Tax Treatment of Prepayment Penalties

As a business owner, you may decide to repay some of your business loans earlier than they are due. This is usually provided for in the loan agreement that you negotiated with your financial institution. Often, there is a penalty, which is typically calculated as a number of months of interest that the financial institution will lose from your early repayment, that you must pay. The Income Tax Act sets out special rules for such penalties and their possible deduction.

For income tax purposes, the expression “prepayment penalty” means a penalty or bonus paid by a borrower because of the repayment of all or part of the principal amount of a debt obligation before its maturity.

Subject to conditions explained below, the prepayment penalty that you pay may be deductible from your business income. If you meet the criteria, the Income Tax Act redefines the penalty and instead deems it to be interest. From there, the normal rules for the deduction of interest apply, with some limitations.

For the deduction to be allowed, the penalty must be paid on money that you have borrowed in the course of carrying on your business or in the course of earning income from property. The money borrowed is referred to as your debt obligation.

Even if these criteria are met, there are circumstances where the Income Tax Act does not deem the payment to be interest. The penalty isn’t reclassified as interest if it is paid to receive an extension of the term of a debt obligation or for the substitution of a debt obligation to another debt obligation. In other words, the penalty must be paid because of an early loan repayment and no other reason.

The penalty will also not be deemed interest if is calculated on variable elements, such as production of goods or dividends to shareholders. The penalty must be paid to compensate the bank for loss of interest on the loan, not for a participation in the business.

If none of these exclusions apply to your loan, your prepayment penalty is deemed to be interest and is deductible from your income as such.

If the Income Tax Act does not deem the prepayment penalty to be interest, it is generally considered to be on account of capital and therefore not deductible. However, there are three exceptions to this rule.

* A prepayment penalty is incurred in connection with the disposition of a capital property, in which case the penalty is taken into account when calculating the gain or loss from the disposition of that property.

* A prepayment penalty qualifies as an eligible moving expense and is deductible as such.

* A prepayment penalty qualifies as a current expense in the context of a particular business, such as a business of trading in mortgages.