Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.
Principal Issues: A shareholder has an amount receivable (the "Receivable") from a corporation which is in financial difficulty. As a result of the financial difficulty, the corporation, through a trustee, made a proposal under the Bankruptcy and Insolvency Act to the corporation's creditors, including the shareholder. Under the proposal, the shareholder agreed to accept a portion of each dollar of debt along with preferred shares in respect of the disposition of the Receivable. Subsequent to the acceptance of the proposal, the shareholder continued to control and manage the corporation. Can the shareholder treat the loss on the disposition of the Receivable as a business investment loss?
Position: No
Reasons: The loss is deemed to be nil under subparagraph 40(2)(g)(ii) of the Income Tax Act (the "Act") pursuant to comments in paragraph 3 of IT-239R2. However, the administrative position in paragraph 6 and 10 of IT-239R2 may, in some cases, result in such a loss not being deemed to be nil so that the business investment loss provisions in paragraph 39(1)(c) of the Act could be considered. However, in relation to the circumstances under consideration, the comments in those paragraphs are only relevant if a shareholder severs all ownership ties with the corporation. As this is not the case, the loss is considered to be nil pursuant to subparagraph 40(2)(g)(ii) of the Act.
November 5,1998
Winnipeg Tax Services Office HEADQUARTERS
Heather Kay M. Eisner
Office Audit (613) 957-2138
980623
Business Investment Losses
This is in reply to your memorandum of March 12, 1998 concerning the above-noted subject. We also acknowledge our telephone conversations on July 10 and July 14 (Eisner/Kay) in which we obtained clarification with respect to your concerns. We note that you made another enquiry, by MS Mail, on April 14, 1998 concerning other issues with respect to business investment losses. Your April 14th enquiry was assigned control #980994 and will be the subject of a separate reply. We apologize for the delay in replying.
In your situation, XXXXXXXXXX (the "Corporation") is a Canadian-controlled private corporation ("CCPC") as defined in subsection 125(7) of the Income Tax Act (the "Act"). As we understand, while the Corporation was in financial difficulty and could not obtain financing, the Corporation, pursuant to Division I of Part III of the Bankruptcy and Insolvency Act, made a proposal (the "Proposal") in XXXXXXXXXX to the Corporation's creditors which included the shareholders of the Corporation and became effective in XXXXXXXXXX. Under the Proposal, a creditor was offered a portion of each dollar of debt along with preferred shares. Each share has a redemption value after the expiration of three years equal to the lesser of (i) XXXXXXXXXX, or (ii) the net book value of the Corporation at the end of the three years. You have indicated that, with respect to the XXXXXXXXXX taxation year, the controlling shareholder (the "Shareholder") treated a loss of $XXXXXXXXXX (the "Loss") as being a business investment loss ("BIL") under paragraph 39(1)(c) of the Act which occurred as a result of the Proposal and was determined by the Shareholder as set out below:
Amount owed by the Corporation prior to the Proposal $XXXXXXXXXX
New Debt Payable to the Shareholder
under the Proposal $XXXXXXXXXX
Fair Market Value of Preferred shares
received under the Proposal XXXXXXXXXX
XXXXXXXXXX
Loss $XXXXXXXXXX
The amount (the "Debt") owed to the Shareholder, prior to the time that the Proposal became effective in XXXXXXXXXX , was non-interest bearing. The Corporation did not cease to carry on its business operation and the Shareholder continued to control the Corporation and manage its
business operation subsequent to acceptance of the Proposal by the creditors of the Corporation. In addition, it is our understanding that the Corporation can be regarded as being a "small business corporation" ("SBC") as defined in subsection 248(1) of the Act at all relevant times.
Taxpayer's Position
The position of the taxpayer's representative is that the Debt was bad at the end of XXXXXXXXXX and that, accordingly, there was a deemed disposition at the end of that year under subsection 50(1) of the Act. The representative has also mentioned that, in his view, the Corporation was insolvent at the end of the year.
Position of Tax Services Office
It is your view that subsection 50(1) of the Act does not apply because the Shareholder disposed of the Debt to the Corporation. In addition, the Shareholder did not deal at arm's length with the Corporation pursuant to subparagraph 251(2)(a)(i) of the Act when the disposition of the debt occurred. As a result, it follows that that the Shareholder is not entitled to treat the Loss as a BIL.
