This article was contributed by Jonathan Willson and Ryan Abrahamson of Stikeman Elliott LLP in Toronto, Canada.
On July 29, 2016, the Department of Finance (Canada) issued drafted legislation to amend the treatment of a sale of a linked note in a secondary market (the "July Proposals"). The July Proposals expand upon earlier tax proposals announced on March 22, 2016, as part of the Canadian federal budget ("Budget 2016"). Currently, the Income Tax Act (Canada) (the "Act") contains rules that deem interest to accrue on prescribed debt obligations, including most standard linked notes. The Act also contains a rule that provides that interest accrued to the date of the sale of a debt obligation is included in the income of the vendor for the year in which the sale occurs, provided that such amount is determinable. Based on the existing rules, investors have been able to sell their linked notes to third parties prior to the date that the full amount of the return would be included in income (e.g. prior to the date where the amount paid at maturity or an accelerated value is determinable). As such, these investors would take the position that no amount in respect of the return on a linked note is accrued interest on the date of the sale of the note. In effect, these investors converted ordinary income that is fully taxable to capital gains, of which only 50% of the amount is taxable.
To address the tax issues arising from the sale of linked notes in the secondary market, Budget 2016 proposed to amend the treatment of any gain realized on a sale of a linked note in a secondary market (the "March Proposals"). The March Proposals deem an amount to be accrued interest on the sale of linked notes. Specifically, the March Proposals require taxpayers to include in their income on the sale of a linked note as accrued interest the amount by which the price for which the debt obligation was assigned or transferred exceeds the price for which the debt obligation was issued (less any principal repayments). The March Proposals also permit taxpayers to deduct from the deemed accrued interest the portion of the amount that the sale price exceeds the issuance price (less any principal repayments) that is reasonably attributable to an increase in the value of "fixed rate interest payments" to be received under the debt obligation because of a decrease in market interest rates from the time of issue of the debt obligation to the time of sale (the "Fixed Rate Deduction").
The July Proposals expand upon the March Proposals by providing a more detailed framework for calculating the Fixed Rate Deduction. Under the July Proposals, the Fixed Rate Deduction from the deemed accrued interest is equal to the amount that is reasonably attributable to the excess, if any, of the present value of all fixed rate interest payments to be received under the note after the date of assignment or transfer (the "Transfer Date") over the present value of all fixed rate interest payments that would be received under a hypothetical debt obligation. For these purposes, the hypothetical debt obligation would have the same terms and conditions as the particular linked note (including the same issuer and maturity date) but would be issued on the Transfer Date and would bear a fair market interest rate determined at the Transfer Date.
While more specific than the March Proposals, the July Proposals leave linked note issuers and investors with considerable uncertainty. Particularly, issuers have not been provided with sufficient guidance as to what constitutes a "fixed rate interest payment", nor have they been properly instructed on the Fixed Rate Deduction calculation. Ideally these issues will be resolved through the consultation process currently being undertaken by the Department of Finance in respect of the July Proposals.