2015-0586301I7 Premiums received on re-opening of debt

Principal Issues: 1. Will the premium received on the re-opening of debt affect the interest deduction for the purposes of paragraph 20(1)(c)? 2. Can such premiums constitute eligible capital amounts?

Position: 1. In these circumstances, yes. The stipulated interest rate on the debt was in excess of a reasonable amount. The interest deduction should be reduced over the life of the debt with reference to the amount of the premium. 2. Yes, subject to the exclusions provided for in variable E, (a)(i)-(iii) and (b).

Reasons: 1. The premium was paid in exchange for a higher rate of interest, which served to adjust the overall yield to reflect the market yield offered on similar instruments. 2. The 2006 amendments to variable E in the definition of CEC removed the requirements for a disposition and mirror image test.

Author: Ferrari, Rob
Section: 20(1)(c), 14(5)

                                                                                                                                                       September 11, 2015

Jennifer Mann                                                                                                                                HEADQUARTERS
Senior Technical Applications Officer                                                                                             Income Tax Rulings
Large Business Audit Division                                                                                                       Directorate
International and Large Business Directorate                                                                                R. Ferrari
Compliance Programs Branch                                                                                                       (613) 670-9007

                                                                                                                                                       2015-058630

Premiums Received on Re-Opening of Debt Obligation
Your file: XXXXXXXXXX

This is in response to your email of May 12, 2015 in regard to a query your division has received from the XXXXXXXXXX Tax Services Office (the “TSO”).

The query deals with the deduction of interest on re-opened debt (the “Notes”) in which the taxpayer received a premium.  You ask whether the interest deduction on the Notes should be restricted to an amount based on the effective yield on the Notes for the purposes of paragraph 20(1)(c) of the Income Tax Act (the “Act”).

FACTS

You have provided the following facts:

1.  XXXXXXXXXX (“the Taxpayer”), is a XXXXXXXXXX company with its head office in XXXXXXXXXX.

2.  XXXXXXXXXX is a holding company that indirectly owns corporations that XXXXXXXXXX business in XXXXXXXXXX.  The Taxpayer also operates a XXXXXXXXXX.

3.  In XXXXXXXXXX, the Taxpayer issued $XXXXXXXXXX in notes that were offered on a private placement basis.  The notes were issued at par, with a XXXXXXXXXX-year term and a XXXXXXXXXX% interest rate (payable semi-annually).

4.  In XXXXXXXXXX, the Taxpayer XXXXXXXXXX re-opened the existing notes, on a private placement basis, with the offering expected to close on XXXXXXXXXX.  The issue was for an additional $XXXXXXXXXX with a stated rate of interest of XXXXXXXXXX%.  The Notes were priced at $XXXXXXXXXX per $XXXXXXXXXX to yield approximately XXXXXXXXXX%.  XXXXXXXXXX

5.  The taxpayer’s tax manager advised that the XXXXXXXXXX offering was re-opened (in XXXXXXXXXX) as this provided cost savings of approximately $XXXXXXXXXX to $XXXXXXXXXX compared to issuing a new offering.  By re-opening the debt, the taxpayer would not have to incur costs for obtaining another credit rating, issuing a new offering memorandum, acquiring a new CUSIP (unique bond identifier) and issuing a new supplemental trust document.  Additionally, the time and effort required by internal resources to manage interest payments and maturity dates would also be reduced under the re-opening as compared to a new offering.

7.  The Taxpayer and the TSO agree that the Taxpayer’s business is not one of lending or borrowing money as described in paragraph 38 of IT-533 “Interest Deductibility and Related Issues” (“IT-533”).

TAXPAYER’S POSITION

In paragraph 38 of IT-533, the CRA indicated that where a premium arises because the debt was deliberately priced to give rise to a premium, the interest expense would not be considered reasonable for the purposes of paragraph 20(1)(c).  At the December 2003 Tax Executive Institute Conference (“2003 TEI Conference”) (footnote 1), the CRA stated a premium received on a debt re-opening could be considered in the category of a premium received where debt is not deliberately priced to achieve this result.