Our Comments
In relation to the above circumstances, a BIL may arise from the disposition by a taxpayer of a debt owing to him or her by a CCPC if, pursuant to subparagraphs 39(1)(c)(i) and (ii) of the Act, such a disposition is made to a person with whom the taxpayer is dealing at arm's length or if it is a disposition to which subsection 50(1) of the Act applies.
In the above circumstances, the available information indicates that the Shareholder received, in respect of the Debt, a new debt of $XXXXXXXXXX that was based on a percentage of the Debt along with the preferred shares. Accordingly, it would follow that pursuant to subparagraph (b)(iii) of the definition of "disposition" in section 54 of the Act, a disposition occurred as that subparagraph refers to any transaction or event by which "any debt owing to a taxpayer or any other right of a taxpayer to receive an amount is settled or cancelled". It would follow that subsection 50(1) of the Act does not apply in respect of the Debt at the end of XXXXXXXXXX, as it was not in existence.
As indicated above, the other consideration is whether the Debt was disposed "to a person with whom the taxpayer was dealing at arm's length" for the purposes of subparagraph 39(1)(c)(ii) of the Act. The determination of whether a settlement of an obligation can be regarded as being a disposition "to a person" can be difficult even when the relevant documentation is available for review. We are not aware of any case law that might be of assistance in resolving this issue. However, whether we consider the settlement of an obligation as being a disposition by the creditor to the debtor or simply as a disposition that was not to anyone, the conditions of subparagraph 39(1)(c)(ii) of the Act will not be met. For example, if the settlement of Debt is not considered a disposition of the Debt to the debtor, then subparagraph 39(1)(c)(ii) of the Act cannot apply. On the other hand, if the Shareholder is considered to have disposed of the Debt to the Corporation, the Shareholder and the Corporation do not deal at arm's length with each other and subparagraph 39(1)(c)(ii) of the Act again does not apply. Nonetheless, as indicated to you in our telephone conversation, there is a further consideration, which involves IT-239R2.
As stated in paragraph 3 of IT-239R2, a taxpayer's loss arising from the deemed disposition of a debt under subsection 50(1) of the Act is nil pursuant to subparagraph 40(2)(g)(ii) of the Act unless the debt had been acquired for the purpose of gaining or producing income from a business or property. Such a loss could arise where a taxpayer has loaned money at less than a reasonable rate of interest. Where subparagraph 40(2)(g)(ii) of the Act deems a loss to be nil, a taxpayer does not have a capital loss or a BIL under paragraph 39(1)(c) of the Act. However, where a taxpayer has loaned money at less than a reasonable rate of interest to a Canadian corporation of which the taxpayer is a shareholder, any subsequent loss arising from the inability of the corporation to discharge its obligation to him may be allowed and not considered to be nil by virtue of subparagraph 40(2)(g)(ii) of the Act if all of the conditions described in paragraph 6 of IT-239R2 are satisfied. One of the conditions is that the corporation must have ceased permanently to carry on its business. As indicated in paragraph 10 of IT-239R2, when this condition is not met but the shareholder sells his shares of the corporation to persons who intend to continue operating the business of the corporation, and, as a result, also transfers to the purchasers or settles his or her loan at less than face value, the loss may be allowed as a deductible capital loss if, in addition to the conditions specified in paragraphs 6(a), (b) and (d) of IT-239R2, the following conditions set out in paragraph 10 of IT-239R2 are satisfied:
(a) the sale of shares is at arm's length, and
(b) the agreement of the shareholder to accept an amount less than the amount of the debt owing to him is a condition of the sale of shares (or antecedent thereto).
However, the exception described above is only intended to apply when the former shareholder severs all ownership ties with the corporation by selling all his or her shares in the corporation. Since the Shareholder did not sell any shares, we are of the view the conditions set forth in paragraph 6 of IT-239R2 have not been satisfied. As a result, and because the loan did not bear interest, the Loss of the Shareholder should be regarded as being nil pursuant to subparagraph 40(2)(g)(ii) of the Act rather than being deductible for income tax purposes.
If you require further technical assistance, we would be pleased to provide our views.
For your information, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the legislation Access Database (LAD) on the Department's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version or they may request a copy severe using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Jackie Page at (613) 957-0682. The severed copy will be sent to you for delivery to the client.
Jim Wilson
Section Chief
Business, Property & Employment Section II
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch
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