29 May 2017 Internal T.I. 2017-0689161I7 - Paragraph 18(9.1)(a) - paying debt with new debt

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: Where a taxpayer borrows money from an arm's length party to pay in full or satisfy completely a pre-existing debt owing to another arm's length party and also pays a prepayment penalty to the latter creditor, will the exclusion in 18(9.1)(a) of the Act apply?

Position: No.

Reasons: A prepayment penalty paid to former creditors may not reasonably be considered to have been paid to them in respect of the substitution of a debt obligation where new and different creditors are providing the substituted debt.

								May 29, 2017

Audit Division						HEADQUARTERS
XXXXXXXXXX Taxation Services Office			Income Tax Rulings
								Directorate
Attention:  XXXXXXXXXX					James Gibbons
(819) 458-3538

								2017-068916

Subsection 18(9.1)

This is in reply to your enquiry regarding subsection 18(9.1) of the Income Tax Act (the “Act”) which was forwarded to us by the Technical Applications Section, Compliance Programs Branch. In particular, you wish to know our views as to whether subsection 18(9.1) of the Act would apply in the situation described below.

FACTS

• XXXXXXXXXX (the “Taxpayer”) is a public company listed on the XXXXXXXXXX Stock Exchange. It owns XXXXXXXXXX and provides XXXXXXXXXX.
• On XXXXXXXXXX, the Taxpayer issued Series A Debentures (the “SAD”) at XXXXXXXXXX% for a principal amount of $XXXXXXXXXX, due XXXXXXXXXX.
• On XXXXXXXXXX, the Taxpayer issued Series B Debentures (the “SBD”) at XXXXXXXXXX%, for a principal amount of $XXXXXXXXXX, due XXXXXXXXXX. They were collateralized by the assets of the Taxpayer and its subsidiary partnerships and guaranteed by the subsidiary partnerships.
• On XXXXXXXXXX, the Taxpayer redeemed the SAD. At the time of the redemption, the principal was $XXXXXXXXXX, and a redemption premium of $XXXXXXXXXX (the “Redemption Premium”) was paid for early discharge of the SAD. Also, accrued interest of $XXXXXXXXXX was paid for the period from the last payment date to the date of the redemption.

For accounting purposes, the Redemption Premium was deducted in XXXXXXXXXX, but for tax purposes, the Redemption Premium was amortized over the remaining term of the SAD pursuant to subsection 18(9.1) of the Act. More specifically, the Taxpayer deducted $XXXXXXXXXX in XXXXXXXXXX and $XXXXXXXXXX in XXXXXXXXXX.

LEGISLATION

Subsection 18(9.1) Penalties, bonuses and rate-reduction payments — Subject to subsection 142.4(10), where at any time a payment, other than a payment that

(a) can reasonably be considered to have been made in respect of the extension of the term of a debt obligation or in respect of the substitution or conversion of a debt obligation to another debt obligation or share, or

(b) is contingent or dependent on the use of or production from property or is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion or by reference to dividends paid or payable to shareholders of any class of shares of the capital stock of a corporation,

is made to a person or partnership by a taxpayer in the course of carrying on a business or earning income from property in respect of borrowed money or on an amount payable for property acquired by the taxpayer (in this subsection referred to as a "debt obligation")

(c) as consideration for a reduction in the rate of interest payable by the taxpayer on the debt obligation, or

(d) as a penalty or bonus payable by the taxpayer because of the repayment by the taxpayer of all or part of the principal amount of the debt obligation before its maturity,

the payment shall, to the extent that it can reasonably be considered to relate to, and does not exceed the value at that time of, an amount that, but for the reduction described in paragraph (c) or the repayment described in paragraph (d), would have been paid or payable by the taxpayer as interest on the debt obligation for a taxation year of the taxpayer ending after that time, be deemed,

(e) for the purposes of this Act, to have been paid by the taxpayer and received by the person or partnership at that time as interest on the debt obligation, and

