2015-0592781I7 treatment of bond locks

Principal Issues: Whether losses on bond locks would be on income or capital account; whether such losses, if on income account, should be amortized.

Position: Income account; yes.

Reasons: Long-standing administrative position; application of case law.

Author: Friedlander, Lara G.
Section: 9

                                                          October 21, 2015

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                                                                                                               2015-059278

Treatment of Bond Locks

This is in response to your email of June 16, 2015 regarding the treatment of certain bond locks under the Income Tax Act (Canada) (the “Act”).

Facts and Assumptions

1. XXXXXXXXXX (“Canco”) is a corporation resident in Canada under the Act.  It is a direct wholly-owned subsidiary of XXXXXXXXXX (“Parent”), also a corporation resident in Canada under the Act.  Generally, all hedging transactions entered into by the Parent corporate group with arm’s length parties are undertaken by Canco.

2.    In XXXXXXXXXX, Canco entered into XXXXXXXXXX (the “Dividend Bond Locks”) with XXXXXXXXXX arm’s length third parties XXXXXXXXXX each a “Counterparty”) and XXXXXXXXXX (the “Interest Bond Locks”, together with the Dividend Bond Locks being the “Bond Locks”) with XXXXXXXXXX arm’s length parties XXXXXXXXXX each also a “Counterparty”).  Some Counterparties were residents of Canada under the Act and some were not.

3.    Each of the Dividend Bond Locks was entered into in either late XXXXXXXXXX, was documented as a confirmation to an ISDA Master Agreement and Schedule and had the following material terms:

a. Termination date of XXXXXXXXXX.

b. Notional amount of C$XXXXXXXXXX (such that the aggregate notional amount for all the Dividend Bond Locks was C$XXXXXXXXXX).

c. Reference bond that is a XXXXXXXXXX with a coupon of XXXXXXXXXX% maturing XXXXXXXXXX. Amount payable on termination (assuming only one payment on termination) is equal to (A-B) x ($XXXXXXXXXX) x C where:

i. A was equal to the yield, on the termination date, at which the relevant securities dealer would sell the Reference Security.

ii.   B was equal to a yield specified in the terms (which was either XXXXXXXXXX).  We assume that this is the yield, on the date the relevant Bond Lock was entered into, at which the Reference Security was being sold. 

iii. C is equal to the dollar value, expressed as a percentage of a one basis point change in the yield of the Reference Security on the termination date corresponding to A.

d.    XXXXXXXXXX

4.    The Dividend Bond Locks were disposed of on their termination dates pursuant to their terms.  As a result, Canco was required to pay an aggregate of $XXXXXXXXXX in XXXXXXXXXX.

5.    The Dividend Bond Locks were said by Canco to be related to XXXXXXXXXX Preferred Shares XXXXXXXXXX issued by Parent.  There were XXXXXXXXXX between Parent and Canco that relate to the Dividend Bond Locks.  The Dividend Bond Locks were said by Canco to provide a hedge with respect to increases in dividend obligations as measured between the date the Dividend Bond Locks were entered into, and the date the relevant Preferred Shares were actually issued or the dividend rates on which were reset.  The XXXXXXXXXX Preferred Shares were first issued in XXXXXXXXXX and were convertible into XXXXXXXXXX Preferred Shares on every XXXXXXXXXX.  Conversely, the XXXXXXXXXX Preferred Shares were also convertible into XXXXXXXXXX Preferred Shares on every XXXXXXXXXX.  Generally, the XXXXXXXXXX Preferred Shares pay XXXXXXXXXX and the XXXXXXXXXX Preferred Shares pay XXXXXXXXXX.  The fixed rate on the XXXXXXXXXX Preferred Shares is reset every XXXXXXXXXX years, with the rate being set by Parent between XXXXXXXXXX days prior to each XXXXXXXXXX year period.  Parent has full discretion as to the rate to be selected, provided that the rate is not less than XXXXXXXXXX% of the relevant Government of Canada yield.  We understand that in XXXXXXXXXX, the XXXXXXXXXX selected a range of XXXXXXXXXX%-XXXXXXXXXX%.  We assume that the rate set by Parent is intended to be a market rate.  XXXXXXXXXX Parent had set an annual fixed dividend rate of XXXXXXXXXX% on the XXXXXXXXXX Preferred Shares for the XXXXXXXXXX period beginning XXXXXXXXXX. XXXXXXXXXX Parent would have XXXXXXXXXX Preferred Shares outstanding (which, based on an issue price and stated value of $XXXXXXXXXX per share, represented an aggregate of $XXXXXXXXXX).  The taxpayer has stated that around the time the Dividend Bond Locks were entered into, there were approximately $XXXXXXXXXX of XXXXXXXXXX Preferred Shares and $XXXXXXXXXX of XXXXXXXXXX Preferred Shares (which themselves could be converted into XXXXXXXXXX Preferred Shares).  XXXXXXXXXX.

