Principal Issues: [TaxInterpretations translation] 1) Is the premium payable on the redemption of a particular exchangeable debenture deductible under subparagraph 20(1)(f)(i)? (2) Is the loss arising from the payment at maturity of a forward transaction in monetization transactions deductible under subparagraph 20(1)(f)(i)? (3) Does the adoption of a misinterpretation of a provision of the Act constitute a misrepresentation attributable to neglect, carelessness or wilful default for the purposes of subparagraph 152(4)(a)(i)?
Position: 1) No. 2) No. 3) Question of fact.
Reasons: (1) The conditions of subparagraph 20(1)(f)(i) are not satisfied. (2) Paragraph 20(1)(f) applies only to an amount paid in satisfaction of the principal amount of any bond, debenture, bill, note, mortgage, hypothecary claim or similar obligation.... on which interest has been declared payable. (3) Case law has established that the adoption of an erroneous interpretation of a provision of the Act may give rise to the application of subparagraph 152(4)(a)(i) unless the taxpayer has adopted that interpretation after a thoughtful and careful consideration of the situation, to which the taxpayer has devoted the care of a wise and prudent person. In addition, the return must be made in a manner that the taxpayer believes is genuinely appropriate.
January 14, 2010
Montreal Tax Services Office Headquarters Audit Division Income Tax Rulings Directorate Mélanie Beaulieu (613) 957-9226 Attention: Francia Jean 2009-032399
Exchangeable debenture and forward transaction - application of paragraph 20(1)(f)
Unless otherwise indicated, all legislative references herein are to the provisions of the Income Tax Act (the "Act").
This is further to your letter of May 20, 2009, in which you requested our opinion on the application of the Act to a particular situation involving an exchangeable debenture and a forward transaction. In particular, you asked us whether subparagraph 20(1)(f)(i) applies to the situations described under the heading "The Facts". Since the normal reassessment period (as defined in subsection 152(3.1)) for the taxpayer for the taxation year in which the transactions in question were made has expired, you also asked us whether subsection 152(4) can be applied to reassess notwithstanding the expiration of the normal reassessment period.
Our understanding of the facts is as follows:
The Facts:
The exchangeable debenture
1. The XXXXXXXXXX ("Corporation 1") issued an exchangeable debenture to XXXXXXXXXX (the "Holder") in the amount of $XXXXXXXXXX. The debenture, which matured on XXXXXXXXXX, was exchangeable at the option of the holder or of Corporation 1 for XXXXXXXXXX common shares of XXXXXXXXXX ("Corporation 2"), a public corporation, held by Corporation 1. We understand that the proceeds from the issuance of this debenture constitute financial capital used by Corporation 1 to earn income from its business or property. In other words, we understand that the costs related to this debenture generally satisfy paragraph 18(1)(a) but are "payments on account of capital" within the meaning of paragraph 18(1)(b) and are therefore not deductible from income unless expressly so permitted by a specific provision.
2. The obligation of Corporation 1 to dispose of the shares of Corporation 2 when the holder exercised its exchange right could be satisfied in whole or in part by a cash payment.
3. On XXXXXXXXXX, Corporation 1 and the holder also entered into a security agreement (the "Exchangeable Debenture Security Agreement") with XXXXXXXXXX (the "Trust Corporation"), pursuant to which Corporation 1 agreed to pledge to the Trust Corporation, on behalf of the holder, the XXXXXXXXXX common shares of Corporation 2 described in paragraph 1 hereof, to secure the performance of its obligations to the holder under the terms of the Debenture.
4. During the XXXXXXXXXX year, the shares of Corporation 1 were held as to XXXXXXXXXX% by XXXXXXXXXX ("Corporation 3"). On XXXXXXXXXX, Corporation 1 was wound up into Corporation 3, such that Corporation 3 became the holder of the XXXXXXXXXX shares of Corporation 2 and the rights and obligations of Corporation 1 under the Exchangeable Debenture and the Exchangeable Debenture Security Agreement were assumed by Corporation 3. The adjusted cost base ("ACB") of the shares of Corporation 2 to Corporation 3, following winding-up, was $XXXXXXXXXX.
5. According to the representative of Corporation 3, Corporation 3 disposed of the XXXXXXXXXX shares of Corporation 2 described in paragraph 1 hereof for an amount of $XXXXXXXXXX and used all of its proceeds of disposition to repay the Exchangeable Debenture. (Endnote 1)
6. As a result of the disposition of the XXXXXXXXXX Shares of Corporation 2, Corporation 3 realized a capital gain of $XXXXXXXXXX ($XXXXXXXXXX - $XXXXXXXXXX), and therefore a taxable capital gain of $XXXXXXXXXX (one-half of $XXXXXXXXXX).
7. In addition, Corporation 3 claimed, in its income tax return for the year ended XXXXXXXXXX, a deduction of $XXXXXXXXXX ($XXXXXXXXXX - $XXXXXXXXXX), representing the difference between the amount paid in satisfaction of the principal amount of the Debenture and the amount for which the Debenture was issued (for purposes of this discussion and for the sake of brevity, we will refer to such difference as the "Premium Paid"). We understand that the Premium Paid is included in the interest expense of $XXXXXXXXXX which appears under the heading "XXXXXXXXXX" in the income statement of Corporation 3 for its fiscal year ended XXXXXXXXXX. (It is relevant to note in this respect that the amount of $XXXXXXXXXX appearing under this item is significant, and that it is in no way comparable to the amount of $XXXXXXXXXX appearing in the comparative figures for the fiscal year ended on XXXXXXXXXX). Rather, in the course of the audit, the representative of Corporation 3 argued that it was as a financing cost pursuant to subparagraph 20(1)(f)(i) that the Premium Paid was deducted.
The forward transaction
8. The XXXXXXXXXX ("Corporation 4") entered into a forward transaction with XXXXXXXXXX (the "Purchaser") with respect to XXXXXXXXXX shares of Corporation 2 that it held.
9. We understand that by virtue of the forward transaction, Corporation 4 essentially undertook to sell to the Purchaser, at the expiry of the contract, its XXXXXXXXXX shares of Corporation 2 at a fixed price determined in advance, namely the forward price. As explained, however, in paragraphs 12 to 15 hereof, settlement at maturity was to be made by cash settlement rather than by the transfer of the shares of Corporation 2.
10. The spot price of the Corporation 2 shares at the time the forward transaction was entered into was $XXXXXXXXXX; the forward price, determined in accordance with the terms of the contract, was set at $XXXXXXXXXX.
11. The maturity date for the forward transaction was on XXXXXXXXXX, or an earlier date if Corporation 4 so elected. Certain events could also automatically terminate the forward transaction.
12. The amount to be paid on completion of this transaction was determined according to a formula established by the parties, and depended on the fair market value ("FMV") of the shares of Corporation 2 at the time of maturity (endnote 2).
13. More specifically, Corporation 4 was required to pay an amount to the Purchaser if, at the time of maturity, the FMV of the shares of Corporation 2 (the "Reference Price") exceeded the forward price, set at $XXXXXXXXXX. The amount payable by Corporation 4, if any, was determinable based on the following formula:
Number of shares x (Reference Price - $XXXXXXXXXX)
14. Furthermore, the Purchaser was required to pay an amount to Corporation 4 if, at the time of maturity, the FMV of the shares of Corporation 2 (the "Reference Price") was less than the forward price, set at $XXXXXXXXXX. The amount, in any, payable by the Purchaser was determinable based on the following formula:
Number of Shares x ($XXXXXXXXXX - Reference Price)
15. For the purposes hereof, and for ease of reference, we will refer to the amount payable at the maturity time as the "Maturity Payment", whether it is an amount payable by the Purchaser or by Corporation 4, without distinction.
