9 July 2002 Internal T.I. 2000-0051797 - DEBTORS GAIN ON SETTLEMENT OF DEBT

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues:

? Whether the comments concerning amounts otherwise included in income as stated in paragraphs 19(e), 25 and 26 of Interpretation Bulletin IT-293R entitled "Debtor's Gain on Settlement of Debt" are still valid.

Position:

? Yes

Reasons:

? These comments can be supported by the case law and, following the amendments to the Debt Forgiveness Rules, continue to be relevant in determining whether the characterization of the settlement of debt should be treated as being on account of income or on account of capital.

	Claude Englehart, Director	HEADQUARTERS
	Technical Applications Division	B. Kerr
	Audit Directorate	957-3498

Attention: Holly Carswell

		2000-005179

Interpretation Bulletin IT-293R - Debtor's Gain on Settlement of Debt

We are writing in response to your memorandums dated October 10, 2000 and October 26, 2001, in which you suggest that, owing to the significant amendments to section 80 in 1995 and recent jurisprudence, we review the CCRA's positions which are described in the Bulletin.

In particular, you refer to the comments in paragraphs 19(e), 25 and 26 concerning the exclusions for amounts otherwise included in computing income and ask whether these comments continue to be relevant.

In regards to paragraphs 19(e) and 25 of the Bulletin, you briefly review the Courts reasons in British Mexican Petroleum Co. Ltd v. Jackson 16 TC 570, Alco Dispensing Canada Ltd. v. The Queen 97 DTC 5463 and Queenswood Land Associates v. The Queen 2000 DTC 9065 and conclude that this jurisprudence is confusing and contradictory thus making it difficult to discern a clear judicial test to be applied to determine whether a forgiveness of a particular debt is on income or capital account. You then state that paragraphs 19(e) and 25 of the Bulletin require clarification in order to update the CCRA's position on this issue.

With respect to paragraph 26 of the Bulletin, you ask whether the comments in this paragraph apply to cases where the arrangements have been made under the Companies Creditors Arrangements Act?

Our Comments

The Bulletin predates the current version of section 80 (generally applicable to taxation years that end after February 21, 1994), and as such certain comments in the Bulletin may not reflect the CCRA's current position. Nevertheless, we have had occasion to consider the comments in paragraphs 19(e), 25 and 26 of the Bulletin on several occasions since 1995 and until recently, considered them to be relevant in determining whether a forgiven amount is required to be included in computing the debtor's income for the year from a business or property or is subject to the rules in section 80. However, recent findings by the Courts involving, for example, settlements of debts on money borrowed from a lender in the course of a borrower-lender relationship are not reflected in paragraphs 19(e) and 25 of the Bulletin.

Paragraphs 19(e) and 25

Where an obligation is settled in a taxation year and there is a forgiven amount, the debt forgiveness rules in section 80 of the Act may apply. The debt forgiveness rules do not apply to the principal amount of an excluded obligation, which is defined in subsection 80(1) of the Act. An obligation is considered an excluded obligation if, inter alia, the principal amount of the obligation would, if it were settled without any payment, be included in the debtor's income in the absence of sections 79 and 80. In effect, section 80 will not apply in certain circumstances where the gain on the settled debt is of an income nature.

In this regard the courts have held that the forgiveness of trade debts and similar obligations incurred in the course of carrying on a business are, in certain circumstances, included in the debtor's income under the general rules of profit computation under section 9 of the Act. The findings of the courts indicate that the determination depends on the purpose and effect of the forgiveness and the use of the debt proceeds. Where it is a trade debt or on account of income, it may be included in the taxpayer's computation of profit under section 9 of the Act. If the debt is considered on account of capital, section 80 of the Act may apply.

The comments in paragraphs 19(e) and 25 relate to forgiveness of a trade debt (including trade payable) and a debt forgiven in respect of merchandise or other property in which the debtor deals.