(f) for the purpose of computing the taxpayer's income in respect of the business or property for the year, to have been paid or payable by the taxpayer in that year as interest pursuant to a legal obligation to pay interest,

(i) in the case of a reduction described in paragraph (c), on the debt obligation, and

(ii) in the case of a repayment described in paragraph (d),

(A) where the repayment was in respect of all or part of the principal amount of the debt obligation that was borrowed money, except to the extent that the borrowed money was used by the taxpayer to acquire property, on borrowed money used in the year for the purpose for which the borrowed money that was repaid was used, and

(B) where the repayment was in respect of all or part of the principal amount of the debt obligation that was either borrowed money used to acquire property or an amount payable for property acquired by the taxpayer, on the debt obligation to the extent that the property or property substituted therefor is used by the taxpayer in the year for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business.

[Our underlining.]

TAXATION SERVICE OFFICE VIEW

It is your view that the Redemption Premium paid by the Taxpayer was “in respect of the substitution” of the SAD and thus the exclusion in paragraph 18(9.1)(a) would apply to the SAD so that it would be excluded from treatment under subsection 18(9.1). Under the latter provision, the Redemption Premium would be deducted in the same year that the interest on the SAD would have been deducted. Instead, it is your view that paragraph 20(1)(e) of the Act would apply to require the Redemption Premium to be amortized over 5 years. Thus, in each of XXXXXXXXXX and XXXXXXXXXX, the Taxpayer would only be permitted to deduct an amount of $XXXXXXXXXX in respect of the Redemption Premium (i.e., $ XXXXXXXXXX), rather than the amounts deducted by the Taxpayer of $XXXXXXXXXX and $XXXXXXXXXX, in XXXXXXXXXX and XXXXXXXXXX, respectively.

In your view, Income Tax Rulings documents E9802143 (the “1998 Ruling”) and E9802565 (the “1998 Interpretation”), which have been cited by the Taxpayer to support its position, are not relevant to the Taxpayer’s situation.

TAXPAYER’S VIEW

It is the Taxpayer’s view that the Redemption Premium would not be considered to be paid “in respect of the substitution” of the SAD since both series of debentures overlapped each other by XXXXXXXXXX days, and the SAD Investors and also the SBD Investors were substantially different.

The Taxpayer cited the 1998 Ruling and the 1998 Interpretation (the “1998 Documents”), as well as file E9425876 (the “1994 Interpretation”), to support its position that subsection 18(9.1) would apply to its circumstances. In particular, the Taxpayer refers to the following comments that were set out in the Summary of the 1998 Ruling:

“Substitution, for purposes of subsection 18(9.1), does not include payments made to buy down an interest rate or, bonus or penalty payments made to prepay the principal of a debt obligation in situations where the debtor has parted with something such that there has been a performance of obligation and that the performance involves an actual payment (not a promise to pay in the future) by the debtor.”

With regard to the 1998 Interpretation, the Taxpayer refers to the following statement:

“In our view, where there has been full payment of that obligation, the provisions of subsection 18(9.1) of the Act will normally apply. Accordingly, a prepayment penalty incurred by a taxpayer who borrows money from one arm’s length party to pay a pre-existing debt owing to another arm’s party would generally be deductible pursuant to subsection 18(9.1) of the Act over what would have been the remaining term of the obligation. However, in our view, if the terms of the original obligation have been modified or extended with the same or different person such that the transaction would constitute a rescheduling or restructuring of a debt obligation, the provision of subparagraph 20(1)(e)(ii.2) of the Act may apply in respect of the borrowing.”

With regard to the 1994 Interpretation, the Taxpayer refers to the following statement:

“It is our understanding that subsection 18(9.1) was originally intended as an alleviating measure for farmers who were prepaying their loans but were being denied a deduction for the portion of the prepayment that represented interest. However, when the legislation was introduced it was not restricted to farmers but covered situations where the penalty or bonus could be considered as a substitution for interest foregone by the lender if the principal of the debt had remained at its original amount until maturity.”