6.    XXXXXXXXXX.

7.    Each of the Interest Bond Locks was entered into in XXXXXXXXXX.  We understand that the XXXXXXXXXX.  We understand that the material terms for the Interest Bond Locks were the same as the material terms for the Dividend Bond Locks except that the issue date for each was in mid-XXXXXXXXXX, the termination date for each was XXXXXXXXXX, the Reference Security was a XXXXXXXXXX either with a coupon of XXXXXXXXXX% maturing XXXXXXXXXX or with a coupon of XXXXXXXXXX% maturing XXXXXXXXXX.  The aggregate notional amount was $XXXXXXXXXX.

8.    We understand that the Interest Bond Locks were related to XXXXXXXXXX debentures (the “Debentures”) issued by Canco on XXXXXXXXXX and maturing XXXXXXXXXX.  C$XXXXXXXXXX of Debentures were issued.  They carried a XXXXXXXXXX% interest rate.  The Debentures were redeemable at any time (with XXXXXXXXXX days’ notice) at the greater of the “Canada Yield Price” and par.  For these purposes, “Canada Yield Price” was defined, generally, to be a price that would result in a yield of the relevant Government of Canada rate plus XXXXXXXXXX basis points. XXXXXXXXXX and the time the relevant Debentures were issued.  Although in XXXXXXXXXX.

9.    The Interest Bond Locks were disposed of on their termination dates pursuant to their terms.  As a result, Canco was required to pay an aggregate of $XXXXXXXXXX in XXXXXXXXXX.

10.   We understand that for accounting purposes, the Interest Bond Locks were eligible for hedge accounting in relation to the Debentures; accordingly, XXXXXXXXXX and were then amortized to profit and loss over the term of the Debentures.  For tax purposes the amounts were deducted as paid.

Taxpayer’s View

Amounts paid under the Bond Locks are immediately deductible.

TSO’s View

Amounts paid under the Bond Locks are deductible, but the deductions must be amortized over the life of the related instruments (the Preferred Shares or the Debentures, as the case may be).

Your View

Subject to George Weston Ltd. v. The Queen, [2015] 4 C.T.C. 2010 (T.C.C.), the amounts paid under the Bond Locks would be immediately deductible.  However, in light of Weston, the amounts may be on capital account.  You would take the view that Weston does not cause the losses to be on capital account, but have requested guidance on this point.

Question

What is the treatment of the amounts paid under the Bond Locks?

Our Comments

1. Income or capital account?

The treatment of a gilt lock (which is the U.K. equivalent of a Canadian bond lock) was considered in 2008-027244 (September 19, 2008).  In that document Rulings stated:  “In our view, the Gilt Lock is not a cost of financing; it is a derivative hedge against the yield on the proposed bond to be issued. The purchase of the derivative is aimed at reducing the interest on the bond.  It is not incurred in the course of borrowing money as required under subparagraph 20(1)(e)(ii) of the Act, thus, in our view, the derivative termination payment does not qualify for the five year amortization.”  Rulings then stated:

The CRA position is to treat a "hedge cost" or "hedge premium" as inherent in the determination of any gain or loss on the derivative contract, which gain or loss can only be determined at the time of contract fulfillment, and is equal to the difference between the payment made under the contract and the Canadian-dollar value of the consideration received therefor, where such consideration is translated to Canadian dollars at the spot rate in effect on the date of delivery. The characterization of this gain or loss as on account of income or capital will depend on the underlying use of funds that gave rise to the liability that the derivative is designed to hedge.