The Court's reasons in British Mexican Petroleum which you correctly identify as the basis for the CCRA's position on trade debts forgiven in a taxation year subsequent to that in which the debt was incurred as described in paragraph 25 of the Bulletin, involved a settlement of a trade account payable in a year subsequent to the year in which the debt was created. The Court stated that income is determined on a yearly basis and adjustments that arise from events in subsequent years affect the income of neither the original year nor the subsequent year. The House of Lords held that prior years could not be reopened and that the release from liability to repay did not give rise to income in the year of settlement. In this case the Court:

? considered the debtor's gain on the settlement to be a gratuitous forgiveness in order to keep British Petroleum in business;
? concluded the debtor's gain on the settlement to be on account of capital; and
? found that as it was on account of capital it should not be included in income.

However, the Supreme Court's reasons in Oxford Motors Ltd v. MNR 59 DTC 1119 (SCC) considered the issue of a gain by a debtor on a forgiveness of debt and whether, relying on the reasons in British Mexican Petroleum such gain should be treated as a "capital accretion". In this regard, the Supreme Court states [at p. 1122]:

The British Mexican case did not decide, that under no circumstances can the forgiveness of a trade debt be taken into account, in determining the taxable profit arising from the carrying on of a business... .

In Oxford Motors the taxpayer's supplier forgave a portion of a debt in respect of the purchase of its car inventory. The forgiveness was granted in the form of a rebate and it was concluded that the rebates in question were intimately related to the appellants trading operations and that the profit realized from them was a trading profit from the business.

The courts reached a similar conclusion in Enjay Chemical Co Limited v. MNR 71 DTC 5293 (FCTD). In this case the taxpayer purchased on credit chemical products from a related company. The chemical product was part of the inventory of the taxpayer and in the immediately subsequent year the creditor forgave a portion of the indebtedness. In its reasons the Court stated [p. 5302]:

If it is found that the forgiveness of a debt in this case was of a capital nature then the British Mexican case clearly applies and it is not taxable, but if, on the other hand, it is considered that it was in the nature of a discount or subsidy paid to supplement respondent's trading receipts, then the Lincolnshire Sugar and Oxford Motors cases apply.

The Court then reasoned [p. 5302 & 5303]:

Unlike the British Mexican case in which it was an express term of the agreement that the sum remitted should be applied by the debtor to reduce the amount shown in its books in respect of its assets to a figure more nearly representing the present value thereof, the remission in the present case seems to have been made to allow respondent to make the profit which it had anticipated making on the sale of the oxo-alcohol at the original price, and that Esso International Inc., although not obliged in any way to make the remission, did have an indirect interest in assisting the respondent company in this way. I would apply, therefore, the dictum of Abbott J. in the Oxford Motors case (supra):

. . . In deciding upon the meaning of income, the Courts are faced with practical considerations which do not concern the pure theorist seeking to arrive at some definition of that term. and where it has to be ascertained for taxation purposes, whether a gain is to be classified as an income gain or capital gain, the determination of that question must depend in large measure upon the particular facts of the particular case.

The Court found that

Taking a common sense commercial view of the matter, therefore, and not allowing the real issue to be obscured by the accounting practice adopted by respondent in this case, it is evident that respondent, as a result of this forgiveness of debt, was enabled to make a profit in the 1962 taxation year which is before me rather than suffering a loss which was otherwise inevitable and that it should, accordingly, pay the appropriate taxation on this profit.

The Court then concluded that the forgiveness had the effect of reducing the taxpayer's cost of goods sold and the benefit was spread over two taxation years as the inventory was sold thereby increasing profits during those years.

Three more recent cases Alco Dispensing Canada Ltd v. The Queen 97 DTC 5463 (FCA), Molstad Development Company Limited v. The Queen 97 DTC 913 (TCC) and Queenswood Land Associates v. The Queen 2000 DTC 9065 (FCA) considered the reasoning of the Courts in the earlier mentioned cases. In all three cases the taxation years involved ended before February 22, 1994, and the Court made a finding on the classification of the gain (i.e. income gain or capital gain) on the basis of the particular facts of the case.

