16 June 2016 Internal T.I. 2015-0597971I7 F - Perte réputée nulle - loss deemed nil -- translation

Principal Issues: The question is whether a debt was acquired by the taxpayer for the purpose of gaining or producing income from a business or property.

Position: No

Reasons: The taxpayers have not demonstrated that the debts were acquired for the purpose of gaining or producing income from a business or property. It is our view that when F1 and F2 made the debts to the company, they did not intend to draw an additional income from those debts or to protect a source of income for themselves.

								June 16, 2016

XXXXXXXXXX Taxation Centre 				Income Tax Rulings
XXXXXXXXXX 							Directorate
Business and Employment Division          	A. Dagenais, Advocate, M. Fisc. BAA

Attention: Mr. XXXXXXXXXX            		2015-059797

Application of subparagraph 40(2)(g)(ii) of the Income Tax Act

This memo is in response to your email of July 8, 2015 in which you requested our comments on the determination of whether a debt was acquired for for the purpose of gain or producing income from a business or property.

This also responds to your emails of February 11 and June 8, 2016 as well as a telephone conversation (Landry / XXXXXXXXXX) in which additional information was provided to us.

DESIGNATION OF THE PARTIES AND ABBREVIATIONS

For the present purposes, some names and company names, as well as some terms, have been replaced by the following names, company names and abbreviations:

XXXXXXXXXX									Corporation
XXXXXXXXXX									Mrs. A
XXXXXXXXXX									F1
XXXXXXXXXX									F2
Canada Revenue Agency    						CRA
Income Tax Act (1985), 5th Supp., C.1 as amended      	Act
Business investment loss            				BIL
Federal Court of Appeal							FCA
Tax Court of Canada     						TCC

All statutory references herein are references to provisions of the Act.

FACTS

Our understanding of the facts is as follows:

1) Mrs. A was the sole shareholder of Corporation. Over the years, she had invested $XXXXXXXXXX in Corporation.

2) F1 and F2 advanced sums to Corporation (hereinafter the "Debt" or "Debts," according to the context).

3) XXXXXXXXXX

4) Corporation issued non-interest bearing promissory notes, payable on demand, under which it promised to pay the sum of $XXXXXXXXXX to F1 and of $XXXXXXXXXX to F2.

5) Mrs. A, F1 and F2 held a building as co-owners XXXXXXXXXX. The building was used in the course of carrying on the business of Corporation.

6) For the taxation year XXXXXXXXXX, rental income from that property was $XXXXXXXXXX. Corporation was the sole tenant of the building and this amount constituted the rent which Corporation paid to the building owners.

7) On XXXXXXXXXX, the building was sold and Corporation ceased operations.

8) In XXXXXXXXXX, F1 and F2 determined that the Debt owing to them had become a bad debt. Each debt was due to them at the end of the year XXXXXXXXXX.

9) In their income return for XXXXXXXXXX, F1 and F2 elected for subsection 50(1) to apply.

10) In XXXXXXXXXX, F1 and F2 claimed a deduction for a BIL as defined in paragraph 39(1)(c).

11) A proposed assessment was provided under which you denied the BIL claimed by F1 and F2.

OPINION OF THE TAX CENTRE

You are of the view that the BIL deductions should be denied as losses resulting from the disposition of the Debts that are deemed to be nil by subparagraph 40(2)(g)(ii).

In your view, F1 and F2 had not acquired the Debts for the purpose of gaining or producing income from a business or property since the Debts were non-interest bearing.

You are of the view that there was no connection between the rental income of F1 and F2 and the Debts.

You agree that the Debts were bad debts at the end of the year XXXXXXXXXX.

OPINION OF THE TAXPAYERS’ REPRESENTATIVE

The representative disagrees with the proposed assessment. To support this disagreement, you tell us that the representative referred to two court decisions as follows:

"1 Although paragraph 40(2)(g)(ii) requires that a connection exists between the lender and the income that the lender can produce from the loan, it is not otherwise necessary that the lender has loan income. The quote from McDonald J. in The Queen v. Byram 99 DTC 5117 (FCA) remains authoritative: (While subparagraph 40(2)(g)(ii) requires a linkage between taxpayer (i.e. the lender) and the income, there is no need for the income to flow directly to the taxpayer from the loan.)