We do not agree with your view that the hedge transaction is on account of capital; although we agree that the underlying item and the use of the bond is capital (to finance an acquisition) and the interest is generally a capital item, but would be deductible under paragraph 20(1)(c) of the Act.  The hedge follows the underlying transaction which in this case is to fix an interest rate to a particular bond that will be issued in the near future.  Further, in our view, it cannot be said that the hedge is a discount similar to a paragraph 20(1)(f) expense. XXXXX did not issue the derivative; they issued the corporate bond and attempted to hedge the yield on that bond.  Moreover, XXXXX attempted to fix the yield on the entire debt obligation, not only during the period before it was issued.

Canadian Banks (see for example, the Bank of Montreal web site) have indicated in press releases, that from a federal tax standpoint, current hedge accounting allows the company to recognize the cost or benefit over the life of the underlying debt. That statement, in our view, is valid as the lock hedges the yield which represents the interest on the obligation; thus, for CRA to recognize the gain or allow the loss over the life of the obligation makes economic sense and is in keeping with our position on characterizing the hedge with the underlying transaction. In the case at hand, the bond has a maturity of XXX years, thus the cost should be spread over that term.

In the case at hand, XXXXX repurchased on XXXXX for cash up to $XXX of its outstanding pound sterling XXX XXXX% note that was due in XXXX.  Since we are trying to match the expense in question over the entire term and the remaining outstanding amount of the bond, an adjustment to increase the expense would be required in XXXX to reflect that fact.

Responding to question 60 of the CRA Round Table at the 1984 Annual Canadian Tax Foundation Conference, which related to an interest rate swap intended to hedge interest obligations on a debt obligation, Rulings stated that “[p]rovided that interest payable by Canco on its debt is deductible for income tax purposes, amounts payable by Canco to the intermediary or receivable from the intermediary pursuant to the agreement are considered to be on income account”.  See also ATR-4 (November 29, 1985).

This position evolved.  At the 1993 Annual Canadian Tax Foundation Conference (4M0966 (February 7, 1994)), Rulings stated the following in respect to question 11:

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.

The use of any underlying borrowed funds is no longer relevant in determining the treatment for income tax purposes of the amounts payable or receivable pursuant to the interest rate swap agreement.

At the December 2003 TEI conference (2003-0048555 (December 2, 2003)) Rulings stated that “[i]t continues to be our view that all amounts payable or receivable, including termination payments, pursuant to a plain vanilla 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.”  See similarly 2003-0030597 (October 30, 2003).

The key question, then, is whether Weston affects this position.  In Weston, the issue was whether a gain on a cross-currency swap entered into by the taxpayer was on income or on capital account.  An indirect subsidiary of the taxpayer had acquired a U.S. bakery business, which resulted in dramatic increase of the U.S. dollar exposure of the taxpayer’s corporate group.  Foreign currency exposure was recorded for financial statement purposes in the taxpayer’s “currency translation account” or “CTA Account”.  Volatility in the CTA Account could have a material impact on the taxpayer’s consolidated equity:  where the Canadian dollar appreciated relative to the U.S. dollar, the taxpayer’s consolidated equity decreased, and vice-versa.  A significant decrease in the taxpayer’s consolidated equity would erode the taxpayer’s debt-to-equity ratio, which could in turn affect the taxpayer’s credit rating, which could in turn result in increased financing costs for the taxpayer generally.

The Court in Weston first considered whether the swap was a hedge of anything.  The following are some of the key passages at paragraphs 70, 73 and 75:

In my view, the appellant has demonstrated that the swaps were entered into as a hedge and not with the intent to speculate…The USD notional value of the swaps closely approximated the total net investments in the USD Operations that were exposed to currency risk.