16. Corporation 4 and the Purchaser also entered into a Securities Pledge Agreement pursuant to which the XXXXXXXXXX shares of Corporation 2 described in paragraph 8 hereof were pledged to the Purchaser to secure Corporation 4's obligations under the Forward Transaction.
17. In XXXXXXXXXX, Corporation 4 and XXXXXXXXXX (the "Bank") entered into a loan agreement in the amount of $XXXXXXXXXX (being an amount not exceeding XXXXXXXXXX% of the initial price of the forward transaction, equal to $XXXXXXXXXX, or XXXXXXXXXX x $XXXXXXXXXX, as required by the Bank). The term of the Loan was XXXXXXXXXX years, provided that it could not exceed the term of the forward transaction, being XXXXXXXXXX, or an earlier date, if applicable. We understand that this loan constitutes financial capital used by the Corporation to earn income from its business or property. In other words, we understand that the costs related to this loan generally satisfy paragraph 18(1)(a) but are "payments on account of capital" within the meaning of paragraph 18(1)(b) and are therefore not deductible from income unless specifically permitted to be deducted under a specific provision.
18. Corporation 4 and the Bank also entered into a Securities Pledge Agreement (the "Loan Guarantee Agreement"), pursuant to which the XXXXXXXXXX shares of Corporation 2 described in paragraph 8 hereof were pledged to the Bank to secure Corporation 4's obligations under the Loan.
19. Corporation 4 agreed that the Purchaser and the Bank could determine their respective rights and priorities as between them on the basis that the same shares of Corporation 2 were pledged to both. In particular, Corporation 4 agreed, in both the Securities Pledge Agreement and the Loan Guarantee Agreement, that the Bank would hold the pledged shares for its own benefit as well as for the benefit of the Purchaser.
20. During the XXXXXXXXXX year, the shares of Corporation 4 were held as to XXXXXXXXXX% by Corporation 3. On XXXXXXXXXX, Corporation 4 was wound-up into Corporation 3, such that Corporation 3 became the holder of the shares of Corporation 2 and the rights and obligations of Corporation 4 under the Forward Agreement, the Securities Pledge Agreement, the Loan and the Loan Guarantee Agreement were assumed by Corporation 3. The ACB of the shares of Corporation 2 to Corporation 3, following the winding-up, was $XXXXXXXXXX.
21. During the XXXXXXXXXX year, when the FMV of the shares of Corporation 2 was $XXXXXXXXXX per share, Corporation 3 disposed of the XXXXXXXXXX shares of Corporation 2 described in paragraph 8 hereof for proceeds of disposition of $XXXXXXXXXX. We understand that it used a portion of the proceeds of disposition, namely $XXXXXXXXXX, to repay the $XXXXXXXXXX Loan and to meet its obligations under the forward transaction (in other words, to make the Maturity Payment that it was obligated to make under the forward transaction). (endnote 3)
22. Corporation 3 realized a capital gain of $XXXXXXXXXX ($XXXXXXXXXX - $XXXXXXXXXX), and a taxable capital gain of $XXXXXXXXXX (one-half of $XXXXXXXXXX) in connection with the disposition of its shares of Corporation 2.
23. In addition, Corporation 3 claimed, in its income tax return for the year ended XXXXXXXXXX, a deduction in respect of the Maturity Payment. We understand that the Maturity Payment was included in the interest expense of $XXXXXXXXXX that appears under the heading "XXXXXXXXXX" in Corporation 3's income statement for its fiscal year ended XXXXXXXXXX. During the course of the audit, Corporation 3's representative instead argued that it was as a financing cost pursuant to subparagraph 20(1)(f)(i) that an amount representing the Maturity Payment was deducted. Based on the description of the facts submitted by the representative of Corporation 3, it appears that Corporation 3 considers that it used an amount of $XXXXXXXXXX to repay the loan granted by the Bank. Rather, as discussed below, we are of the view that $XXXXXXXXXX was used to repay the loan, while $XXXXXXXXXX allowed Corporation 3 to make the Maturity Payment (endnote 4).
Normal reassessment period expired
24. It is understood that the normal reassessment period applicable to Corporation 3 for its taxation year ended on XXXXXXXX has expired.
Questions
25. The questions you have submitted to us are as follows:
(a) Could Corporation 3 deduct the Premium Paid of $XXXXXXXXXX under subparagraph 20(1)(f)(i)?
(b) Was Corporation 3 entitled to deduct the Maturity Payment of $XXXXXXXXXX under subparagraph 20(1)(f)(i)?
(c) Can subparagraph 152(4)(a)(i) be used to reassess despite the expiry of the normal reassessment period?
Our Comments:
Exchangeable debenture - application of subparagraph 20(1)(f)(i)
26. Paragraph 20(1)(f) permits a deduction where an amount is paid in the year in satisfaction of the principal amount of an obligation on which interest has been stipulated to be payable, provided certain conditions are satisfied. Paragraph 20(1)(f) refers to an amount that otherwise complies with paragraph 18(1)(a), but whose deductibility is not permitted because of paragraph 18(1)(b).
27. In essence, for an amount to be deductible under paragraph 20(1)(f) in respect of a debt, the lesser of the principal amount and the total of all amounts paid in satisfaction of the principal amount of the debt must exceed the amount for which the debt was issued.
28. On the other hand, if the principal amount of the debt or the total of all amounts paid in satisfaction of the principal is equal to the amount for which the debt was issued, there is no excess and paragraph 20(1)(f) cannot apply.
29. Subsection 248(1) defines "principal amount", in relation to any obligation, as the amount that, under the terms of the obligation or any agreement relating thereto, is the maximum amount or maximum total amount, as the case may be, payable on account of the obligation by the issuer thereof, otherwise than as or on account of interest or as or on account of any premium payable by the issuer conditional on the exercise by the issuer of a right to redeem the obligation before the maturity thereof.
30. According to the Agency's long-standing position, prior to Imperial Oil Ltd. and Inco Ltd. v. The Queen, 2006 DTC 6660 (S.C.C.) ([2006] 2 S.C.R. 447, 2006 SCC 46) ("Imperial Oil") and Tembec Inc. et al. v. The Queen [a.k.a. Provigo Inc. v. Canada], 2008 DTC 6601 (F.C.A.), 2008 FCA 205 ("Tembec"), the principal amount of an exchangeable debenture for the purposes of paragraph 20(1)(f) could be equal to the FMV of the shares of the particular corporation at the time the holder exercised the exchange right, since this would be the maximum amount payable by the issuer in respect of the debenture. In such a case, the principal amount of the debenture could therefore exceed the face amount of the debenture, if the FMV of the shares of the particular corporation at the time the holder exercised its exchange right exceeded that face amount. This position applied both in cases where the issuer physically delivered the shares of the particular corporation to the holder in repayment of the debenture and in cases where, as in the present situation, the issuer of the debenture could instead make to the holder a cash payment equivalent to the FMV of the shares of the particular corporation at the time the exchange right was exercised. In either case, the maximum amount payable by the issuer under the debenture was equal to the FMV of the shares of the particular corporation, regardless of whether the payment was made with shares or in cash.