The Taxpayer argues that the CRA’s use of the term “deliberate” is intended to apply where tax avoidance considerations drive the decision to re-issue debt in order to obtain a tax-free premium.  This was not the case in the Taxpayer’s situation since the choice of re-opening the debt was based on legitimate business reasons (cost savings) and the stated interest rate was based on normal commercial practices.  Further, the Taxpayer argues that a degree of leeway should be permitted in establishing a reasonable interest rate and the difference between the stated rate and effective yield is only about XXXXXXXXXX basis points.  The Taxpayer concludes that the interest deduction on the Notes based on the rate of XXXXXXXXXX% rate of interest was reasonable in the circumstances for the purposes of paragraph 20(1)(c).

TSO’S POSITION

The TSO accepts that the Taxpayer re-opened the debt for valid business reasons; however, it does not agree that paragraph 38 of IT-533 supports the Taxpayer’s position.

The taxpayer priced the re-opened debt to yield XXXXXXXXXX%, in accordance with their assessment of the market rate at that time.  The TSO is of the opinion that the deduction of interest calculated on the stated rate of XXXXXXXXXX% is not reasonable for the purposes of paragraph 20(1)(c) and the deduction should be based on the yield.  Your division supports the TSO’s proposed adjustments.

OUR COMMENTS

A deduction for interest under paragraph 20(1)(c) is limited to the amount paid or payable in the year or “a reasonable amount in respect thereof, whichever is the lesser.”  The CRA’s position on a premium received on the issuance of a debt is stated in paragraph 38 of IT-533, (footnote 2) which reads as follows:

“Where debts are issued with a stated interest rate greater than prevailing market rates, the debt issuer will receive greater than 100% of the principal amount of the debt issue (that is, a premium). Where the borrowed money constitutes stock-in-trade for taxpayers in the financing business (for example, moneylenders), the premium amount will be included in computing income under section 9. For other taxpayers it will generally be considered a non-taxable capital receipt. Where the premium arises because the debt was deliberately priced to give rise to a premium, the interest expense otherwise deductible will not be considered reasonable. As such, the interest expense will be reduced over the life of the debt with reference to the amount of the premium.  Since the issue premium serves to adjust the overall yield to reflect the market yield currently being offered on similar instruments, it is the CRA's position that the stipulated interest rate on the debt is in excess of a reasonable amount as determined for the purposes of paragraph 20(1)(c).”

At the 2003 TEI Conference, the CRA was asked whether the comments in IT-533 also applied to re-opened debt, in circumstances in which the borrowed money did not constitute the stock-in-trade of a taxpayer.  The CRA stated that the views expressed in IT-533 did not address the issue of re-opened debts.  The CRA stated that it could provide general comments and identified that “…a premium received on a debt re-opening could be considered in the category of a premium received where debt is not deliberately priced to achieve this result.”  However, the CRA also stated that “a binding reply would require a comprehensive review of the facts of the situation” and “…we would need to become more familiar with this practice…”

In these circumstances, the Taxpayer issued the Notes with a stated interest rate in excess of a rate that would have been required in the market at the time the debt was re-opened.  The premium on the Note arose in exchange for the excess rate of interest and served to adjust the overall yield to reflect the market yield.

We agree with the TSO that the interest deduction that was based on an interest rate of XXXXXXXXXX% is unreasonable in these circumstances.  In determining a reasonable amount, it should be noted that IT-533 did not state that the interest rate should be reduced to the yield.  Instead, it states “the interest expense will be reduced over the life of the debt with reference to the amount of the premium.”