…Here, I find that the evidence establishes that the appellant, in entering into the swaps, was acting in close consultation with and on behalf of its subsidiaries in order to protect the equity of the whole Weston group, as disclosed in the consolidated financial statements. As stated by Ms. Frost and Mr. Thornton, the underlying USD net investments were in a direct way highly sensitive to GWL's currency risk. Indeed, I agree with the appellant that the fluctuations in the USD investments affected GWL's own capital structure and had an impact on the value of GWL's direct investments in its subsidiaries…

Further, the respondent's argument fails to recognize that a real risk existed in GWL's business after the Bestfoods acquisition, regardless of any GAAP requirements or “notional” reporting prior to the termination of the swaps. That risk was reflected in the CTA, in accordance with GAAP, but that does not change the fact that GWL was exposed to currency risk associated with an increasing debt to equity ratio as a result of its expanded indirect holdings in US assets. That risk led to tangible consequences as detailed by Ms. Frost and as evidenced by Standard & Poor's credit watch discussed above. This caused management to hedge the risk using swaps which were directly tied to the value of GWL's US assets.

Having found that the swap was a hedge, the Court in Weston then went on to characterize the gain.  The Court stated the following at paragraphs 86 and 89:

The appellant argued that nothing in the present case suggests that the swaps were related to an underlying item that was on income account (such as production or inventory costs, or sales revenues). Nor is there any evidence showing that the intention was to make a profit in the financial markets when entering into the swaps. As a matter of fact, GWL was not permitted under either its credit facilities or its corporate policy to speculate (GWL was only allowed to enter into hedging agreements for the purpose of managing its risks in a manner consistent with the derivatives risk management policy approved by the board of directors…)…

I agree with the appellant. My perception on the whole is that, from a commercial perspective, GWL would not have entered into the swaps in issue in the absence of the Bestfoods transaction. Before that acquisition, GWL had entered into a few cross-currency swaps to hedge part of its assets in the United States. Apart from that, it was not GWL's policy to get involved in derivatives or to speculate on currency fluctuations. I accept that the intention in entering into the swaps was to hedge the investment in the USD Operations, which exposed GWL to currency risk in that it had an impact on its investments and its capital structure. GWL's indirect investment in USD Operations, just like its direct investment in its subsidiaries, was capital in nature. I therefore find that the swaps were entered into to hedge a capital investment.

At the International Fiscal Association conference in May, 2015 (2015-057769 (May 28, 2015)), the following question was asked of Rulings and the following response was offered regarding the Weston decision:

Question 1 - George Weston: impact on CRA’s position re: hedges
The Tax Court of Canada recently rendered its decision in the George Weston Ltd. (GWL) case [citation omitted], which considered the income or capital characterization of the taxpayer’s gains on foreign currency derivatives. 
In 2001, the taxpayer borrowed significant funds to finance the acquisition of a U.S. based business (the “US Operations”) by its indirectly held subsidiaries.  Due to the risk of currency fluctuations, the taxpayer entered into a series of cross-currency swaps in order to protect against the impact of currency fluctuations on the translated value of the US Operations reported on its consolidated balance sheet.  In 2003, the risk of currency fluctuations had been reduced and the taxpayer chose to terminate the swaps.  The taxpayer realized a gain on the termination of the swaps and reported the gain on account of capital, which the CRA reassessed as being on account of income.  The Court held in favour of the taxpayer finding the taxpayer entered into the swaps to hedge a capital investment and the gain was appropriately reported as being on account of capital.

The GWL case was not appealed.  How does this decision impact the CRA’s position with respect to foreign currency hedges for net investments in foreign operations and their characterization for income tax purposes?

CRA Response

The CRA accepts the decision in GWL. While the decision affirmed that there are circumstances in which a foreign currency derivative can be considered a hedge of a taxpayer’s net investments in foreign operations there must, however, be evidence that demonstrates that the derivative is sufficiently linked to the underlying capital assets.  The determination of whether there is sufficient linkage to the underlying capital assets will be a question of fact and can only be made after considering all of the surrounding circumstances.