31. In light of the Federal Court of Appeal's decision in the Tembec case (endnote 5) as well as certain passages from the Supreme Court of Canada's decision in the Imperial Oil case, the above position has recently been modified. In particular, at the 2009 annual conference of the Canadian Tax Foundation ("CTF"), we announced that the Agency's long-standing position was no longer consistent with the state of the law in light of the Tembec case, which held that “the deduction of financing costs provided for by paragraph 20(1)(f) is limited to the monetary discount granted when an obligation is issued.” We then announced that the Agency could no longer allow a deduction by virtue of paragraph 20(1)(f) that would reflect the appreciation of principal over and above the face value of the debenture. As this announcement represents a change in the Agency's position, we clarified that this new position would be administered on a prospective basis, for debentures issued on or after January 1, 2010. This is consistent with the Agency's normal practice when revising an interpretation or position in a Bulletin, where the new interpretation or position is not to the benefit of taxpayers, it will generally apply only to the taxation year of the change and subsequent taxation years, or it will apply to transactions entered into after the date of the announcement of the change.
32. In light of the foregoing, for the purposes hereof, we will determine the entitlement of Corporation 3 to a deduction under paragraph 20(1)(f) by virtue of the Agency's long-standing position regarding the application of paragraph 20(1)(f) to the Exchangeable Debentures as it applied prior to the Imperial Oil and Tembec cases.
33. That being the case, paragraph 20(1)(f) contains two subparagraphs that apply on a mutually exclusive basis.
34. Subparagraph 20(1)(f)(i) applies when the debenture has been issued for an amount not less than 97% of its principal amount, and the debenture meets a certain yield test. Where this provision applies, the deduction is essentially equal to “the amount by which the lesser of the principal amount of the obligation and all amounts paid… in satisfaction of its principal amount exceeds the amount for which the obligation was issued”.
35. Subparagraph 20(1)(f)(ii) applies in other cases, where subparagraph 20(1)(f)(i) does not apply, for example, where the debenture was issued for less than 97% of its principal amount. Where subparagraph 20(1)(f)(ii) applies (note 6), the deduction is essentially equal to “1/2 of the lesser of the amount so paid and the amount by which the lesser of the principal amount of the obligation and all amounts paid… in satisfaction of its principal amount exceeds the amount for which the obligation was issued.”
36. The position taken above is that the principal amount of an exchangeable debenture may be equal to the FMV of the shares of the particular corporation (in this case, Corporation 2) at the time of the holder's exercise of the exchange right, thereby permitting a deduction by virtue of paragraph 20(1)(f) where that principal amount exceeds the price for which the debenture was issued. Thus, under this position, it is only when the debenture is redeemed (whether or not following the exercise of the exchange right) that the principal amount can be determined. Under this position, subparagraph 20(1)(f)(ii) applies if the issue price of the debenture is less than 97% of the principal amount, determined by reference to the FMV of the shares of the particular corporation (in this case, Corporation 2) at the time of repayment.
37. In this situation, pursuant to the position previously stated, the principal amount of the debenture, determined at the time of repayment, was $XXXXXXXXXX. However, the issue price of the Debenture of $XXXXXXXXXX represents approximately XXXXXXXXXX% of that principal amount, which is a much lower issue price than the 97% of that principal amount. It follows that subparagraph 20(1)(f)(ii) and not subparagraph 20(1)(f)(i) was applicable under the previously stated position, so that the deduction to which Corporation 3 was entitled under that position was equal to $XXXXXXXXXX, an amount equal to 1/2 of the Premium Paid or, in other words, 1/2 of the amount by which $XXXXXXXXXX (being the principal amount and the aggregate of the amounts paid in satisfaction of the principal amount of the Debenture) exceeds $XXXXXXXXXX (being the price for which the Debenture was issued).
38. We are therefore of the view, subject to the following comments regarding the application of subparagraph 152(4)(a)(i), that Corporation 3 should be reassessed to reduce the deduction claimed in respect of the Premium Paid under subparagraph 20(1)(f)(i) to an amount of $XXXXXXXXXX as being deductible under subparagraph 20(1)(f)(ii).
Forward transaction - application of subparagraph 20(1)(f)(i)
39. As noted above, paragraph 20(1)(f) permits a deduction where an amount is paid in the year in satisfaction of the principal amount of any bond, debenture, bill, note, mortgage, hypothecary claim or similar obligation on which interest was stipulated to be payable, provided certain conditions are satisfied. The "threshold test" for the application of paragraph 20(1)(f), in the words of Sharlow J. of the Federal Court of Appeal in the Imperial Oil case (FCA 361, 2004 DTC 6702 (F.C.A.)) (para. 10) will therefore only be satisfied if an amount is “paid in the year in satisfaction of the principal amount of any bond … or similar obligation … on which interest was stipulated to be payable".
40. However, the Maturity Payment described in paragraph 15 hereof is clearly not a payment in satisfaction of the “principal amount of any bond … or similar obligation … on which interest was stipulated to be payable.”
41. A forward transaction cannot be considered to be any bond, debenture, bill, note, mortgage, hypothecary claim or similar obligation. In this regard, it may be relevant to refer, by analogy, to Federated Co-operatives Ltd. v. The Queen, 2001 FCA 217, 2001 DTC 5414 (F.C.A.) ("Federated Co-operatives"). In that case, Madam Justice Sharlow of the Federal Court of Appeal held that a banker's acceptance was not included in the expression “any bond, debenture, bill, note, mortgage, hypothecary claim or similar obligation” for the purposes of paragraph 181.2(4)(c), applicable in computing the investment allowance for the purposes of the federal large corporations tax. In coming to her conclusion, Sharlow J. concluded that a banker's acceptance does not have the essential characteristics of “an obligation of the issuer that is similar to a bond, debenture, note or mortgage” since it is not "a document evidencing indebtedness of the maker in the form of a promise to pay". Similarly, we are of the view that a forward transaction is not a writing that evidences the indebtedness of the maker in the form of a promise to pay, and therefore is not any bond, debenture, bill, note, mortgage, hypothecary claim or similar obligation, for purposes of paragraph 20(1)(f).
42. In light of the foregoing, it seems clear that paragraph 20(1)(f) cannot be applied in the context of a forward transaction.
43. Based on the description of the facts submitted by the representative of Corporation 3, we understand that Corporation 3 considers that it used $XXXXXXXXXX to repay the loan made by the Bank in XXXXXXXXXX. This interpretation would imply that the Loan and the Forward Transaction were considered as one and the same transaction and, therefore, that the amount of $XXXXXXXXXX was paid by Corporation 3 in satisfaction of the principal amount of the Loan, which would satisfy the test of an “amount paid…in satisfaction of the principal amount of any bond … or similar obligation … on which interest was stipulated to be payable" for the purposes of paragraph 20(1)(f).
44. We are of the view that the characterization of the legal relationship that existed between the parties is rather that Corporation 3 (through its predecessor, Corporation 4) was involved in two separate legal transactions, namely, the Forward Transaction and the Loan, and that only an amount of $XXXXXXXXXX was used to repay the Loan, while an amount of $XXXXXXXXXX allowed Corporation 3 to make the Maturity Payment.