2- The recent judgment in Neil MacCallum v. The Queen 2011 DTC 1225 repeats the quote from Justice McDonald. In MacCallum, Justice Miller concluded that the loan guarantee made by Mr. MacCallum was to keep the Corporation in operation so that it could meet the payments due and protect the lender’s source of income. "

According to your request, the representative of the taxpayers provided the following arguments:

"The advances made by F1 and F2 were clearly made in order that the Corporation could continue to operate for the purpose of gain or producing income from which to pay the rent and repay debts. If the Corporation did not have the money necessary to continue operating, the rent would not have been paid and no amount repaid to the lenders. The loans made were made for the purpose of preserving the source of the Corporation's income and to preserve its active business. "

QUESTION

You wish our views and comments regarding the proposed assessment and the arguments of the representative of the taxpayers.

OUR COMMENTS

As we understand it, you are of the view that F1 and F2 would be entitled to the BIL deduction under paragraph 39(1)(c) were it not for the application of subparagraph 40(2)(g )(ii). Consequently, our discussion will be limited to the application of this subparagraph with respect to this particular situation.

In short, subparagraph 40(2)(g )(ii) provides that such a loss from the disposition of a debt is deemed to be nil unless the debt was acquired by the taxpayer for the purpose of gaining or producing income from a business or property.

In this situation, three conditions must be met for a loss to be deemed to be nil under subparagraph 40(2)(g)(ii). First, the amounts must constitute a "debt", next the loss must result from the "disposition of a debt" and finally "the debt ... was [not] acquired by the taxpayer for the purpose of gaining or producing income from a business or property… . "

Debt

In the current situation, F1 and F2 advanced sums to the Corporation and the promissory notes appear to have been issued to establish the existence of these debts to F1 and F2. Consequently, we are of the view that F1 and F2 held debts in this situation and that the first condition of subparagraph 40(2)(g )(ii) was satisfied.

Disposition of a debt

For the loss to be deemed to be nil under subparagraph 40(2)(g)(ii), the loss must result from the "disposition of a debt."

Paragraph 50(1)(a) provides where a debt owing to a taxpayer at the end of a taxation year (other than a debt owing to the taxpayer in respect of the disposition of personal-use property) is established by the taxpayer to have become a bad debt in the year, the taxpayer is deemed to have disposed of the debt at the end of the year for nil proceeds and to have reacquired it immediately after the end of the year at a nil cost, provided that the taxpayer elects in the taxpayer’s return of income for the year to have subsection 50(1) apply in respect of the debt.

For paragraph 50(1)(a) to apply, the taxpayer must establish that a debt owing to the taxpayer at the end of the taxation year is a bad debt. Since you have confirmed that the Debts were bad debts and the election was made for subsection 50(1) to apply, we are of the view that the second requirement of subparagraph 40(2)(g )(ii) was satisfied.

Debt was not acquired by the taxpayer for the purpose of gain or producing income from a business or property

The third requirement of subparagraph 40(2)(g )(ii) is that "the debt ... was [not] acquired by the taxpayer for the purpose of gaining or producing income from a business or property… . "

According to the courts (footnote 1), it is not necessary that an original purpose of gaining or producing income from a business or property is the predominant purpose for the loan. A subordinate purpose is sufficient.

The expression "gaining or producing income from a business or property" is not defined in the Act. Decisions rendered by the courts can assist in the determination of whether a debt was acquired for the purpose of gaining or producing gain or producing income from a business or property. According to the jurisprudence (footnote 2), this determination is made when the loan is made.

Moreover, according to the courts (footnote 3), the onus is on the taxpayers to demonstrate that, at the time of granting the loan, there was a genuine purpose to gain or produce income from a business or property.

Jurisprudence

Edwin J. Byram case (footnote 4)

The representative cited the Byram case in which the FCA considered the question of whether a taxpayer had acquired a debt to gain or produce income from a business or property where certain loans were made while the taxpayer was a direct shareholder and other loans while an indirect shareholder.