OUR VIEWS

For purposes of our reply, it is assumed that the Taxpayer’s deduction of the Redemption Premium in XXXXXXXXXX and XXXXXXXXXX would otherwise qualify under subsection 18(9.1) if the exclusion in paragraph 18(9.1)(a) did not apply. In other words, the only issue that we have examined is whether paragraph 18(9.1)(a) applies in the particular circumstances.

The 1998 Documents indicate that a “payment” for purposes of section 18(9.1) requires “performance of the obligation.” In this regard, the expression “performance of the obligation” in the 1998 Documents referred to the requirement that a debtor actually pay with something other than a promise to pay in the future. Consequently, where a debtor issues a new debt obligation to a lender as fulfillment for an existing debt obligation issued by that lender, there would be no “performance of obligation” and thus no payment. In such cases, generally, the new debt would be considered to be a substitution for the existing debt obligation for purposes of the exclusion in paragraph 18(9.1)(a).

As set out in the 1998 Interpretation, where a prepayment penalty has been incurred as a result of the “full payment” of an existing obligation, the provisions of subsection 18(9.1) of the Act may generally apply. Thus, as indicated in that document, where a taxpayer borrows money from an arm’s length party to pay in full or satisfy completely a pre-existing debt owing to another arm’s length party and also pays a prepayment penalty to the latter creditor, the taxpayer may be entitled to deduct the prepayment penalty pursuant to subsection 18(9.1) of the Act over what would have been the remaining term of the obligation.

A textual analysis of paragraph 18(9.1)(a) also supports the position that this paragraph would generally not apply in this context where a prepayment penalty is paid on the settlement of an existing debt where that existing debt is paid from funds obtained from different creditors. In this regard, paragraph 18(9.1)(a) refers to, inter alia, “[a payment that] can reasonably be considered to have been made …in respect of the substitution of a debt obligation to another debt obligation.” Thus, for purposes of applying paragraph 18(9.1)(a), the issue is whether it is reasonable to consider that a payment is “[made] in respect of the substitution” of a debt obligation.” It is our view that a prepayment penalty paid to former creditors may not reasonably be considered to have been paid to them in respect of the substitution of a debt obligation where new and different creditors are providing the substituted debt. In the Taxpayer’s case, since the SAD Investors are a substantially different group of investors than the SBD Investors, it is our view that it could not reasonably be considered that the SAD Investors were paid the Redemption Premium “in respect of the substitution of the [SAD]” since it was the SBD Investors, and not the SAD Investors, who provided a substitute debt for the SAD.

In conclusion, assuming that there was full and absolute payment of the SAD in XXXXXXXXXX, as asserted by the Taxpayer, it is our view that the exclusion in paragraph 18(9.1)(a) would not apply to the payment of the Redemption Premium. If the Redemption Premium would otherwise qualify under subsection 18(9.1), it is our view that, based on the information provided, it appears that the Taxpayer would be entitled to a deduction of the Redemption Premium in XXXXXXXXXX and XXXXXXXXXX pursuant to this provision. You may wish to refer to Income Tax Folio S4-F2-C1, “Deductibility of Fines and Penalties,” for additional details regarding the deductibility of amounts under subsection 18(9.1).

Unless exempted, 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. After a 90-day waiting period, a severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. You may request an extension of this 90-day period. The severing process removes all content that is not subject to disclosure, including information that could reveal the identity of the taxpayer. The taxpayer may ask for a version that has been severed using the Privacy Act criteria, which does not remove taxpayer identity. You can request this by e-mailing us at: ITRACCESSG@cra-arc.gc.ca.

A copy will be sent to you for delivery to the taxpayer.

G. Moore
for Director
Partnerships and Corporate Financing Section
Reorganizations Division
Income Tax Rulings Directorate
Legislation Policy and Regulatory Affairs Branch

cc. Leslie Bafia, Manager, Technical Applications Section, Compliance Programs Branch