these amounts for tax purposes.

3. Is the payment of the Make-Whole Amount that included foreign exchange fluctuations on US Notes and interest deductible? You have included fact sheets with filing and information as well as the XXXXXXXXXX taxpayer letter requesting changes to the filing. You have also included XXXXXXXXXX from the Note Agreement of the XXXXXXXXXX Prepayment Agreement (with no attachments).

Our Comments:

As the Canco representatives have asserted, we have stated in document 2003-0023137 dated September 30, 2003, "that subsection 18(9.1) of the Income Tax Act (the "Act") should apply to a penalty or bonus payment made on the early redemption of an outstanding debt obligation provided the payment otherwise met the conditions set out in that subsection. Subsection 18(9.1) provides that the amount payable in paragraph 18(9.1)(d) will be deemed paid as interest and may be deducted in future years to which the interest would have related but for the repayment of the debt obligation before its maturity. There are two conditions placed on the deductibility of payments described in paragraphs 18(9.1)(c) and 18(9.l)(d) of the Act. First, a payment is deductible only to the extent that it can reasonably be considered to relate to an amount that, but for the repayment of the debt obligation, would have been paid as interest in the year. Second, the payment must not exceed the "value" at that time of an amount that, but for the payment, would have been paid or payable as interest on a debt obligation for a taxation year ending after the repayment by the taxpayer."

With respect to the first condition, the Make-Whole Amount was payable by Canco as a penalty because of the repayment of the Note before maturity. Canco needed to borrow because of its XXXXXXXXXX parent's problems and Canco could not borrow from anyone other than the Plan and the Plan required that the existing Notes be paid. The penalty represents the compensation for the interest rate spread between the coupon rate on the Notes and the then current market interest rates. In other words, the Noteholders were compensated for almost all the interest they would have received had the Noteholders held the Notes to maturity. Accordingly, in our view, it is reasonable to conclude that the Make-Whole Amount reasonably relates to an amount that, but for the repayment of the debt obligation, would have been paid as interest. A second condition that the penalty payment must not exceed the "value" applies to the total interest otherwise payable for the term and to each taxation year in which the taxpayer claims the deduction. The amount of interest that would have otherwise been paid on the Notes in each taxation year has been stated to be less than the interest otherwise payable for the remaining term of the Notes. Both straight line method and the present value method of amortization can be used to calculate a deduction under subsection 18(9.1) of the Act. For the sake of simplicity, Canco has calculated the amortization of the Make-Whole Amount using the straight line method. In our view, this should be acceptable.

The New Notes, are replacing the Notes and, accordingly, subsection 20(3) of the Act would apply since borrowed money has been used to repay money previously borrowed and is deemed to have the same use, at least up to the amount owing on the Notes. We noted that Canco borrowed $XXXXXXXXXX to repay $XXXXXXXXXX . We suggested that a tracing be made of the additional funds to determine whether the funds were put to an eligible or ineligible use to ensure the deduction claimed under paragraph 20(1)(c) of the Act is allowable. XXXXXXXXXX has since stated that she has done this tracing and is satisfied that the funds were put to an eligible use. As to the foreign exchange component, the capital gain or loss in respect of the foreign currencies is governed by subsection 39(2) of the Act. Accordingly, the foreign exchange components of the payments on the Make-Whole Amounts are capital gains or losses to Canco.

With respect to the foreign exchange hedge that was discussed (XXXXXXXXXX /Tremblay), you may wish to discuss this further with Doug Watson, the financial transaction specialist.

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. Jackie Page at (819) 994-2898. 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