In GWL, the Court found sufficient evidence to conclude the taxpayer’s intent and purpose for entering into the swap contracts was to hedge the risk of currency fluctuations on its investment in the US Operations in order to counteract their impact on the taxpayer’s capital structure and the value of its direct investments in its subsidiaries.  The Court concluded that the taxpayer would not have entered into the swaps if it had not acquired the US Operations.  The Court took into consideration, among other things, that the notional value of the swaps closely approximated the investments in the US Operations, the taxpayer’s formal derivative policy and its credit facilities prohibited it from speculating in derivatives, and in arriving at its finding, that there was no evidence that the swaps were related to an underlying item that was on income account and that there was no evidence of a profit or speculation motive on the part of the taxpayer.

The Court did not consider the early termination of the derivative in these circumstances, to cause the derivatives to be considered speculative in nature.  The termination occurred after the taxpayer’s risk had declined (its debt to equity ratio had returned to acceptable levels) and the derivatives were no longer required to protect GWL’s capital structure.

As set out above, the CRA’s administrative position on interest rate derivatives has been to treat them as being independent from other transactions and therefore on income account.  Weston addresses the linkage principle in the context of foreign exchange derivatives that hedge investments in foreign operations.  In our view, Weston should not affect the CRA’s administrative positive relating to interest rate derivatives. 

The remaining question here, then, is whether the Interest Bond Locks and the Dividend Bond Locks fall within Rulings’ position in 2008-027244, which follows Rulings’ policy on interest rate swaps.  You have indicated that your view is that, in the absence of Weston, the Interest Bond Locks and the Dividend Bond Locks would be considered to be on income account under Rulings’ policy.  We agree with this view.  Given that it is our view that Weston should not have any effect on Rulings’ policy regarding interest rate derivatives, Rulings’ policy regarding interest rate derivatives would continue to apply and therefore the Bond Locks should be considered to be on income account.

2.    Is there amortization?

Amortization was recommended in 2008-027244.  That document stated:

…the lock hedges the yield which represents the interest on the obligation; thus, for CRA to recognize the gain or allow the loss over the life of the obligation makes economic sense and is in keeping with our position on characterizing the hedge with the underlying transaction. In the case at hand, the bond has a maturity of XXXXXXXXXX years, thus the cost should be spread over that term.

In the case of the Bond Locks, which were settled prior to or simultaneously with the issuance of the Debentures and the reset of the rates on the XXXXXXXXXX Preferred Shares, amortization of the cost of the Bond Locks over the term of the Debentures or over the next XXXXXXXXXX interest period on the XXXXXXXXXX Preferred Shares would result in a material timing difference as contrasted with immediate deductibility.

The legal basis for amortization would be Canderel Ltd. v. The Queen, [1998] 2 C.T.C. 35 (S.C.C.), which provides guidelines as to when an expense the deductibility of which is governed by section 9 should be amortized.  The guidelines were summarized by the Court as follows:

(1)   The determination of profit is a question of law.

(2)   The profit of a business for a taxation year is to be determined by setting against the revenues from the business for that year the expenses incurred in earning said income:  Minister of National Revenue v. Irwin, supra, Associated Investors, supra.

(3)   In seeking to ascertain profit, the goal is to obtain an accurate picture of the taxpayer's profit for the given year.

(4)   In ascertaining profit, the taxpayer is free to adopt any method which is not inconsistent with

(a)   the provisions of the Income Tax Act;

(b)   established case law principles or “rules of law”; and

(c)   well-accepted business principles.

(5)   Well-accepted business principles, which include but are not limited to the formal codification found in G.A.A.P., are not rules of law but interpretive aids. To the extent that they may influence the calculation of income, they will do so only on a case-by-case basis, depending on the facts of the taxpayer's financial situation.

(6)  On reassessment, once the taxpayer has shown that he has provided an accurate picture of income for the year, which is consistent with the Act, the case law, and well-accepted business principles, the onus shifts to the Minister to show either that the figure provided does not represent an accurate picture, or that another method of computation would provide a more accurate picture.

The taxpayer has argued that requiring amortization in year subsequent to realization would be inconsistent with the Act and other rules of law.

Canderel specifically contemplates that expenses realized in a particular year can be amortized over future years (indeed, that is the fact pattern in Canderel).  The Court in Ikea Ltd. v. The Queen, [1998] 2 C.T.C. 61 (S.C.C.), another case in the trilogy of tenant inducement cases, specifically found that the realization principle required the immediate inclusion of income, but no such conclusion was reached in Canderel.  Accordingly, we do not find an argument based on the realization principle to be very persuasive. 