It is important to briefly summarize the facts of that case. For only part of the relevant period, Mr. Byram was a direct shareholder of the borrowing Corporation ("Corporation A"). During another part of the period, Mr. Byram was one of the shareholders of Corporation B. Corporation B was the sole shareholder of Corporation A. Mr. Byram was also a shareholder in Corporation C which was also a shareholder of Corporation B. During the relevant years, Mr. Byram made nine non-interest bearing loans to Corporation A to finance the activities of the latter. Four of the loans were made while Mr. Byram was a shareholder of Corporation A. The other five loans were made at a time when Corporation B was the sole shareholder. Furthermore, Mr. Byram and his family members were the main shareholders, officers and directors of the companies involved. Finally, for the years covered, the evidence showed that Corporation B became the sole shareholder of Corporation A for reasons related to immigration and not for commercial reasons.

In his analysis, Justice McDonald made the following comments:

"[16] The language of section 40 is clear. The issue is not the use of the debt, but rather the purpose for which it was acquired. While subparagraph 40(2)(g)(ii) requires a linkage between the taxpayer (i.e. the lender) and the income, there is no need for the income to flow directly to the taxpayer from the loan."

Thus, the Court decided that the linkage between the loan and the eventual dividend income was sufficient in the circumstances to give effect to the exclusion in subparagraph 40(2)(g )(ii) (i.e. to consider that the debt was acquired for gaining or producing income from a business or property). In this regard, Justice McDonald also made the following comments:

[17] Such an approach is also consistent with commercial reality. Frequently, shareholders make such loans on an interest-free basis anticipating dividends to flow from the activities financed by the loan. To adopt the position of the Minister would require that this Court ignore this reality. It would also be contrary to the comments of the Supreme Court of Canada in Stubart Industries Ltd. v. The Queen (footnote 5). Commercial reality is to be considered by the Courts in interpreting tax provisions like subparagraph 40(2)(g)(ii) so long as it is consistent with the text and purpose of the provision. (footnote 6 ).

[18] The ultimate purpose of a parent company or a significant shareholder providing a loan to a corporation is, without question, to facilitate the performance of that corporation thereby increasing the potential dividends issued by the company. This purpose is clearly within the scope of both the text and the purpose of subparagraph 40(2)(g)(ii), a section which is directed towards preventing taxpayers from deducting losses that are not incurred for the purpose of gain or producing income from a business or property.

[19] There is a growing body of jurisprudence that considers current corporate reality as being sufficient to demonstrate that the expectation of dividend income justifies a capital loss deduction under subparagraph 40(2)(g)(ii). As articulated above, this approach is consistent with current corporate realities and the purpose of subparagraph 40(2)(g)(ii).

[...]

[21] It is equally clear that the anticipation of dividend income cannot be too remote. It is trite law that sections 3 and 4 of the Act, in conjunction with the rules set out in subdivisions (a) through (d) of division B, establish that the income of a taxpayer is to be determined on a source by source basis. Furthermore, the availability of certain deductions under the Act, including subparagraph 40(2)(g)(ii), require that some regard be given to the source of income that is relevant to the deduction. Accordingly, a deduction cannot be so far removed from its corresponding income stream as to render its connection to the anticipated income tenuous at best. This does not preclude a deduction for a capital loss incurred by a taxpayer on an interest-free loan given to a related corporation where it had a legitimate expectation of receiving income through increased dividends resulting from the infusion of capital.

[22] The shareholders of a company are directly linked to that corporation"s future gain or producings and its payment of dividends. Where a shareholder provides a guarantee or an interest free loan to that company in order to provide capital to that company, a clear nexus exists between the taxpayer and the potential future income.9 Where a loan is made for the purpose of gain or producing income through the payment of dividends, this connection is sufficient to satisfy the purpose requirement of subparagraph 40(2)(g)(ii).

