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FROM: MAY-JUN 2009 ISSUE | BY FRANCINE ST-ONGE
Businesses experiencing financial difficulties may wish to change their financing structure, but high costs are often related to restructuring. It is important to be aware of the tax treatment of these outlays. Several provisions of the Income Tax Act allow for the deductibility of these costs under certain conditions.
Subsection 18(9.1) of the Act permits the deduction of penalties for prepayment of loans and payments made to reduce the rate of interest on such obligations. Under that provision, the amounts paid are deemed to be interest which must generally be deducted over the period that the interest rate is to be reduced, or over the period that would have been the remaining term of the debt obligation, in the case of a penalty for prepayment.
The amount deductible under subsection 18(9.1) must relate to the interest due on the loan. This amount cannot exceed the value of the interest that would have been payable over the remaining term of the loan.
Subsection 18(9.1) specifically excludes payments that can reasonably be considered to have been made in respect of:
- the extension of the term of a debt obligation;
- the substitution of a debt obligation for another debt obligation or share;
- the conversion of a debt obligation to another debt obligation or share;
- participatory payments.
When a debt obligation is substituted for another debt obligation, the CRA takes the position that the same debtor replaces his original obligation with a new one from the same creditor. Therefore, a penalty for prepayment paid in the context of refinancing with a different creditor would not be covered by the exclusion.
Subparagraph 20(1)(e)(ii.2) applies when the payment of a debt obligation is rescheduled or restructured with the same creditor. Under this provision, costs related to these transactions are deductible at the rate of 1/5 per year if they are not otherwise deductible under another provision of the Act.
For expenses to be deductible, the rescheduling or restructuring of the debt obligation must provide for:
- the modification of the terms or conditions of the debt obligation;
- the conversion of the debt obligation to
- a share or another debt obligation;
- the substitution of the debt obligation with another debt obligation or share.
Deductible expenses include fees paid to any professional who has participated in dealings related to the refinancing or in the preparation of documents, fees, and offsetting costs required by the creditor.
If the restructuring involves a new creditor, the costs related to obtaining the new loan will be subject to subparagraph 20(1)(e)(ii) and will also be amortized over five years.
Note that under subparagraph 20(1)(e)(v), an undeducted balance of expenses may be deducted from income when the debt obligation that generated these expenses is extinguished during the year. However, this rule does not apply in the case of refinancing.
Under paragraph 20(1)(e.1), the total amount of certain costs that can reasonably be considered to relate solely to the year can be deducted in that year, rather than over a five year period. For example, annual standby charges incurred by a debtor to maintain a line of credit with a financial institution are deductible under paragraph 20(1)(e.1) in the year they are paid. The same is also true for annual guarantee costs and service charges.
Allowable expenses do not include participatory payments:
- an amount that is contingent or dependent on the use of, or production from, property;
- an amount that is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion;
- an amount that is computed by reference to dividends paid or payable to shareholders of any class of shares of the capital stock of a corporation.
In order for these expenses to be deductible the money that was borrowed must have been used for the purpose of earning income from a business or non-exempt income from property, or to acquire property for the purpose of producing income from a business or non-exempt income from the property.
As a rule, expenses related to a loan to honour a guarantee can not be deducted from income unless it can be demonstrated that the guarantee was granted to increase the guarantor’s ability to earn income.
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