45. In Shell Canada Ltd. v. The Queen, [1999] 3 S.C.R. 622, the Supreme Court stated that the economic realities of a situation could not justify a new characterization of the true legal relationships established by the taxpayer (paras. 39-40). The following passage is particularly relevant in the context of a term loan transaction (para. 41):
[41] [...] Linden J.A. held that, when the Forward Exchange Contract between Shell and Sumitomo was considered alongside the Debenture Agreements between Shell and the foreign lenders, “[t]he higher interest rate coupled with the discounted forward rate created a blended payment of interest and principal” (para. 58). With respect, this ignores the actual relationship between Shell and the foreign lenders, a relationship to which Sumitomo was not a party.
46. Similarly, in the situation at hand, Corporation 3 (through its predecessor, Corporation 4) has been involved in two separate transactions, with two separate counterparties, namely: the Purchaser, in the case of the Forward Transaction, and the Bank, in the case of the Loan. The actual legal relationship created under the Loan was between Corporation 4 (following its winding-up, Corporation 3) and the Bank, a relationship to which the Purchaser was not a party.
47. In the Shell case, the main issue was the deductibility of interest payable by Shell under a loan denominated in New Zealand currency, the proceeds of which had been converted into United States currency. Shell had also entered into a hedging transaction in order to hedge against the fluctuation of the New Zealand currency in the market and to bring the interest rate it had to pay in respect of New Zealand dollars down to approximately the interest rate it would have paid for United States dollars. The dispute therefore raised an incidental question as to whether the foreign exchange gain realized by Shell as a result of entering into the forward exchange contract should be included in its income for tax purposes or whether it should be taxed on capital account. The Supreme Court concluded that the gain should be taxed on capital account:
[70] Whether a foreign exchange gain arising from a hedging contract should be characterized as being on income or capital account depends on the characterization of the debt obligation to which the hedge relates. As noted, Shell entered into the Forward Exchange Contract in order to hedge with US$ the market risk on the Debenture Agreements, which were denominated in NZ$. Indeed, Shell would not have entered into the Debenture Agreements in the absence of the Forward Exchange Contract. The gain on the Debenture Agreements was characterized as being earned on capital account and so therefore should the gain on the Forward Exchange Contract. Both gains were earned on capital account and three-quarters of them are taxable when realized.
48. The same reasoning applies, in our view, to this case.
49. It is also relevant to note that the tax consequences applicable in the context of similar transactions, i.e. a financial exchange transaction involving a loan as part of a monetization transaction, were described in detail by the Agency in document F 2003-0023761I7. The following passages are relevant:
[TaxInterpretations translation] We are of the view that the financial exchange transaction entered into by the Taxpayer constitutes a true swap (endnote 7). We believe, however, that this transaction must be analyzed in its context. Thus, before addressing the analysis as such of the tax treatment of the swap entered into between the Taxpayer and the Financial Institution, we believe it is appropriate to specify that the swap is part of a set of transactions commonly referred to as monetization.
Monetization is a financial operation that makes the value of an asset (e.g. shares in a public company) liquid while protecting from the fluctuating value of that asset. It allows a shareholder to diversify its investment portfolio. Monetization is therefore an alternative to the outright sale of the security without triggering its tax disposition. It involves two separate transactions. The first transaction consists of hedging the risk of fluctuations in the value of the security in question by using a derivative product, in this case a swap. The second transaction consists of using the shares as well as the derivative product for financial leverage by taking out a loan. In order to obtain the loan, the shareholder will grant a hypothec with dispossession on the monetized shares as well as on all its rights and obligations under the hedging contract.
Briefly, a swap agreement is a private contract between two parties (usually an investor and a financial intermediary) who agree to exchange financial flows with each other. Considered a derivative, a swap is therefore a financial product whose value is determined by the value of an underlying asset, liability, index or rate.
Two fundamental principles emerge from Canadian case law on the taxation of derivatives: first, to determine the nature of the income or loss resulting from the use of a derivative, one must consider whether the derivative as such constitutes a hedging transaction that is sufficiently closely related to the hedged transaction, in which case, one must refer to the hedged transaction to determine the nature of the income. If not, consideration must be given to the circumstances surrounding the derivative transaction in question, namely, whether the transaction in question is part of the commercial activities of the taxpayer's business or is a speculative transaction, whether it constitutes an adventure or concern in the nature of trade, or whether it is an investment or is of an enduring nature to a business.
In our view, the income or capital character of a derivative may be determined by the character of a reference asset, liability or transaction (principal transaction) which may be different from the reference asset, liability or transaction used to determine the value of the derivative if the derivative is used for hedging purposes and if the relationship between the derivative and the principal transaction is sufficiently close.
The principle of nexus with respect to a hedging transaction now appears to be entrenched in Canadian jurisprudence as a result of the Shell decision. In that case involving loans and a forward contract, it appears that at the time of the final payment on the forward contract, the New Zealand dollar had lost less than expected against the U.S. dollar, resulting in a gain of US$21 million for Shell. [...]
It follows from the Shell case that there must be a close link between the hedging transaction and the underlying obligation in order to establish the nature of the gain or loss arising from the hedging transaction.
We are of the view that the link between the swap and the loan is close enough to enter into a hedging transaction for the following reasons:
- The terms and conditions such as the duration, amount and maturity of the swap are in line with those of the loan granted;
- Although the main contract indicates that the swap transaction involves certain risks, the analysis of the contracts indicates that the swap is a hedging transaction; in fact, the taxpayer risks nothing but the future capital gain on these shares. Indeed, contrary to an interest rate swap where the taxpayer risks losing its stake, in the present case, the taxpayer has ensured, thanks to the swap transaction, obtaining at the conclusion of the transaction a value at least equal to the floor value of the shares at the time the transaction was entered into. Not obtaining the potential future capital gain accumulated over five years on the shares in question was immaterial since the purpose of the transaction as a whole was to obtain as of now the value of the shares subject to the swap without having to dispose of such assets for the specific purpose of immediately enjoying such value without having to pay at that time the tax on the capital gain accumulated on such assets.
- The creation of the swap is a precondition for the realization of the loan;
- The swap matures at the same time as the loan agreement;
- It does not appear from the facts of the case that the Taxpayer is engaged in other derivative trading activities; the swap is not related to a business carried on by the Taxpayer.
- The termination of one of the two transactions necessarily entails the termination of the other;
- There is a legal relationship between each of the contracts analyzed for the purposes hereof.
- The value of the shares of Corporation2 was used as the basis for the swap transaction but this transaction was carried out in order to cover the amount of credit granted by the financial institution to the Taxpayer. Furthermore, the contracts show that the value of the credit granted corresponds to the floor value of the swap multiplied by the number of shares given as collateral for the loan. Furthermore, the Taxpayer was assured of receiving from the financial institution the floor value determined in the swap agreement. Since the term of the swap corresponded to the term of the loan, the Taxpayer was able to repay the borrowed money (which amount could not exceed the floor value established in the swap) with the amounts paid by the financial institution at the end of the swap. The transaction was therefore not a speculative transaction nor can it be considered as an adventure of a commercial nature.
