In Budget 2016, the Department of Finance continued its quest to eliminate investment products that have ‘character conversion’ features (those that can have the effect of converting what would otherwise be ordinary income into capital gains only one-half of which are included in income). In particular, Budget 2016 proposed rules to prevent the accrued performance of linked notes from being treated as capital gains when such notes are transferred or assigned prior to maturity by a taxpayer who holds their notes as capital property. Under the proposed rules, the accrued performance to the date of sale will be treated as interest on the linked notes.
Generally, linked notes are debt obligations where the return is linked to the performance of a reference asset such as a basket of stocks, a stock index, a commodity, a currency or units of an investment fund. Financial institutions, among others, have been issuing linked notes for many years. The terms of such notes can vary widely: for example, the notes may be denominated in foreign currency, pay fixed interest, have partial principal repayment and have principal protection features. As well, the issuer of linked notes will often assist in maintaining a secondary market for the notes to facilitate their sale before maturity.
From a tax perspective, linked notes are usually “prescribed debt obligations” described in paragraph 7000(1)(d) of the Income Tax Regulations (“Regulations”), requiring annual interest accrual under the ITA. However, since the linked return on a note that does not mature in the year is typically undeterminable, the full amount of such return on the note is included in income only in the year it matures and the linked return becomes determinable. Where a linked note that is capital property is disposed of prior to the time the return becomes determinable, the “accrued return” is often treated as a capital gain, only 50 per cent of which is included in income.
Draft provisions to implement the proposed deemed interest rule were included in the Notice of Ways and Means Motion (“NWMM”) that formed part of Budget 2016. Revised draft provisions are included in the 2016 Legislative Proposals and there have been material additions to the operative provisions, additional consequential amendments to the foreign currency reporting regime in section 261, as well as further additions to the Regulations relating to information reporting for linked notes. Certain of the changes and additions appear to be designed to provide more detailed rules to prevent inappropriate accrual that could result from the wide variety of linked notes in the marketplace.
The main provision of the rules is proposed subsection 20(14.2) to the ITA which will deem a portion of the sale price of a debt obligation described in paragraph 7000(1)(d) of the Regulations to be interest for the purpose of existing subsection 20(14). Where the linked note is denominated in a foreign currency, foreign currency fluctuations will be ignored solely for the purpose of calculating this deemed amount (in other words a foreign currency gain or loss may otherwise arise for purposes of the ITA). Generally, the portion deemed to be interest is determined by the formula A - (B + C), where
- is the sale price;
- is the original issue price less any principal repayments; and
- is the portion of the sale price representing fluctuations in market interest rates where the linked note has a fixed interest feature.
A major change in proposed subsection 20(14.2) from the version that appeared in the NWMM is that item C has been expanded to specify how the market interest rate fluctuation component is to be calculated, although it remains a difficult calculation to make. Specifically, item C is to be determined by comparing the present value of the remaining fixed interest rate payments on the linked note to the fixed interest rate that would be payable by the issuer on a hypothetical debt obligation issued on the date of sale of the original linked note, but otherwise having the same terms and maturity date of the original note. This addition seems to require that there be market-based analysis undertaken to support the level of accrual each time a linked note that has a fixed interest component is disposed of by a taxpayer. The examples provided in the technical notes forming part of the 2016 Legislative Proposals largely gloss over the manner in which item C is to be calculated. The revised provision may cause issuers to limit the transferability (or the times at which notes can be transferred) of certain linked notes to minimize their reporting and compliance burden.
In the context of linked notes, the 2016 Legislative Proposals now also include changes to paragraphs 261(2)(b) and 261(5)(c) and subparagraph 261(5)(f)(i) of the ITA relating to foreign currency reporting. These changes are required to reflect the fact that, among other things, proposed subsection 20(14.2) ignores foreign currency fluctuations for the purpose of calculating the deemed interest component.
Finally, the 2016 Legislative Proposals clarify the Regulations to provide that a “financial company” (as defined in in section 211 of the Regulations), is required to provide an information return where it pays, whether as principal or agent, a portion of the sale price of a linked note to which proposed subsection 20(14.2) of the ITA applies to deem an amount to be interest.
The linked note regime in the 2016 Legislative Proposals will apply to sales of linked notes that occur after September 2016, leaving several weeks for taxpayers to consider disposing of linked notes prior to the effective date of the new deemed interest rule.