8 August 2003 Internal T.I. 2003-0025837 - EXCHANGEABLE SHARES DEBT FORGIVENESS

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 CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: whether section 80 settlement of debt or capital gain

Position: yes

Reasons: legal termination of the debt on payment of the value of certain shares

August 8, 2003

	TORONTO CENTRE TSO	HEADQUARTERS
	Verification and Enforcement	Corporate Financing Section
		Denise Dalphy, LL.B.
	Attention: W.A. Ross MacFadden	(613) 941-1722

2003-002583

Exchangeable Debentures
XXXXXXXXXX

This is in response to your memorandum dated June 23, 2003 wherein you enquired whether XXXXXXXXXX redemption of certain exchangeable debentures would result in a capital gain or a forgiveness of debt pursuant to section 80 of the Income Tax Act (the "Act").

Facts

Our understanding of the relevant facts is as follows:

1. In XXXXXXXXXX issued XXXXXXXXXX% exchangeable debentures (the "debentures") maturing XXXXXXXXXX in the amount of US $XXXXXXXXXX .

2. The terms of the debt included a provision that the debentures were redeemable by XXXXXXXXXX either for XXXXXXXXXX common shares of XXXXXXXXXX (the "XXXXXXXXXX shares") for each US $XXXXXXXXXX of the principal amount of the debenture or for cash in an amount equal to the current market value of the XXXXXXXXXX shares at the time of the redemption.

3. In XXXXXXXXXX exercised its right to redeem the debentures for cash in the amount of US $XXXXXXXXXX for every US $XXXXXXXXXX principal amount, plus accrued interest to the redemption date. The total redemption price was US $XXXXXXXXXX.

4. The amount paid by XXXXXXXXXX to redeem the debentures was CDN $XXXXXXXXXX [US $XXXXXXXXXX] less than the principal amount of the debentures. For tax purposes, XXXXXXXXXX reported the gain in accordance with the rules in section 80 of the Act.

5. XXXXXXXXXX.

History of the Old Debt Forgiveness Rules

In discussing the history of the debt forgiveness rules, Canadian Tax Services - Stikeman Analysis stated:

The "old rule" was introduced in 1972, presumably as a result of the acceptance by Canadian courts of certain U.K. caselaw that suggested that gains resulting from the forgiveness of debt is capital in nature, and therefore not subject to income taxation. However, the Canadian courts did begin to distinguish between trade debts resulting from a vendor-purchaser relationship, and capital debts resulting from a borrower-lender relationship, with gains resulting from the extinguishment of trade debts considered to be profit under section 9. The old section 80 rules applied with respect to the settlement of all debt, but specifically did not apply where any resulting gain was otherwise included in income under section 9 (i.e., where the debt was a trade debt). The new section 80 rules, as discussed below, maintain this distinction.

Under the "old rule", when a taxpayer was relieved of the obligation to pay a debt, the forgiven amount was applied to reduce, in order, the taxpayer's:

• non-capital losses
• capital losses
• capital cost of depreciable property
• adjusted cost base of capital property, other than depreciable property.

If the taxpayer did not have sufficient basis in capital property to absorb the forgiven amount, any excess simply disappeared and there were no adverse consequences to the taxpayer.

However, as noted above, where the debt was not a capital debt, the forgiven amount may have been included in the income of the taxpayer pursuant to section 9, and thereby excluded from the application of the section 80 rules. Revenue Canada has had mixed results pursuing the application of section 9 to gains arising from the settlement of debt before the Courts. They were successful in Alco Dispensing Canada Ltd v The Queen, [1997] 3 C.T.C. 145 (FCA), [1996] 1 C.T.C. 2662 (TCC), dealing with the reversal of management bonuses, but not in Queenswood Land Associates Ltd v The Queen, [2000] 1 C.T.C. 352 (FCA) where funds were borrowed to acquire inventory. See also Molstad Development Co Ltd v The Queen, [1997] 2 C.T.C. 2360 (TCC) where money borrowed to finance assets, including inventory, was held to be a capital transaction and therefore a partial forgiveness of the debt did not give rise to an income inclusion under section 9. In Denthor Developments Ltd v The Queen, [1997] 1 C.T.C. 2075 (TCC) section 9 did not apply where money had been borrowed to acquire real estate for resale. The Court determined that no business profit could arise prior to the disposition of the real estate, and that section 9 would only apply to include a forgiven amount in income where the forgiveness was in respect of an expense that was deductible in computing income for the year of the forgiveness. For a situation where a forgiven amount gave rise to a benefit from employment and was therefore not subject to section 80 see John M Mcllhargey v The Queen, [1991] 2 C.T.C. 52 (FCTD)."

The Relevant Law

The relevant laws in this situation are contained in subsections 80(1) and (2) of the Act:

""forgiven amount" at any time in respect of a commercial obligation issued by a debtor is the amount determined by the formula

A - B
where
A is the lesser of the amount for which the obligation was issued and the principal amount of the obligation, and
B is the total of

(a) the amount, if any, paid at that time in satisfaction of the principal amount of the obligation, etc."