- Consequently, we are of the view that the gain or loss arising from the payment at maturity of the swap is of the same nature as the loan. If the borrowing is of a capital nature, as we have assumed, the gain or loss arising from the payment of the amount by the Taxpayer upon termination of the swap that is the subject of this letter will be treated in the same manner. Thus, since the Taxpayer had to pay an amount to the financial institution as a consequence of the termination of the swap, the loss incurred by the Taxpayer resulting from the payment of the swap is capital in nature. [Emphasis added]
50. In the situation at hand, we are of the view that, as in the excerpt above, there is a sufficiently close link between the forward transaction and the loan to conclude that the Forward Transaction is a hedge of the loan. The evidence of this connection is as follows:
- Terms and conditions such as the term, amount and maturity of the forward transaction are consistent with those of the loan;
- The contract analysis indicates that the forward transaction is a hedge. As in the excerpt above, under the Forward Transaction, Corporation 4 (and, following its winding-up, Corporation 3) risks nothing except the potential future appreciation in value of such shares to the extent that it exceeds the Forward Price of $XXXXXXXXXX per share. Company 4 has ensured through the Forward Transaction that it will obtain a value at the end of the transaction is at least equal to the Forward Price of $XXXXXXXXXX per share. As in the above excerpt, not obtaining the potential future capital gain accumulated over XXXXXXXXXX years on the shares in question was immaterial since the purpose of the monetization transaction in its entirety was to obtain the value of the shares of Corporation 2 subject to the Forward Transaction now without having to dispose of such shares for the specific purpose of immediately enjoying such value without having to pay tax at that time on the capital gain accumulated on such shares;
- The creation of the swap constituted a precondition for the loan granted by the Bank;
- The Forward Transaction matures at the same time as the loan agreement;
- It is not apparent from the facts of the case that Corporation 4 (or, following its winding-up, Corporation 3) engaged in other derivatives trading activities; the Forward Transaction was not related to a business carried on by Corporation 4 (or, following its winding-up, by Corporation 3);
- There is a legal relationship between each of the contracts analyzed (the Forward Transaction, the Loan agreement, the Securities Pledge Agreement and the Loan Guarantee Agreement) for the purposes of this analysis.
51. Consequently, we are of the view that the Forward Transaction is a hedge. It follows from the Shell decision that the characterization of the Maturity Payment under the Forward Transaction as a current expense or a capital payment depends on the characterization of the debt to which the Forward Transaction relates (being a hedge). In other words, it is our view that the Maturity Payment is of the same nature as the borrowed money. If, as we understand it, the borrowed money in this case is an addition to the borrower's financial capital, the borrowing is capital in nature (Note 8) and the Maturity Payment is, therefore, capital in nature.
52. We are therefore of the view, subject to the following comments regarding the application of subparagraph 152(4)(a)(i), that Corporation 3 should be reassessed to deny the deduction claimed in respect of the Maturity Payment under subparagraph 20(1)(f)(i).
Assessment after the expiry of the normal assessment period - the applicable law
53. The Agency may, at any time after the normal reassessment period has expired, make an assessment or reassessment under subparagraph 152(4)(a)(i) if the taxpayer has made any misrepresentation that is attributable to neglect, carelessness or wilful default or has committed any fraud in filing the return or in supplying any information under the Act.
54. In order for the Agency to issue a reassessment of tax payable beyond the normal reassessment period, under subparagraph 152(4)(a)(i), it is not necessary for penalties to be imposed; the Agency must only prove that the taxpayer has made any misrepresentation that is attributable to neglect, carelessness or wilful default (or has committed any fraud), and not that the taxpayer was guilty of gross negligence. Thus, the burden of proof is less onerous in the case of an assessment under subparagraph 152(4)(a)(i) than in the case of a penalty under subsection 163(2).
55. In determining whether there has been a misrepresentation, the Agency must, at a minimum, prove that an error was made by the taxpayer and, although it may have been made in good faith, that it was an error that a prudent and conscientious person would have avoided.
56. Whether a person has made any misrepresentation that is attributable to neglect, carelessness or wilful default can only be resolved in light of an examination of all the relevant facts.
57. In particular, the question of whether a person, in adopting a particular interpretation of the Act, has made any misrepresentation that is attributable to neglect, carelessness or wilful default, has been considered by the jurisprudence. The following principles can be drawn from the relevant jurisprudence:
- One of the purposes of subparagraph 152(4)(a)(i) is to promote the careful and accurate preparation of income tax returns (Nesbitt v. The Queen, 96 DTC 6045 (F.C. T.D.), affirmed by the Federal Court of Appeal: 96 DTC 6588 (F.C.A.) ("Nesbitt"));
- It is at the time the return is filed that it can be determined whether or not there has been misrepresentation that is attributable to neglect or carelessness in completing the return (Nesbitt);
- Facts have been misrepresented if there is something inaccurate in the return, at least something that is material for the purposes of the return and any subsequent reassessment (Nesbitt);
- Such a misrepresentation may result from an interpretation of the Act adopted by the taxpayer; however, where the taxpayer, after a thoughtful and careful examination of the situation, evaluates the situation and files a return in the manner that the taxpayer believes in good faith is appropriate, there can be no misrepresentation within the meaning of subparagraph 152(4)(a)(i) (Regina Shoppers Mall Ltd. v. The Queen, 90 DTC 6427 (F.C.T.D.), affirmed by the Federal Court of Appeal; 91 DTC 5101 (F.C.A.) ("Regina Shoppers Mall"));
- In determining whether the taxpayer has made a thoughtful and careful consideration that would permit the application of subparagraph 152(4)(a)(i) to be disregarded, the necessary care must be consistent with that of a wise and prudent person and the return must be made in a manner that the taxpayer believes is genuinely appropriate (Regina Shoppers Mall);
- A misrepresentation is a misrepresentation even though the Agency could or does identify the error in the return through a careful analysis of the supporting documentation (Nesbitt);
- A taxpayer cannot generally avoid the application of subparagraph 152(4)(a)(i) simply by blaming its accountant if it has not itself reviewed and understood the various elements of its income tax return or if, in case of doubt, it has not questioned its accountant in order to understand the more ambiguous elements and be satisfied that the return was prepared in a manner that it truly believes to be appropriate (Nesbitt, Venne v. The Queen, 84 DTC 6247 (F.C.T.D.) ("Venne"), Can-Am Realty Ltd. v. The Queen, 94 DTC 6293 (F.C.T.D.) ("Can-Am"), Snowball v. The Queen, 97 DTC 512 (T.C.C.) ("Snowball").
58. The jurisprudence provides several examples of the application of these principles. In this regard, the decisions in Fukushima et al. v. The Queen, 99 DTC 553 (T.C.C.), Ridge Run Developments Inc. v. The Queen, 2007 DTC 734 (T.C.C.) and College Park Motors Ltd. et al. v. The Queen, 2009 TCC 409 (T.C.C.) are particularly instructive. It is also relevant to note, as indicated by Angers J. of the Tax Court of Canada in Dalphond v. The Queen, 2008 DTC 4757 (T.C.C.), affirmed by the Federal Court of Appeal (F.C.A.) (paras. 34, 36):
[34] [...] It is not sufficient, in preparing a tax return, simply to give the CRA the information and leave it to the CRA to do the calculations, or to claim deductions without worrying about whether one is actually entitled to them.
[...]
