We Can Deduct. We Can Hedge. We’re Doing It More and More.
This past year saw a flurry of cases, transactions and Canada Revenue Agency (CRA) interpretations dealing with interest deductibility and hedging. Some present new planning opportunities by expanding conventional boundaries or by rejecting restrictive CRA interpretations. Others serve to muddle rather than clarify the law in these important areas.
Interest Deductibility
TDL Group Co. v. The Queen1
This March 6, 2015 decision of the Tax Court of Canada deals with the deductibility of interest on funds borrowed to subscribe for common shares. Unfortunately, in this case, both the facts and the law seem to get confused.
The taxpayer, TDL Group Co., was part of the Tim Horton’s group, which was owned by Wendy’s International Inc. TDL borrowed money from a U.S. affiliate and used the proceeds to subscribe for additional common shares of its existing wholly owned subsidiary, Tim Donut U.S. Limited, Inc. Tim’s U.S. used the proceeds of the share subscription to make a non-interest-bearing loan to Wendy’s, the indirect parent of both it and TDL. After this structure had been in place for about seven months, Tim’s U.S. contributed the receivable from Wendy’s to a wholly owned subsidiary and the receivable was refinanced into an interest-bearing note. The Minister of National Revenue denied a deduction for the interest expense incurred by TDL during the seven-month period during which the loan to Wendy’s bore no interest.
The Court agreed with the Minister, denying a deduction for the interest at issue. With no dispute about the direct use of the borrowed funds, the only issue was whether the common shares of Tim’s U.S. were acquired for the purpose of earning non-exempt income. The Court found that the purpose test must be applied at the time the investment was made. As a result the issue became whether “it [could] be said that the Appellant had the reasonable expectation to earn income; either immediate or future dividend income or even increased capital gains as a result of the purchase of shares at the time of such purchase.”
The Court found that TDL had no such reasonable expectation. The Court found that there was no expectation at the time of the share subscription that Tim’s U.S. would be in a financial position to pay dividends in the short term, and that the 10-year plan for Tim’s U.S. did not contemplate the payment of dividends. These findings create uncertainty about the period of time over which a company’s dividend-paying capacity should be assessed for interest deductibility purposes, as well as narrowly construing dividend-paying capacity by ignoring the possibility of borrowing to distribute retained earnings. The Court also discounted evidence that the non-interest-bearing loan was replaced by an interest-bearing loan and that the proceeds of the interest-bearing loan were intended to be used to fund store expansion in the U.S., instead concluding that, at the time of the share subscription, the only intended use of the subscription proceeds was to make a non-interest-bearing loan to Wendy’s. These factual findings are difficult to understand, and also appear to reflect the application of a different legal test than the one set out at the beginning of the reasons. In particular, in finding that “the sole purpose. . .being to facilitate an interest free loan to Wendy’s,” the Court seemed to focus on the purpose of the series of transactions, rather the purpose of the use of the borrowed funds by TDL. Hopefully, the Federal Court of Appeal will straighten this one out.
Basket “C” Transactions
The last year saw two important developments—one a CRA interpretation and the other a transaction—in the effort to design instruments that both support an interest deduction for Canadian income tax purposes and achieve partial equity treatment for rating agency purposes (known as Basket “C” Equity Treatment from Moody’s and “Intermediate Equity Credit” from S&P).
The CRA interpretation2 considered whether mandatorily convertible notes with a 60-year term would constitute “borrowed money,” permitting a deduction for interest on the notes.3 On a bankruptcy or insolvency of the issuer, the notes, together with any accrued interest, would be automatically and mandatorily converted into a fixed number of fixed-rate preferred shares and the notes would be extinguished. While the CRA provided general comments, indicating it could come to a definitive conclusion only in the context of an advance tax ruling, its comments should comfort taxpayers who might consider applying for a ruling where the taxpayer is in good financial condition and the prospect of financial collapse is remote. Basically, the CRA said the mandatory conversion clause would not keep the notes from being considered borrowed money as long as the events giving rise to the conversion (such as bankruptcy or insolvency) are “remote and would occur only in extraordinary circumstances” and are beyond the control of the issuer.
