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: Whether replacing an old loan with a new loan from a different arm's-length creditor, to obtain more favourable rates, constitutes a substitution of a debt obligation for the purposes of paragraph 18(9.1)(a)
Position: Question of fact, but in the circumstances described, likely no.
Reasons: The CRA has previously taken the position that where an old debt is repaid and a new debt is obtained from a different arm’s length creditor, the transactions would generally not be considered as a substitution of debt.
Author: Ferrari, Rob
Section: 18(9.1), 20(1)(e)
May 31, 2018
Re: Substitution of Debt Obligation
This is in reply to your email of April 24, 2018 with regard to the replacement of old debt with new debt.
You describe a situation in which a taxpayer has a loan with an arm’s-length financial institution. In order to obtain a lower interest rate on its debt, the taxpayer wishes to obtain a new loan from another arm’s-length financial institution, the proceeds from which will be used to settle the first loan. The taxpayer will incur a penalty as a result of the early retirement of the first loan. You ask whether these transactions would be considered to be made in respect of the substitution or conversion of a debt obligation to another debt obligation for the purposes of paragraph 18(9.1) of the Income Tax Act (the “Act”.)
This technical interpretation provides general comments about the provisions of the Income Tax Act and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.
Information on the application and conditions stipulated in subsection 18(9.1) of the Act may be found in the Income Tax Folio 2, S4-F2-C1: Deductibility of fines and penalties. In general terms, subsection 18(9.1) may apply to a penalty payment or bonus, paid in the course of carrying on a business or earning income from property, in consideration of the early repayment of all or part of a borrowing or an unpaid purchase price for property. Subject to meeting certain conditions, subsection 18(9.1) may deem the penalty or bonus that can reasonably be considered to relate to the amount of interest that would have been paid or payable on the debt obligation for a taxation year of the taxpayer ending after that time, to be interest that may be deductible in future tax years.
However, paragraph 18(9.1)(a) provides that a penalty or bonus will not be deemed to have been paid as interest where the payment 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. The preamble to subsection 18(9.1) and paragraph 18(9.1)(a) reads as follows:
“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,…”
In the circumstances you described, the taxpayer will settle the first loan with an arm’s-length financial institution and obtain a new loan from another arm’s-length financial institution. It is a question of fact whether a payment can reasonably be considered to fall within the ambit of paragraph 18(9.1)(a). However, the Canada Revenue Agency has opined that a 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-length party would not constitute a substitution of a debt obligation for the purposes of paragraph 18(9.1)(a). Accordingly, the amount as described in your email and to the extent as provided for under subsection 18(9.1), would generally not be considered as paid for the substitution or conversion of the debt obligation as contemplated under paragraph 18(9.1)(a).
Partnerships and Corporate Financing Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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