[36] It is the duty of all taxpayers to prepare their tax returns with care, providing accurate and complete information, and they must moreover attest to having done this by signing their returns. When taxpayers claim a deduction, they must do more than simply think they are entitled to it, particularly when the benefit obtained through the deduction is substantial. …
59. Furthermore, it is relevant to note that, under subsection 152(4.01), where the Agency issues a notice of reassessment based on a misrepresentation, it is required to adjust only that aspect of the corporation's return and cannot take advantage of the opportunity to disallow other expenses where the return would otherwise be statute-barred in respect of those expenses. In other words, subsection 152(4.01) requires that the Agency be able to determine, in respect of both the Exchangeable Debenture and the Forward Transaction, that there has been a misrepresentation that is attributable to neglect, carelessness or wilful default on the part of Corporation 3 in order to issue a reassessment in respect of either of those items. Therefore, we need to consider these issues in turn.
Contribution after expiry of normal contribution period - exchangeable debenture
60. As stated above, in its income tax return for the year ended XXXXXXXXXX, Corporation 3 claimed a deduction of $XXXXXXXXXX, i.e., the Premium Paid. We understand that the Premium Paid is included in the interest expense of $XXXXXXXXXX that appears under the heading "XXXXXXXXXX" in the income statement of Corporation 3 for its fiscal year ended XXXXXXXXXX. As stated above, the amount of $XXXXXXXXXX appearing under this item is significant, and is in no way comparable to the amount of $XXXXXXXXXX appearing in the comparative figures for the fiscal year ended XXXXXXXXXX, which should have attracted the attention of Corporation 3.
61. It is difficult to understand how the Premium Paid could have been considered by Corporation 3 as interest, as appearing in its income statement for its fiscal year ended on XXXXXXXXXX. This is because the Premium Paid does not meet the criteria set out in paragraph 1 of IT-533, Interest Deductibility and Related Issues, or in paragraph 2 of that Bulletin.
62. With respect to the nature of the Premium Paid, it is relevant to refer to Gifford v. The Queen, [2004] 1 S.C.R. 411, 2004 DTC 6128 (S.C.C.) ("Gifford"). In that case, one of the issues before the Supreme Court of Canada was whether interest payments could be a current expense. The Supreme Court concluded that, as a general rule, a borrowed sum is added to the borrower's financial capital and, for this reason, interest payable on a borrowed sum generally constitutes payments on account of that financial capital. In our view, the same principle applies in this situation, since the proceeds of the debenture were borrowed money that was to be repaid at the maturity of the debenture. If, as the Supreme Court indicates, interest payable on a borrowed amount that is in addition to the financial capital constitutes payments on account of that financial capital, a fortiori, an amount payable once and for all at the maturity of the debenture, under the terms of the debenture, constitutes a payment on account of the financial capital of the issuer of the debenture.
63. Corporation 3's representative submits that it was by virtue of subparagraph 20(1)(f)(i) that the Premium Paid was deducted by Corporation 3. It is our view that a person who had examined its tax return with the care of a wise and prudent person could not, in good faith, have claimed a deduction for the Premium Paid under subparagraph 20(1)(f)(i) and that, therefore, such deduction constitutes a misrepresentation that is attributable to neglect, carelessness or wilful default, such as to justify the application of subparagraph 152(4)(a)(i).
64. In considering that it was by virtue of subparagraph 20(1)(f)(i) that Corporation 3 deducted the Premium Paid, the question that arises is whether Corporation 3 has made any misrepresentation that is attributable to neglect, carelessness or wilful default or has committed any fraud by claiming a deduction by virtue of subparagraph 20(1)(f)(i) rather than by virtue of subparagraph 20(1)(f)(ii).
65. As stated above, it is at the time the return is filed that it can be determined whether or not there has been a misrepresentation through neglect or carelessness, and therefore reference should be made to the information available at the time the Corporation 3 income tax return for the taxation year XXXXXXXXXX was filed to determine whether, in taking the position at that time that it could claim a deduction by virtue of subparagraph 20(1)(f)(i), Corporation 3 exercised the care of a wise and prudent person in reaching that conclusion.
66. The tax community was advised of the above-stated position regarding the application of paragraph 20(1)(f) to exchangeable debentures when document 90063-3, dated July 30, 1990, was issued. In response to the question "What are the tax consequences to the Issuer and the Holder on the exercise by the Holder of the exchange right in an exchangeable debenture? In particular, what are the Issuer's proceeds of disposition of the Target Shares?” The answer published in that document was as follows (we reproduce only the relevant passages for our purposes):
On an exchange, the Issuer would dispose of the Target Shares for proceeds equal to their fair market value, which is the amount of the Issuer's obligation pursuant to the exchangeable debenture which is satisfied by their delivery. The Issuer's proceeds would thus equal the Holder's adjusted cost base of the Target Shares. The Issuer would be entitled to a deduction under paragraph 20(1)(f) of the Act with respect to the difference between the fair market value of the Target Shares (the amount paid in satisfaction of the principal amount) and the face amount of the debenture (the amount for which it was issued). In other words, if the Issuer is required to deliver the Target Shares, the principal amount, within the meaning of subsection 248(1) of the Act, of his obligation would be an amount equal to the fair market value of the Target Shares. (endnote 9)
67. Although the distinction between the application of subparagraphs 20(1)(f)(i) and (ii) was not discussed in detail in that document (endnote 10), the rationale for the application of paragraph 20(1)(f), namely that the principal amount of the debenture, as well as the amount paid in satisfaction of the principal amount, was dependent on the FMV of the shares of the particular corporation that the debenture issuer was obligated to deliver on exchange, was clearly stated. A taxpayer who took advantage of this deduction on the exchange of an exchangeable debenture of which the taxpayer was the issuer could therefore easily determine, on the basis of this statement, what the principal amount of the debenture was and whether or not the test in subparagraph 20(1)(f)(i) was satisfied.
68. On the other hand, a taxpayer who had not followed that reasoning could not, on the basis of a reading of paragraph 20(1)(f), have concluded that the provision could otherwise be relied upon. Indeed, the only reasonable alternative interpretation of that provision was that the principal amount is equal to the face value of the debenture. (In this case, it was $XXXXXXXXXX.) If a taxpayer were to adopt this interpretation, the principal amount of the debt was therefore equal to the amount for which the debt was issued, and there was no excess, so that paragraph 20(1)(f) could not apply.
69. In other words, in this case, Corporation 3 could reasonably have opted for either of two interpretations of paragraph 20(1)(f). Under the first interpretation, the principal amount of the debenture, determined at the time of repayment, was $XXXXXXXXXX. The 97% test in subparagraph 20(1)(f)(i) could therefore not be satisfied, but subparagraph 20(1)(f)(ii) could otherwise apply. Under the second possible interpretation, the principal amount of the debenture was $XXXXXXXXXX. As the principal amount was equal to the issue price of the debenture, there was no excess for the purposes of paragraph 20(1)(f), and therefore that paragraph could not apply.
70. Moreover, in an advance ruling dated XXXXXXXXXX 2002, the distinction between the application of subparagraphs 20(1)(f)(i) and (ii) was clarified (endnote 11). The facts of this case were unique, and do not need to be reviewed in detail for the purposes of this decision. The following passage from the decision summary, however, clearly indicates the Agency's position on the application of subparagraph 20(1)(f)(ii) in a context that is similar to the situation of Corporation 3:
For purposes of paragraph 20(1)(f) the principal amount under the terms of the Debenture Agreements is the total amount paid by the issuer at the time of the repayment such that that portion of the said amount paid by the issuer that is in respect of the fair market value of the 8% Interest will constitute an amount paid in the year in satisfaction of the principal amount.