[23] In situations where the taxpayer does not hold shares in the debtor, but rather is a shareholder of a parent company or other shareholder of the debtor the taxpayer is not entitled to dividend income directly from the debtor. Generally speaking, the burden of demonstrating a sufficient nexus between the taxpayer and the dividend income, in such cases, will be much higher. The determination of whether there is sufficient connection between the taxpayer and the income earning potential of the debtor will be decided on a case by case basis depending on the particular circumstances involved. [Emphasis added] "

As stated in Income Tax Technical News No. 18, June 16, 2000, the CRA accepted the reasoning in this decision.

In our view, the principle identified by the Byram case is that there must be a link between the taxpayer and the future income but it is not necessary that the taxpayer directly receives the loan income. However, in these circumstances, if the taxpayer does not directly derive income from the loan, the taxpayer should indirectly derive income from the loan. In that case, the indirect purpose of gaining or producing income from a business or property was considered sufficient because of the potential right of the shareholders to receive dividends generated from the injection of capital.

In reaching this conclusion, the Court took commercial realities into account. Thus, when a shareholder makes a non-interest bearing loan to the shareholder's corporation to provide capital, it is realistic to expect that the activities financed by this loan will assist the corporation to generate additional profits to eventually be paid to the shareholder as in dividends. In other words, in this decision, the Court found that the purpose of the loans was to boost the corporation's performance so as to generate additional dividends attributable to the new loans. This link was considered sufficient to satisfy the condition based on the purpose specified by subparagraph 40(2)(g)(ii).

However, this decision indicates that the proof of the existence of a sufficient link between the taxpayer and the enhanced dividend income will be much harder to demonstrate where a taxpayer does not hold shares in the capital of the debtor corporation and has no right to receive a dividend directly from the debtor corporation. The FCA is of the view that the question of determioning whether there is a sufficient link between a taxpayer and the potential earnings from a debtor corporation is decided on a case by case basis, based on the facts of each situation.

Regarding the four loans which were made while Mr. Byram was a shareholder of Corporation A, taking into account the commercial reality, the Court concluded that the link between the loans and income in the form of increased dividends generated by infusions of capital gave rise to the creation of a debt acquired in order to gain or produce income from a business or property and it was sufficient to conclude that subparagraph 40(2)(g)(ii) would not apply.

Regarding the other five loans that were made during the period of time where Corporation B was the sole shareholder, the Court concluded that Mr. Byram had not received dividend income directly from Corporation A, but the Court was satisfied that the link between loans and potential dividend income was sufficient in the circumstances to give effect to the exclusion in subparagraph 40(2)(g )(ii). In reaching this conclusion, the FCA stated that the trial judge found that the reasons which prompted Mr. Byram to make these loans continued to apply, regardless of whether or not he was a direct shareholder of Corporation A. Furthermore, the FCA adopted the conclusions of the trial judge to the effect that Corporation B had become the sole shareholder for reasons related to immigration and not for commercial reasons. Finally, at all relevant times, Mr. Byram and his family members were the main shareholders, officers and directors of the companies involved. From these facts, we understand that Mr. Byram could legitimately expect to receive income in the form of increased dividends generated by the injection of capital.

We share the view of the representative to the effect that it is not necessary that the taxpayer derive income directly from the loan. However, we are of the view that it is clear from the judgment that the taxpayer must intend to derive increased income as a result of the loan. We are therefore of the view that the analysis by the taxpayer’s representative of the Byram case should have taken this principle into consideration. In our view, the application to this case of the principle in the Byram case requires a determination of whether F1 and F2 had the intention of deriving additional income from the loan. Based on what you have submitted, the taxpayer's representative did not take this requirement into account in the representations made.

MacCallum case (footnote 7)

In the submissions made, the representative quoted the MacCallum decision which applied the principle identified in the Byram case (footnote 8) to a taxpayer who was not a shareholder.

In the MacCallum decision, the TCC examined the question of whether a taxpayer had acquired a debt to gain or produce income from a business or property where he secured a line of credit from a bank for his son's corporation ("Mitchco"). The son of the taxpayer was the sole shareholder of the latter.

In short, in the facts of this case, the taxpayer held 51% of the shares in the SeaReach Holdings Ltd. corporation. ("SeaReach") and his wife held the remaining 49%. SeaReach was the sole shareholder of the D&N Truck Lines corporation ("D&N").