The transaction involves trust notes issued in the principal amount of US$750 million by TransCanada Trust. TransCanada Trust is a unit trust whose sole voting beneficiary is TransCanada PipeLines Limited (TCPL); the trust notes are unsecured and subordinated with a 60-year term bearing fixed interest for the first 10 years and redeemable at par after 10 years.
The trust notes were structured explicitly with the intention of achieving Basket ‘‘C’’ and ‘‘Intermediate Equity Credit’’ status. In particular, on a bankruptcy or insolvency event, the trust notes are to be automatically and mandatorily exchanged for a fixed number of fixed-rate preferred shares of TCPL. In addition, TCPL and its parent corporation provided an undertaking to refrain from paying dividends on their preferred shares should interest not be paid on the trust notes when required, and holders are required to invest interest received on their trust notes in preferred shares of TCPL should TCPL or its parent not pay dividends on their preferred shares.
TransCanada Trust used the proceeds from issuing the notes to acquire notes of TCPL. It is expected that TCPL is entitled to deduct interest on these notes and that there is no material amount of tax in TransCanada Trust.
Hedge Transactions
Character Issues
George Weston Limited v. The Queen4
This Tax Court of Canada case involved the character (i.e., income or capital account) of approximately C$316 million received on the termination of a cross-currency swap. The decision affirmed the taxpayer’s capital treatment of the receipt, firmly rejecting CRA’s administrative position that a derivative cannot be linked to an investment in a subsidiary for tax purposes without there being some intention to sell that investment.
In 2001, George Weston Limited (GWL), through a subsidiary, acquired a baking business in the U.S., increasing its net investment in “USD Operations” from approximately US$800 million to over US$2 billion. Foreign exchange adjustments translating this amount to Canadian dollars in the preparation of consolidated financial statements were reflected in GWL’s currency translation account (CTA). GWL was concerned about a strengthening in the Canadian dollar, which would erode its consolidated equity and decrease its debt-equity ratio. GWL gave evidence that this could in turn reduce its credit rating, violate loan covenants or cause a reduction in its stock price. Accordingly, following the acquisition, GWL entered into a number of cross-currency swaps to hedge its net investment in USD Operations. By 2003, with the Canadian dollar having appreciated, GWL determined that its currency risk was waning and terminated the swaps with the counterparties. GWL reported the resulting termination payments on capital account and the Minister assessed them on income account.
The Court found that the swaps were on capital account, and that the proceeds received on termination were also on capital account. Citing an earlier case and commentary, the Court stated that “a transaction is a hedge where the party to it genuinely has assets or liabilities exposed to market fluctuations, while speculation is ‘the degree to which a hedger engages in derivatives transactions with a notional value in excess of its actual risk exposure.’” The Court found GWL to be hedging, not speculating, although was not clear as to what in its view was being hedged (the direct shares owned by GWL, GWL’s indirect investment in its subsidiaries or its equity as a whole). Importantly, the Court was not troubled by the fact that the USD Operations were carried out by subsidiaries and not directly by GWL and rejected the notion that GWL could only hedge a transaction, i.e., a proposed sale.
The case should make it easier for taxpayers to achieve hedge treatment for tax purposes where that is desired, although the Court’s lack of clarity about what precise risk it thought was being hedged introduces some uncertainty. Capital treatment is not always desired, at least not at the inception of a swap when the contract is as likely to yield a loss as a gain.
Capital treatment is not always desired, at least not at the inception of a swap when the contract is as likely to yield a loss as a gain.
Rollovers
Two recent CRA documents consider the treatment of derivatives in the context of the tax-deferred rollover of property under subsection 85(1). One dealt with the tax treatment to the transferor and the other to the transferee.
One of the documents involved a taxpayer that had entered into cross-currency swaps involving Canadian and U.S. dollars.1 While the swaps appear to have been entered into in connection with an issuance of U.S. dollar notes, the technical interpretation presumes the swaps are on income account. The interpretation addressed whether the swaps, which were “in-the-money” for the taxpayer, constitute “inventory” for purposes of their being transferred to a subsidiary for shares on a tax-deferred rollover basis. The CRA concluded that the swaps were inventory, and as such eligible for rollover treatment, as their cost or value would be relevant in the computation of the taxpayer’s income.