However, the amount for which the Debentures were issued is substantially less than 97% of the principal amount and the "effective yield" is substantially more than 4/3 or the interest rate payable. As such, subparagraph 20(1)(f)(i) will not apply, rather 20(1)(f)(ii) will apply.
71. This document was published long before Corporation 3 filed its income tax return for the XXXXXXXXXX taxation year.
72. In our view, a wise and prudent person could not, on the basis of the information available at the time, conclude that it was entitled to rely on subparagraph 20(1)(f)(i) in circumstances similar to those described in paragraph 5 hereof.
73. The taxpayer's representative argued, in support of Corporation 3's decision to rely on subparagraph 20(1)(f)(i), that this position was consistent with the position taken by another taxpayer, Imperial Oil in the aforementioned case of the same name. In this regard, he cites paragraph 2 of the reasons for judgment of the Supreme Court in that case.
74. In our view, this argument does not help Corporation 3, for the following reasons.
75. First, the fact that another taxpayer has adopted an interpretation of the Act that is consistent with the interpretation adopted by Corporation 3 does not of itself lead to the conclusion that Corporation 3 acted wisely and prudently in adopting that interpretation, if that interpretation is patently unreasonable.
76. Second, the argument raised by the representative does not take into account the fact that as soon as its case was heard before the Federal Court of Appeal on September 7, 2004, Imperial Oil had dropped this part of its argument (as appears from paragraphs 29 and 31 of the Court of Appeal's reasons for judgment, rendered on October 26, 2004: 2004 DTC 6702). The Federal Court of Appeal had itself concluded in that case (para. 64) that subparagraph 20(1)(f)(i) was not applicable.
77. Third, the issue raised in Imperial Oil did not involve exchangeable debentures, but rather debentures denominated in a foreign currency. The issue that was raised was whether the fluctuation in that foreign currency had an impact on the determination of principal for the purposes of paragraph 20(1)(f). The debentures in this case had been issued at a discount, and the Agency conceded that, subparagraph 20(1)(f)(i) applied to the initial issue discount, as the conditions for the application of that subparagraph were satisfied on the assumption that the principal amount in this context was limited to the face value of the debenture (and was not modified to take into account the fluctuation in the foreign currency). However, the Agency denied any deduction under paragraph 20(1)(f) that was attributable to the fluctuation in foreign currency. The fact that Imperial Oil, in this case, argued that subparagraph 20(1)(f)(i) allowed it to deduct, in addition to the original issue discount, an amount attributable to the fluctuation of that foreign currency, cannot justify the position taken by Corporation 3 in the present case.
78. Fourth, it is interesting to note that, at the same time, another taxpayer, Inco, claimed a deduction under subparagraph 20(1)(f)(ii) for foreign exchange losses of the same nature as those claimed by Imperial Oil, in a context where there was no initial issue discount. Bonner J. of the Tax Court of Canada held that paragraph 20(1)(f) did not apply in these circumstances. Inco had intervened in Imperial Oil's appeal to the Federal Court of Appeal, but continued to rely on subparagraph 20(1)(f)(ii). As noted above, Imperial Oil had, at that time, agreed with Inco's interpretation on this point and the judgment of the Federal Court of Appeal in Imperial Oil on October 26, 2004 concluded that subparagraph 20(1)(f)(ii) applied. The judgment of the Federal Court of Appeal in Inco (2005 DTC 5109) overturned the judgment of the Tax Court of Canada, based on the judgment in Imperial Oil on October 26, 2004. The Supreme Court granted the leave to appeal sought by the Agency in these two cases on May 19, 2005.
79. At that time, although the debate in Imperial Oil and Inco was not closed, uncertainty as to the outcome of that debate was limited to two possibilities: (1) the principal amount was determinable based on foreign currency fluctuations and paragraph 20(1)(f)(ii) was applicable; or (2) the principal amount was not dependent on foreign currency fluctuations and paragraph 20(1)(f) was not applicable (except in the context of the initial issue discount in the case of Imperial Oil). The former could justify Corporation 3 claiming a deduction by virtue of subparagraph 20(1)(f)(ii); the latter did not allow it to claim any deduction by virtue of paragraph 20(1)(f). Nothing in the state of the law at that time, as determined by the Federal Court of Appeal, nor in the arguments raised by either side, suggested that subparagraph 20(1)(f)(i) could apply in a context where the principal amount had fluctuated since the issuance of the debt such that the issue price was less than 97% of the amount payable at maturity.
80. For all these reasons, we are of the view that the argument of the representative of Corporation 3 as to the application of subparagraph 20(1)(f)(i) cannot be accepted.
81. In summary, we are of the view that there are several arguments to support the contention that there has been misrepresentation that is attributable to neglect, carelessness or wilful default on the part of Corporation 3 with respect to the Exchangeable Debenture. It follows from the foregoing that the mere fact that Corporation 3 deducted the Premium Paid, whether as interest or pursuant to subparagraph 20(1)(f)(i), constitutes a misrepresentation for the purposes of subparagraph 152(4)(a)(i). As to whether this misrepresentation was the result of neglect, carelessness or wilful default attributable to Corporation 3, we are of the view that there is some evidence to support this conclusion.
82. In this regard, we are of the view that if Corporation 3 had reviewed its income tax return for the year ended XXXXXXXXXX with the care of a wise and prudent person, it would have noticed the significant interest expense of $XXXXXXXXXX - huge compared to the previous year's $XXXXXXXXXX - that appeared on its financial statements. It would then have questioned its accountant about it. It is impossible to know what the accountant's response would have been, but it is reasonable to assume that if the accountant had been so questioned, the accountant would have had to admit that the bonus paid was not interest, and the accountant would have amended the financial statements accordingly. The accountant would then have had to review the tax treatment of the Premium Paid, and if the accountant had done so with the care of a wise and prudent person, the accountant certainly would not have deducted the Premium Paid as interest expense.
83. Specifically with respect to the possible application of subparagraph 20(1)(f)(i), it is our view that the foregoing demonstrates that if the accountant had analyzed this issue with the care of a wise and prudent person, the accountant could not have concluded that subparagraph 20(1)(f)(i) was applicable. Indeed, it appears from the foregoing that the accountant could have interpreted this provision in either of the two ways described in paragraphs 69 and 79 hereof. Either of these interpretations excluded the potential application of subparagraph 20(1)(f)(i). Thus, regardless of the reason given in support of the Corporation 3 representative's position that the premium paid was fully deductible, it is difficult to believe that the accountant would have maintained the accountant’s interpretation if the accountant had been led to question it.
84. In our opinion, this makes it difficult to believe that Corporation 3 has reviewed its tax return with the care of a wise and prudent person. Based on all of these arguments, we would argue that subparagraph 152(4)(a)(i) applies so as to permit you to reassess the Premium Paid in respect of the Exchangeable Debenture notwithstanding the expiration of the normal reassessment period.
Assessment after expiry of the normal reassessment period - Forward Transaction
85. As previously stated, we understand that the Maturity Payment is included in the interest expense of $XXXXXXXXXX which appears under the heading "XXXXXXXXXX" in the income statement of Corporation 3 for its fiscal year ended XXXXXXXXXX. However, during the course of the audit, Corporation 3's representative instead argued that this amount was deducted as a financing cost under subparagraph 20(1)(f)(i).
86. As in the case of the Premium Paid, it is difficult to understand how the Maturity Payment could have been considered by Corporation 3 as interest, as it indicates in the income statement for its fiscal year ended on XXXXXXXXXX. As noted above, the suggestion by the Corporation 3 representative that the loan and the forward transaction were one and the same is untenable in light of the Shell decision.
