18 January 2001 Internal T.I. 2000-0055097 - PROMISSORY NOTES EXCH. FOR TRADE DEBTS

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.

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: Whether the Taxpayer may deduct a reserve for doubtful debts pursuant to paragraph 20(1)(l) of the ITA in respect of promissory note received from certain debtors in respect of overdue debts which could not be paid on time because of the financial difficulties encountered by them.

Position: Question of fact but likely yes.

Reasons: It depends on whether the Taxpayer accepted the promissory notes as conditional payment or as absolute payment of the original trade accounts. If the promissory notes were accepted as conditional payment only, a reserve may be claimed. Paragraph 3 of IT-436R states that CCRA will assume that the promissory note is received as conditional payment unless the sales agreement clearly indicates that the note has been accepted as absolute payment.

		January 18, 2001

	Toronto West Services Office	HEADQUARTERS
	Team Leader	J. Gibbons, CGA
	Technical Advisors	(613) 957-2135

	Attention: P. Gilkinson
		2000-005509

XXXXXXXXXX (the "Taxpayer")

We are replying to your email dated November 7, 2000, in which you requested our views on whether the Taxpayer may deduct a reserve for doubtful debts pursuant to paragraph 20(1)(l) of the Income Tax Act (the "Act") in respect of certain promissory notes receivable. As we understand it, the promissory notes were provided by certain debtors in respect of overdue debts which could not be paid on time because of the financial difficulties encountered by them. We understand that some promissory notes were received for capital items but that the reserve for doubtful debts is being considered only for those promissory notes (hereinafter referred to as the "promissory notes") that were received for trade accounts receivable that were included in income (hereinafter referred to as the "trade accounts").

In the statement of facts included with your memorandum, you outlined the history of the Taxpayer's trade accounts leading up to the time when the promissory notes were received in respect thereof. We did not outline these facts because we believe that the primary issue in this case is whether the Taxpayer accepted the promissory notes as absolute or conditional payment of the trade accounts. Only when this is determined, can one determine whether the Taxpayer is entitled to a deduction under paragraph 20(1)(l) of the Act. You should note that we have not reviewed whether the quantum of the Taxpayer's deduction is reasonable in the circumstances, i.e., whether the deduction reflects the amount of trade accounts that are in fact doubtful.

Audit's View

Your Auditors are of the view that any write-off of the Taxpayer's promissory notes should be treated as being on account of capital. Their position appears to be based on the fact that the Taxpayer removed the trade accounts from its general ledger and posted them separately as promissory notes receivable, and also because these notes range in terms from one year to thirty years. In this regard, Audit has made reference to paragraphs 14 and 15 of Interpretation Bulletin IT-442R, "Bad Debts and Reserves for Doubtful Accounts."

Your view

Your view is that the promissory notes should retain their original character for income tax purposes, i.e., as accounts receivable, thus qualifying for the deduction under paragraph 20(1)(l) of the Act.

Our views

As noted above, the issue of whether a reserve for doubtful debts may be taken with respect to the promissory notes depends on whether the Taxpayer accepted them as conditional payment or as absolute payment of the original trade accounts. In this regard, paragraph 2 of IT-436R states that conditional payment means that the "vendor is considered to have accepted the note as evidence of or security for the debt and the creditor's rights to recover the original debt owing is merely suspended until such time as the maker of the note fails to honour the note" and absolute payment means that "the vendor is considered to have accepted the note as full or actual payment of the debt, and, as such accepts the note at the risk of the note being dishonoured with the only legal recourse being an action against the maker of the note for failure to honour the said note."

Paragraph 3 of IT-436R states that "Normally the Department will assume that the promissory note is received as conditional payment unless the sales agreement clearly indicates that the note has been accepted as absolute payment." Accordingly, unless there is an indication in the relevant agreements or other documentation suggesting that the promissory notes were accepted as absolute payment, our view is that they should be considered to have been received by the Taxpayer as conditional payment. If they are deemed to have been received as conditional payment, a reserve for doubtful debts on the promissory notes may be deducted by the Taxpayer in respect of the original trade accounts, subject to the test of reasonableness.

If it is determined that the Taxpayer accepted the promissory notes as absolute payment of the trade accounts, it is our view that these accounts will be considered to have been settled at that time and the income tax treatment outlined in paragraph 14 of IT-442R will apply. According to this paragraph, a taxpayer may be entitled to a deduction under paragraph 20(1)(p) for bad debts when the taxpayer accepts property as full settlement of an income debt and the fair market value of the property received is less than the amount owing or amortized cost.

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 Agency'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 severed using the Privacy Act criteria, which does not remove client identity. You may request this latter version by contacting Jackie Page at (613) 957-0682, who will send the severed copy to you for delivery to the client.

John Oulton, CA
Section Manager
Business and Individual Section
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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