"(2) Application of debt forgiveness rules - For the purposes of this section,

(a) [when obligation settled] - an obligation issued by a debtor is settled at any time where the obligation is settled or extinguished at that time (otherwise than by way of a bequest or inheritance or as consideration for the issue of a share described in paragraph (b) of the definition "excluded security" in subsection (1));

Meaning of "settled or extinguished"

The terms "settled" and "extinguished" are not defined in the Act, but the meaning of these terms was considered in the following case law: Central City Financial Services Ltd. v. The Queen, [1997] 3 CTC 2949 (TCC) (aff'd [1999] 1 CTC 85 (FCA), Carma Developers Ltd. v. The Queen, [1996] 3 CTC 2029 (TCC), and Arcade Construction Ltd. v. MNR, 81 D.T.C. 655 (Tax Review Board).

In Central City, the Tax Court stated that the word "settle" connotes a final and legal resolution of a taxpayer's obligation whereby that obligation is reduced or brought to an end", that this question must be considered from the debtor's point of view, and that there must be "a formal and binding forgiveness or reduction of debt".

In Carma, Mr. Justice Bowman provided the following interpretation of the word "settle":

"The term "settle" has a variety of meanings, some of which are colloquial, in the sense that a problem is resolved one way or another. The terms "settle" or "compromise" are used in some of the documents. In the context of section 80, however, "settle" connotes a final and legal resolution of a taxpayer's obligation whereby that obligation is reduced or brought to an end. It must be considered from the point of view of the taxpayer who would be affected by section 80, not the creditor. Moreover, it must be a final and legally binding termination or reduction of the debtor's obligations." [emphasis added]

In Arcade Construction, MJ Bonner considered the meaning of "settled" as it was used in former section 80 of the Act. In this case, the corporate taxpayer corporation had borrowed money from a bank. In 1978, the bank reduced the loan by $16,000.

"The appellant says that it has not paid the bank. The bank says that someone has paid it and until that someone appears it does not intend to claim the money. In such circumstances I cannot find the debt has been extinguished."

It cannot, in my view, be said that on April 22, 1977, a debt or other obligation of the appellant was "settled" within the meaning of section 80. It seems to me that in ordinary English usage a debt or obligation is settled when creditor and debtor deliberately agree to fix or vary their existing rights and obligations. Nothing of the sort happened here." [emphasis added]

Interpretation Bulletin IT-239R, Debtor's Gain on Settlement of Debt

Paragraph 6 of IT-293R provides:

" For a debt or obligation to be "settled or extinguished" all liability for payment must be terminated. Payment, cancellation, set-off, substitution of debtors and release are examples of some possible means of settlement. A debt or obligation is not settled where a creditor abandons his right to enforce payment or becomes statute-barred from enforcing his right to payment. However, a settlement does occur where, by statute, the debtor's actual liability to pay is extinguished after a specified period of time has elapsed."

Our Comments

In our view, a determination as to whether a debt or other obligation is settled or extinguished is a question of the law of contract and commercial law. In the situation described above, all liability for its payment was terminated and the fact that the termination occurred pursuant to the terms of the XXXXXXXXXX debt obligation would not remove the settlement of the debt from within the ambit of section 80 of the Act. Although one could try to use an argument that the ratio in Arcade Construction would support a position that the debt forgiveness rules in section 80 of the Act do not apply where a debt is terminated pursuant to the original contract, since I believe that a court would conclude that any legal termination of the commercial debt obligation is sufficient to bring the transaction within subsection 80(2) of the Act. Further, when the Court in Arcade Construction stated that "...a debt or obligation is settled when creditor and debtor deliberately agree to fix or vary their existing rights and obligations." The Court was not considering a situation where the terms of the contract provided circumstances where the debt may be terminated on the payment of less than the principal amount, such as the future value of certain shares of the capital of a corporation. In addition, in the case of XXXXXXXXXX, the fact that, on forming the contract the debtor and creditor agreed on the repayment of the principal amount of the debt by a floating amount, does not mean that such an agreement would fall outside of the scope of section 80. While colloquially one might consider the forgiveness of debt rules to apply only where an action to vary the contract occurs after it has been formed, the scope of section 80 is much broader.

Finally, a debt obligation is a property of a creditor and it may be held by a creditor on capital or on income account. However, even if a debtor has incurred a debt for capital reasons, the debt obligation is a liability of the debtor: I have found no support that a debt obligation is a "property" of a debtor. It would seem that the capital gains rules on dispositions of property could not apply to debtors. At any rate, the specific rules in section 80 of the Act would take priority over the general rules of the taxation of capital gains in the Act (generalia specialibus non derogant -"wherever there is a particular enactment and a general enactment in the same statute, and the latter, taken in its most comprehensive sense, would override the former, the particular enactment must be operative" Dreidger).

We hope this opinion will be of assistance.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the CCRA's electronic library. 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 electronic library version, or they may request a copy severed using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

Steve Tevlin
Manager
Corporate Financing Section
Financial Industries Division
Income Tax Rulings Directorate