The other document, from 2014, addresses the treatment to a subsidiary of a gain it realized on forward contracts received on a rollover transaction.6 In the scenario considered by the CRA, a parent corporation entered into a series of foreign currency forward contracts to hedge senior U.S. dollar notes it had issued. The parent transferred the forward contracts to a wholly owned subsidiary for shares on a tax-deferred rollover basis under subsection 85(1). The forward contracts were then terminated and the subsidiary reported its gains on the forward contracts as capital gains, which it sheltered with its own capital losses. The CRA agreed with the subsidiary that its gains on the forward contracts were on capital account on the basis that the forward contracts had been held by the parent on capital account since they were linked to a capital debt obligation of the parent and maintained that character in the hands of the subsidiary. The CRA reached this conclusion even though the contracts could not have been a hedge for the subsidiary.
Timing Issues
Kruger Inc. v. The Queen1
This case involves the timing of the recognition of gains and losses on option contracts held on income account. The taxpayer reported gains and losses using the mark-to-market method (i.e., reporting and gains and losses annually) whereas the Minister assessed on the basis that gains and losses could be recognized only when realized (i.e., when the contracts expired or were closed out).
Kruger’s core business was the manufacturing of newsprint, coated paper products and tissue paper. It was the third-largest newsprint company in North America and also operated a lumber business selling to the U.S. market. Since most of its sales were outside Canada, approximately 75% of its accounts receivable were in U.S. dollars. Kruger also carried on a business of speculating in foreign currency options that was separate from its other businesses (and was not hedging its accounts payable or receivable). It was a leading trader of option contracts in Québec and had experienced traders. It entered into a large number of contracts and the amounts of the contracts were significant. Kruger claimed a loss of $91 million from its business of trading in derivatives in its 1998 taxation year, stemming from marking to market its foreign currency option contracts in that year.
The Court denied mark-to-market losses on option contracts written by Kruger, finding that Kruger had to follow the realization method in recognizing losses from those contracts. There is not much by way of reasons for this conclusion, other than to say that mark-to-market reporting could require a taxpayer to report gains “where there is no clear statutory language requiring him or her to do so” and that the realization principle “is basic to Canadian tax law.” It appears that the Court was troubled somewhat by the variation in valuations in the contracts among the different financial institutions. The Court did, however, allow Kruger to recognize mark-to-market losses on the contracts that it had purchased (as opposed to written) on the basis that those contracts were inventory to Kruger and could be recorded at the lower of cost and value.
The mark-to-market method is used by financial institutions who are subject to express rules that require marking in certain circumstances and who are otherwise permitted by the CRA to use the method.
The mark-to-market method is used by financial institutions who are subject to express rules that require marking in certain circumstances and who are otherwise permitted by the CRA to use the method. Mark-to-market is also sometimes used by taxpayers who are not financial institutions. Kruger creates uncertainty for these taxpayers. We will have to wait until the appeal to see if the result stands or can be better explained. We understand that the grounds of appeal include that the Court should have attempted to determine whether the mark-to-market method resulted in an accurate picture of the taxpayer’s income for the year, rather than merely applying the realization principle as a rule of law.
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1 [2015] 4 C.T.C. 2122 (T.C.C.), under appeal.
2 CRA document number 2014-0563351E5, dated May 25, 2015.
3 The requirement for “borrowed money” is thought to impose a more onerous test than merely needing an instrument to constitute debt. “Borrowed money” suggests an obligation to repay the amount advanced, while debt can represent a promise to repay a lesser amount.
4 [2015] 4 C.T.C. 2010 (T.C.C.).
5 CRA document number 2014-0544651I7, dated January 29, 2015.
6 CRA document number 2013-0500891I7, dated March 5, 2014.
7 [2015] 5 C.T.C. 2006 (T.C.C.), under appeal.