From February 1996 to June 1996, D&N provided equipment and materials to Mitchco so that the latter could perform one of its contracts. Mitchco was unable to pay D&N and the amount of its debt to D&N remained outstanding. In July 1996, Mr. MacCallum guaranteed the line of credit granted by the bank to Mitchco. In June 2003, to honour his guarantee, Mr. MacCallum made a payment to the bank. In September 2003, Mitchco ceased operations. Mr. MacCallum’s claim for a deduction for a BIL respecting the payment to the bank was denied.

The evidence demonstrated that a dispute respecting one of Mitchco's contracts had put it in a precarious financial position. This dispute led Mr. MacCallum to guarantee the loan from the bank to Mitchco. In this regard, witnesses confirmed that the lawsuit filed by MItchco against a third party was well founded and that they were convinced that the claim would succeed. According to the witnesses, the decision of Mr. MacCallum to provide the guarantee had in particular the commercial objective of allowing Mitchco to continue operations so that D&N could be repaid its debt at the end of the dispute. The objective was also to protect and recover a very significant source of income for D&N and for himself. The judge concluded as follows in paragraphs 43 to 46 of the decision:

“[43] I find that the Appellant has shown that one of his purposes for signing the guarantee in July 1996 was to support the continued existence of Mitchco, and thereby protect and collect a very significant source of earnings for D&N and for himself.

[44] This purpose was not too remote to satisfy the requirements of subparagraph 40(2)(g)(ii) of the Act.

[45] There was substantial evidence with respect to the business relationship between Mitchco and D&N and the Appellant. The Appellant was the majority shareholder of SeaReach which was the only shareholder of D&N. The only other shareholder in SeaReach was the Appellant’s spouse.

[46] The Appellant acted in a reasonable manner and with consideration for his own commercial interest. He is entitled to deduct the ABIL.”

The MacCallum decision extends the principle laid down in the Byram case by linking the purpose of gain or producing income from a business or property to income other than from dividends. Specifically, the MacCallum decision adopts the principle to the effect that where there is no direct link between the debt of the taxpayer and the income the taxpayer wishes to gain or produce from this debt, there must be a sufficient indirect connection.

The indirect purpose of gaining or producing income from a business or property was considered sufficient because of the particular facts of this case. According to the judge, Mr. MacCallum wished to allow Mitchco to continue its operations. Also, according to the judge, the result was that Mr. MacCallum wished to preserve and collect a very significant source of income for D&N and for himself. In our view, this entailed preserving the D&N business from which Mr. MacCallum could indirectly derive income. It was this purpose that was considered sufficient to satisfy the exception provided in subparagraph 40(2)(g)(ii).

According to our understanding of the judgment, the mere fact of wanting to help his son was not a determining factor in the judge's decision.

In our view, by guaranteeing the line of credit granted by a bank to Mitchco, Mr. MacCallum was hoping that Mitchco could eventually repay its debt to D&N. In our view, this is, however, not relevant in the judge's decision. Indeed, in paragraph 43 of the judgment, the judge referred to the fact that Mr. MacCallum was seeking to protect and collect a very significant source of income for D&N and for himself. He did not speak of the debt but the source of income which in our opinion was the business of D&N.

However, contrary to the position of the taxpayer’s representative and as we will see below, we are of the view that this requirement for a purpose of preserving and collecting a significant source of income is not satisfied in the file under review.

Our Position

To satisfy the requirement under subparagraph 40(2)(g )(ii), it is incumbent upon F1 and F2 to demonstrate that when they acquired the non-interest bearing Debts, they had an inention of deriving income from a business or property.

In the Byram case, Mr. Byram had demonstrated, taking into account the commercial realities, that when he made the non-interest bearing loans, he had the intention to gain or produce income in the form of increased dividends generated from the injection of capital. Consequently, the link between the debts and the additional income due to the loans resulted in there being a debt acquired for the purpose of gaining or producing income from a business or property, and this was sufficient in order to conclude that subparagraph 40(2)(g)(ii) did not apply.