In addition to our comments with respect to paragraph 20(1)(c), we have also considered whether the premiums received would otherwise reduce the taxpayer’s cumulative eligible capital (“CEC”).  Subsection 14(1) of the Act requires certain amounts to be included in a taxpayer's income where, at the end of a taxation year, the amounts required to be deducted from a taxpayer's CEC pool exceed the amounts required to be added to the CEC pool.  The calculation of the CEC is provided for in subsection 14(5) by the following formula:

(A + B + C + D + D.1) – (E + F)

In general terms, a taxpayer’s CEC pool may be reduced for amounts described in variable E of the formula.  In 2006, the definition of CEC and variable E were amended.  Before the amendments, for an amount to be included in variable E, the amount was required to have been received as a result of a disposition, as well as having been required to meet what was generally referred to as the “mirror image” test.  Under the mirror image test, the taxpayer was to hypothetically consider that if it had made the payment, whether such payment would have constituted an “eligible capital expenditure”.  Former variable E read, in part, as follows:

"E    is the total of all amounts each of which is 3/4 of the amount, if any, by which

(a) an amount which, as a result of a disposition occurring after the taxpayer's adjustment time and before that time, the taxpayer has or may become entitled to receive, in respect of the business carried on or formerly carried on by the taxpayer where the consideration given by the taxpayer therefor was such that, if any payment had been made by the taxpayer after 1971 for that consideration, the payment would have been an eligible capital expenditure of the taxpayer in respect of the business…”
(Emphasis added)

Several exclusions are provided for in the definition of eligible capital expenditures.  Under the mirror image test, items (d) and (f) in the definition of eligible capital expenditure may have been considered as applicable to preclude the premiums as being considered eligible capital expenditures for the purposes of then variable E.  Items (d) and (f) are listed in the definition of eligible capital expenditures as follows:

“(d) any amount paid or payable to any creditor of the taxpayer as, on account or in lieu of payment of any debt or as or on account of the redemption, cancellation or purchase of any bond or debenture,

(f) any amount that is the cost of, or any part of the cost of,
(i) an interest in a trust,
(ii) an interest in a partnership,
(iii) a share, bond, debenture, mortgage, hypothecary claim, note, bill or other similar property, or
(iv) an interest in, or for civil law a right in, or a right to acquire any property described in any of subparagraphs (i) to (iii);”

As a result of the 2006 amendments to variable E, amounts that may fall within the ambit of variable E have been expanded.  A disposition is no longer stipulated in variable E and the mirror image test is no longer required.  Amended variable E reads as follows:

“E is the total of all amounts each of which is 3/4 of the amount, if any, by which
(a) an amount that the taxpayer has or may become entitled to receive, after the taxpayer's adjustment time and before that time, on account of capital in respect of the business carried on or formerly carried on by the taxpayer, other than an amount that
(i) is included in computing the taxpayer's income, or deducted in computing, for the purposes of this Act, any balance of undeducted outlays, expenses or other amounts for the year or a preceding taxation year,
(ii) reduces the cost or capital cost of a property or the amount of an outlay or expense, or
(iii) is included in computing any gain or loss of the taxpayer from a disposition of a capital property”
exceeds
(b) all outlays and expenses that were not otherwise deductible in computing the taxpayer's income and were made or incurred by the taxpayer for the purpose of obtaining the amount described by paragraph (a)”
(emphasis added)

We have consulted with our Business Income and Capital Transactions Section (“ITRD Section 25”) of the Income Tax Rulings Directorate (“ITRD”).  They support the view that the premiums received by the Taxpayer could now fall within amended variable E of the definition of CEC, assuming that the amounts are not otherwise included in the Taxpayer’s income or have reduced the amount of an outlay or expense, (i.e., in these circumstances, if a reduction to paragraph 20(1)(c) did not apply as discussed above.)

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.

We trust that the above comments will be of assistance.

G. Moore
for Director
Partnerships and Corporate Financing Section
International Division
Income Tax Rulings Directorate

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1  CRA document 2003-004856

2  Effective March 6, 2015, IT-533 has been cancelled and replaced with Folio S3-F6-C1: “Interest Deductibility”.  Paragraph 1.96 of Folio S3-F6-C1 contains the same wording as paragraph 38 of IT-533.

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