15 December 2005 Internal T.I. 2005-0156081I7 - novation 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: When does a change in the terms of a debt obligation result in a new obligation?

Position: Question of fact based on laws of contract in the relevant jurisdiction

Reasons: Case law

December 15, 2005

WINNIPEG TSO HEADQUARTERS
Verification and Enforcement Income Tax Rulings
Directorate
Attention: Noella Turcan G. Moore
(613) 957-8982

2005-015608

Disposition of Note

This is in response to your memorandum of October 26, 2005, in which you ask for our comments regarding whether a change to the terms of a Note results in a novation of the Note.

The situation is as follows: Corporation A owns Corporation B. A and B are Canadian companies. XXXXXXXXXX. In XXXXXXXXXX, A lends B $XXXXXXXXXX on an unsecured subordinated Note maturing XXXXXXXXXX at an interest rate of XXXXXXXXXX%. On XXXXXXXXXX, both A and B agree to amend the Note to change the interest rate from the above interest rate to the market rate of XXXXXXXXXX%. This has the effect of reducing the non-deductible interest expense in B and reducing the taxable income of A. No other terms of the Note were changed. If the change in interest rates is considered a novation, there is a deemed disposition of the Note at fair market value.

You are asking whether there is a disposition of the Note.

Our Comments

The CRA's current views regarding changes in the terms of debt obligations are set out in Income Tax Technical News No. 14, dated December 9, 1998. In that publication, we state that we have reviewed our comments in paragraph 7 of IT-448 and:

"As a result of the review, it is now our position that if a debt obligation is renegotiated otherwise than as provided for in its original terms, the determination of whether a change in its terms is a substitution of a debt obligation for another should be made in accordance with the law of the relevant jurisdiction.

. . .

. . . a rescission of a debt obligation will be implied when the parties have effected such an alteration of its terms as to substitute a new obligation in its place, which is entirely inconsistent with the old, or, if not entirely inconsistent with it, inconsistent with it to an extent that goes to the very root of it."

The current standard established by the courts regarding changes in the terms of debt obligations and whether the said changes have created a new obligation rather than simply modified an existing obligation, are set out in the findings of the Federal Court of Appeal in General Electric Capital Equipment Finance Inc. v. The Queen 2002 DTC 6734 (FCA). The taxpayer argued that no new obligation was created as a result of changes to the promissory notes relating to the amount of principal, interest, and the date of maturity as they were merely amendments to the original obligation. The taxpayer further argued that the only way an existing legal obligation can be superceded such as to acquire a new issue date is by means of a novation. When it can be said that substantial changes have been made to the fundamental terms of an obligation which materially alter the terms of that obligation, then a new obligation is created.

Justice Sexton in his reasons in General Electric Capital case considered the question of how to determine whether transactions have created a new obligation rather than simply modified an existing obligation and sought some guidance from the decision in Wiebe et al. v. The Queen 87 DTC 5068 (FCA) where the Court held that fundamental changes to a stock option agreement which substantially affected the basic elements of the agreement were inconsistent with the continuing existence of that agreement.

Whether the change in the terms of a debt obligation results in a "new" obligation for the purposes of the Act is a question of fact to be determined on the basis of the law of contract in the relevant jurisdiction.

Although the long line of case law that relates to novation/recission of contracts was not cited by the Federal Court of Appeal in the General Electric case, we are of the opinion that this decision is consistent with case law from at least the Morris v. Baron and Co. case in the House of Lords ((1918) AC 1) to, inter alia, Weibe et al v. The Queen (87 DTC 5068), Amirault v. MNR (90 DTC 1330), National Trust Co. v. Mead [1990] 2 S.C. R. 410] and Quincaillerie Laberge Inc. v. The Queen (95 DTC 47 and 155).

Where there has been a novation, recission, or accord and satisfaction at common law, it would usually mean that one contract/obligation has been replaced by a new contact/obligation.

Some guidance can be obtained from considering the case law relating to novation. In Prospect Mortgage v. Van-5 Developments Limited [1985] B.C.J. No. 2472 Mr. Justice Esson, speaking for the British Columbia Court of Appeal, said:

"Because novation is essentially an issue of fact, it would be wrong in principle to say, as a generalization, that assumption agreements or extension agreements, or other particular classes of documents, do or do not create a novation. The question must be decided in each case having regard to all circumstances of which the language of the new contract is only one."

This statement was quoted with approval by Madam Justice Wilson in National Trust v. Mead [1990] 2 S.C.R. 410 at page 432, who confirmed that novation is a question of fact.

We have reviewed the documentation you submitted. As indicated above, it is a question of fact whether there is a new Note or whether there was an amendment to the original Note. In our view, the change to the Note does not represent substantial changes to the fundamental terms of the Note. We are also of the view that the changes do not meet the "inconsistency" test referred to in Income Tax Technical News No. 14; that is, the amendment to the Note does not result in the amended Note being "entirely inconsistent" or inconsistent ... to an extent that goes to the very root of the Note as it existed prior to such amendment. As such, it is our view that the change is not sufficiently fundamental as to bring into existence a new Note.

We trust that these comments 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 Canada Revenue Agency'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 severed copy 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
for Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Policy and Planning Branch