In this case, for accounting purposes, the taxpayer amortized the loss incurred pursuant to the Interest Bond Locks over the term of the Debentures, but immediately expensed the loss incurred pursuant to the Dividend Bond Locks.  As noted by the court in Canderel, accounting treatment may be persuasive, but it is not determinative.

In concluding that the expenses in that case were immediately deductible, the Court stated the following at paragraphs 61, 62 and 65:

But the findings of fact made by the trial judge are more instructive. Brulé J. found that the payments yielded four primary benefits for Canderel: the prevention of a “hole in income” which otherwise would have been caused by maintaining a vacant building, the ability to satisfy the underlying requirements of its interim financing and to obtain permanent financing, the ability to meet its competition and to maintain its market position and reputation, and the generating of revenues through rentals and through management and development fees (which were to some extent contingent upon the rate of lease-up). From this, he concluded that the payments constituted “running expenses”, as they could not be causally linked to any single or  specific stream of revenue, and that the matching principle therefore did not apply in the circumstances, as contended for by the Minister.

It is immediately apparent that, while some of the benefits identified by Brulé J. are of a type that would be realized over a period of years, others, such as the satisfaction of interim financing requirements and the maintenance of market position and reputation, are benefits that were immediately realized by Canderel in the year the payments were made. From this observation emerges one serious practical difficulty inherent in the Federal Court of Appeal's view of the law: even if it can properly be argued that the payments are “directly referable” to some future revenues, what is to be made of a situation where they are also referable to other, immediate benefits? It would be unduly arbitrary to allocate the expenses only to the specific revenues while ignoring the other, less tangible benefits. But there also exists no specific legal formula for the apportionment of the expenses among the various benefits. Perhaps some appropriate amortization formula could be devisfinanceed to cover such an apportionment, but any such device would need to be a creature of statute; anything less would constitute judicial legislation of a very intrusive variety. It is similarly no answer to suggest that because the payments were amortized by Canderel for financial accounting purposes, they can be similarly amortized for taxation purposes. As I have already explained, the two portrayals of profit are substantially different in nature and purpose…

Indeed, in my view, the fact that in the instant case, Brulé J. found that the TIPs were properly attributable to a number of different expenses makes inevitable the conclusion that they constituted running expenses. As I have already noted, I do not see how, under these circumstances, it is possible with any accuracy to amortize the payments over the term of the lease, in the absence of an established formula acceptable for tax purposes, which was not advanced by the Minister. It follows, then, that the TIPs were not referable to any particular items of income, i.e., they cannot be correlated directly, or at least not principally, with the rents generated by the leases which they induced. They therefore qualify as running expenses to which the matching principle does not apply: see Oxford Shopping Centres, supra. The findings of fact made by Brulé J. in this regard are entitled to considerable deference. There is no indication that these findings were unsupported by the evidence, and I can see no reason to reject them.

In this case, we understand that, as a factual matter, the benefits of the Bond Locks are primarily related to the interest stream on the Debentures and the dividend stream on the XXXXXXXXXX Preferred Shares.  The taxpayer does not seem to have made any representations that the Bond Locks provided any immediate benefits.  Accordingly, it appears that there is a good case to be made that amortization is appropriate in this context.

The taxpayer has asked that the CRA confirm that if losses on the Bond Locks are amortized, then gains should be amortized as well.  However, we note that the Canderel trilogy, including Ikea, contemplates the potential amortization of deductions but not the potential amortization of income or gains.  Indeed, as noted above, the Court in Ikea specifically states that there is no possibility of an amortization of income.

We trust that these comments will be of assistance.

For your information, 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.  A severed copy will also be distributed to the commercial tax publishers, following a 90-day waiting period (unless advised otherwise to extend this waiting period), 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 the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity.  Requests for this latter version should be e-mailed to: LPRA-PLAR ITR-DDI Access Team-Équipe d'Accès.   In such cases, a copy will be sent to you for delivery to the taxpayer.

G. Moore
for Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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