Contrary to the Byram decision, we are of the view that when F1 and F2 provided the interest-free Debts, no fact demonstrates that they had the intention of deriving additional income from these Debts in the form of rental income or in another form. Consequently, we are of the view that the conclusions in the Byram case do not apply in this file.

In the MacCallum decision, Mr. MacCallum demonstrated that he derived income from the D&N business, which represented a considerable source of income for him. Accordingly, when Mr. MacCallum agreed to guarantee the line of credit granted by a bank to his son’s corporation, he protected a considerable source of income for himself. Consequently, since a link between the guarantee and the preservation of a considerable source of income for himself was demonstrated, the debt he had acquired at the time of subrogation, which took place when the guarantee was extinguished by the payment to the bank in June 2003, was considered to be a debt acquired for the purpose of gaining or producing income from a business or property, and this was sufficient to conclude that subparagraph 40(2)(g)(ii) did not apply.

Contrary to the MacCallum decision, we are of the view that when F1 and F2 provided the non-interest-bearing Debts, they did not preserve a source of considerable income. This source is the building. Indeed, Mrs. A, F1 and F2 owned a building that generated rental income. This income was derived from the holding of the building and represented the return from the holding of the building. Thus, unless proven otherwise, we are of the view that Mrs. A, F1 and F2 always had the option of renting the property to a tenant other than Corporation and thus continuing to gain or produce rental income from that property. Consequently, there is no basis for concluding that, when F1 and F2 acquired the Debts, they had the intention of preserving and recovering a considerable source of income for themselves. Since F1 and F2 have not demonstrated that by reason of the Debts they preserved a considerable source of income, we are of the view that the conclusions in the MacCallum case are not applicable in this file.

Finally, we wish to provide an additional argument for denying a BIL deduction. When F1 and F2 acquired the Debts of Corporation, we are of the view that they had more the character of debts between relatives; Mrs. A is the sole shareholder of Corporation. Thus, when F1 and F2 acquired the Debts in order to assist the XXXXXXXXXX business, although they might have wished to ensure the sustainability of Corporation, we are of the view that the Debts had no business purpose. Indeed, according to the facts, F1 and F2 respectively lent $XXXXXXXXXX and $XXXXXXXXXX without interest even while the regular rent earnmed by the three owners of the building was approximately $XXXXXXXXXX in total or approximately $XXXXXXXXXX each. In our view, these facts are not easily reconcilable with the commercial realities.

Conclusion

In this file, we are of the view that the exception under subparagraph 40(2)(g)(ii), respecting where each Debt was acquired for the purpose of gaining or producing income from a business or a property, is not satisfied.

Therefore, we recommend that you deny the BIL deductions that F1 and F2 have claimed.

For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. A severed copy will also be distributed to the commercial tax publishers, following a 90-day waiting period (unless advised otherwise to extend this waiting period), 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 the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be e-mailed to: ITRACCESSG@cra-arc.gc.ca. In such cases, a copy will be sent to you for delivery to the taxpayer.

We trust that these comments will be of assistance.

Michel Lambert, CPA, CA, M. Fisc.
Manager
Business and Employment Income Division
Income Tax Rulings Directorate
Legislative Policy
and Regulatory Affairs Branch

FOOTNOTES

Due to the our system requirements, footnotes contained in the original document are reproduced below:

1 Rich v. R., 2003 FCA 38, paragraph 10.
2 In this regard, see especially Curtis v. The Queen, 2004 TCC 156 (Tax Court of Canada [general procedure]), paragraph 56.
3 Id., Paragraph 64.
4 Edwin J. Byram v. R. 1999 CarswellNat 4251, [1999] 2 C.T.C. 149 (Federal Court of Appeal).
5 Stubart Investments Limited v. The Queen [1984] 1 S.C.R. 536.
6 Bronfman Trust v. The Queen, 87 D.T.C. 5059 (S.C. C.); [1987] 1 S.C.R. 32.
7 MacCallum v. The Queen, 2011 TCC 316 (Tax Court of Canada [general procedure])
8 Cited in footnote 4.