With respect to the Alco Dispensing case the FCA in its decision delivered from the bench dismissed the taxpayers appeal substantially for the reasons offered by Justice Bonner of the Tax Court of Canada wherein he stated:

Furthermore I will observe that the assertion that the forgiveness of the bonus is a capital transaction is clearly illogical. If the creation of an enforceable obligation to pay bonus results in a cost which diminishes profit so also must the receipt of a waiver intended to boost profit by eradicating that same obligation result in an increase in profit.

It is our view that in future, any factual situations similar to those in Alco Dispensing, may, depending upon the timing of the transactions, be subject to the provisions of subsection 78(4) which deals with an amount in respect of a taxpayer's expense that is unpaid remuneration that includes salary and wages and is unpaid on the day that is 180 days after the end of the taxation year in which the expense was incurred.

In both the Queenswood Land Associates and the Molstad Development cases the taxpayer borrowed money from a financial institution which it then used to acquire inventory. In both cases the debt including all accrued and unpaid interest increased over time to a point where it significantly exceeded the fair market value of the inventory. The debts were ultimately settled such that in both cases the debtors realized gains on the settlement of the debt. However, in both cases the courts reasoned that notwithstanding that the borrowed monies were used to fund the acquisition of inventory, the debt incurred in a borrower-lender relationship is nevertheless considered capital. In this regard, the Federal Court of Appeal in its reasons in Queenswood Land Associates stated:

More recently, the Tax Court of Canada, in a case [Molstad Development] that appears to be on all fours with the present one had to rule on the character of the forgiveness of a debt owed pursuant to a loan advanced to finance the borrower's land development business. Rip, T.C.C.J. expressed the view that the question as to whether the forgiveness of a debt is on revenue or capital account depends on whether the debt itself is on revenue or capital account. He went on:

When a person subscribes for share capital in a corporation the transaction is a capital transaction regardless of the use the corporation applies the money. The corporation may use the funds to purchase a plant or use the funds to purchase its inventory; in both cases the money obtained from shareholders is capital. Similarly when a corporation borrows money from its banker to finance acquisition of assets, including inventory, for example, the transaction between the lender and borrower is a capital transaction. The debt is on capital account.

Rip, T.C.C.J. later concluded:

The repayment of the loan by [the borrower] would not have affected its profit in the year of payment; neither should the forgiveness of part of the loan affect its profit. The partial forgiveness of the debt amounted to no more than a saving to [the borrower] and a saving of money is not to be included in a taxpayer's income.

The CCRA's positions set out in paragraphs 19(e) and 25 do not reflect the Courts reasons in the Queenswood Land Associates and the Molstad Development cases.

With respect to your comment that this jurisprudence is confusing and contradictory such that it is difficult to discern a clear judicial test to be applied to determine whether a forgiveness of a particular debt is on income or capital account we refer again to the Supreme Courts statement in the Oxford Motors case [at p. 1122]:

whether a gain is to be classified as an income gain or capital gain, the determination of that question must depend in large measure upon the particular facts of the particular case.

Paragraph 26

With respect to paragraph 26 of the Bulletin it is our view that the reference therein to "other federal or provincial legislation relating to creditors, arrangements" would include arrangements under the Companies Creditors Arrangements Act. This position is consistent with the findings of the Courts as set out above and in particular, with British Mexican Petroleum since the Courts would likely consider an arrangement under such legislation to be a gratuitous forgiveness in order to keep a taxpayer in business and in light of the discussion on capital debts in a borrower-creditor arrangement in Queenswood Land Associates.

We wish to note that IT-293R should likely be revised to reflect the new legislation and continuing relevant jurisprudence. As part of that review, we will look at the possibility of adding additional comments which may be of help in determining whether a gain on settlement of an obligation is to be classified as an income gain or capital gain and will be consulting with you to obtain your feedback on the new commentary.

Paul Lynch
Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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