87. Corporation 3's representative submits that it was by virtue of subparagraph 20(1)(f)(i) that the Maturity Payment was deducted by Corporation 3. We are also of the view that a person who had examined the person’s tax return with the care of a wise and prudent person could not, in good faith, have claimed a deduction for the Maturity Payment under subparagraph 20(1)(f)(i) and that, therefore, such a deduction would have constituted a misrepresentation that is attributable to neglect, carelessness or wilful default, such as to justify the application of subparagraph 152(4)(a)(i).
88. Indeed, considering that it was by virtue of subparagraph 20(1)(f)(i) that Corporation 3 deducted the payment when due, the question that arises is whether Corporation 3 made a misrepresentation that is attributable to neglect, carelessness or wilful default or has committed any fraud in claiming a deduction under that provision, rather than respecting the legal relationships of the parties and following the tax treatment applicable to hedging transactions.
89. Again, reference should be made to the information available at the time Corporation 3's income tax return for the XXXXXXXXXX taxation year was filed to determine whether, in taking the position that it could claim a deduction under subparagraph 20(1)(f)(i), Corporation 3 exercised the care of a wise and prudent person in coming to that conclusion.
90. The Supreme Court decision in the Shell case was rendered on October 15, 1999, well before Corporation 3 filed its tax return for the 2004 taxation year. Document F 2003-0023761I7 is dated 29 July 2004. This document was published by the tax publishers shortly after that date, and was therefore available when Corporation 3 filed its tax return for that year. A person exercising the care of a wise and prudent person could not have concluded in good faith that paragraph 20(1)(f) applied to the payment when due.
91. As in the case of the bonus paid, it is our view that if Corporation 3 had reviewed its tax return for the year ended XXXXXXXXXX with the care of a wise and prudent person, it would have noticed the significant interest expense of $XXXXXXXXXX - huge compared to the previous year's $XXXXXXXXXX - that appeared on its financial statements. It would then have questioned its accountant about it. It is impossible to know what the accountant's response would have been, but it is reasonable to think that if the accountant had been so questioned, the accountant would have had to admit that the Maturity Payment was not interest, and the accountant would have changed the financial statements accordingly. The accountant would then have had to review the tax treatment of the Maturity Payment, and if the accountant had done so with the care of a wise and prudent person, the accountant certainly would not have deducted it as interest expense.
92. As for the possible application of subparagraph 20(1)(f)(i), we are of the view that the foregoing demonstrates that if the accountant had analyzed this issue with the care of a wise and prudent person, the accountant could not have concluded that this provision was applicable. Thus, as in the case of the Premium Paid, regardless of the reason given in support of the position taken by Corporation 3 in its income tax return, according to which the Maturity Payment was fully deductible, it is difficult to believe that the accountant would have maintained the accountant’s interpretation if the accountant had been led to question it.
93. As a result, it is difficult to believe that Corporation 3 has reviewed its tax return with the care of a wise and prudent person. For all these reasons, we are of the view there are several arguments to support the argument that subparagraph 152(4)(a)(i) applies so as to allow you to reassess the Maturity Payment, notwithstanding the expiration of the normal reassessment period.
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We hope that these comments are of assistance.
Manager
Financial Sector and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.
ENDNOTES
1 We note that your letter of May 20, 2009 instead states that the holder exchanged its debenture for the shares of Corporation 2 which had a value of $XXXXXXXXXX at the time of the exchange. Our analysis for the purposes of this letter would be the same in either of these situations. The circumstances surrounding the repayment of the exchangeable debenture should nevertheless be clarified.
2 In the event of the termination of the Forward Transaction resulting from one of the events listed in the clause entitled "Particular Provisions" of the document entitled "Confirmation", certain other amounts, including losses resulting from the termination of the transaction, were also to be taken into account in the calculation.
3 The circumstances surrounding the repayment of the loan and the termination of the Forward Transaction should be clarified.
4 It is not clear to us how this amount of $XXXXXXXXXX was calculated. According to Corporation 3's representations, this amount results from the following calculation:
Number of shares (XXXXXXXXXX ) x Reference price ($XXXXXXXXXX) - Forward price ($XXXXXXXXXX) = $XXXXXXXXXX.
The manner in which the forward price was calculated to arrive at the price of $XXXXXXXXXX appears questionable to say the least. The Corporation 3 representative details this amount as representing XXXXXXXXXX (i.e. the Loan amount) + $XXXXXXXXXX (XXXXXXXXXX ) + $XXXXXXXXXX (XXXXXXXXXX ). No explanation has been provided to us as to the relevance of these amounts in the calculation of the forward price.
Instead, under the terms and conditions of the Forward Transaction, we understand that the Forward Price was set at $XXXXXXXXXX per share and that the amount payable by Corporation 3 to the Bank was to be calculated according to the following formula:
Number of shares (XXXXXXXXXX) x (Reference price ($XXXXXXXXXX) - Forward price ($XXXXXXXXXX)) = $XXXXXXXXXX.
We do not understand how Corporation 3 or its representative arrived at a different result. We also note the different amount that appears in the income statement as stated in the letter of May 20, 2009. To simplify this, however, we will refer for the purposes of our analysis to the amount of $XXXXXXXX claimed by Corporation 3 as a deduction by virtue of subparagraph 20(1)(f)(i). However, we are of the view that this amount should be recalculated, subject to more specific explanations from Corporation 3 as to its method of calculation. See notes 2 and 3 hereto.
5 The taxpayers' application for leave to appeal in this case was dismissed by the Supreme Court on XXXXXXXXXX.
6 As it applies to amounts becoming payable after XXXXXXXXXX.
7 Term used to designate the financial exchange transaction.
8 Gifford v. The Queen, [2004] 1 S.C.R. 411, 2004 DTC 6128 (S.C.C.) ("Gifford") and Imperial Oil, inter alia.
9 This position has been reiterated several times subsequently. See, for example: 9719413, 9809643, 1999-0008753.
10 This is easily explained by the fact that this document was a theoretical question, without any amount being stated. In this context, it would have been impossible to determine which of subparagraphs 20(1)(f)(i) or (ii) was applicable. This is true of most situations that are the subject of a technical interpretation or advance ruling. In the former case, the Agency's comments are generally limited to interpreting provisions of the Act, and do not include factual details specific enough to make such a determination. In the second case, the Agency's comments relate to proposed transactions. Since the determination of principal in the context of exchangeable debentures could, according to the Agency's interpretation, only be made at the time of repayment, the Agency generally did not know the amount of principal at the time it issued an advance ruling. As a result, it was not possible for the Agency to determine which of the two subparagraphs would apply, which is why the Agency's comments were generally limited to confirming that paragraph 20(1)(f) applied in an exchangeable debenture context, without specifying which of the two subparagraphs applied in a particular case.
11 Document E 2002-0167263. Unlike advance rulings cases in general, this case involved a situation for which advance rulings had already been issued, but more specifically involved an amendment to the terms of debentures on which the Agency had already issued a ruling. The issues before us were limited to the impact of these amendments on an early redemption of the debentures. At the time the decision was rendered, the redemption was imminent and an estimate of the principal amount was known. It was therefore possible to determine, on the basis of that estimate, which of subparagraphs 20(1)(f)(i) or (ii) was likely to apply.