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: Income Tax treatment of damage costs and a related forgivable loan
Position: General comments provided
November 17, 2009
Dear XXXXXXXXXX :
Re: Damage costs and a related forgivable loan
This is in response to your e-mail dated July 10, 2009, wherein you requested our views concerning the income tax treatment of damage costs and a related forgivable loan.
You presented the following situation:
1. A stock broker (the "Broker"), who is an employee of a firm (the "Firm"), makes an error on a trading transaction.
2. As a result of the error, the Broker has to pay $XXXXXXXXXX in damages to the party whose account he was dealing with, to compensate the party for a loss on the transaction.
3. The Firm considered itself partly responsible for the error and agreed to the following arrangement:
The Firm will make an interest-free loan to the Broker in the amount of $XXXXXXXXXX that will be amortized and forgiven in equal amounts over a period of XXXXXXXXXX years, i.e., $XXXXXXXXXX each year, unless the Broker leaves the current employment before the XXXXXXXXXX -year period ends, in which case the Broker will have to repay the Firm any outstanding loan balance.
Written confirmation of the tax implications inherent in actual proposed transactions is given by this Directorate only where the transactions are the subject of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, entitled Advance Income Tax Rulings. This Information Circular and other Canada Revenue Agency ("CRA") publications can be accessed on our website at http://www.cra-arc.gc.ca. If, however, the particular transactions are completed or partially completed, the enquiry should be addressed to the relevant Tax Services Office. Your request was not submitted as an advance income tax ruling request, however, as stated in paragraph 22 of IC 70-6R5, we do provide written opinions on general enquiries which are not advance income tax rulings and we are prepared to provide you with the following comments.
Where an individual is an employee, he or she may be eligible to claim a deduction under the provisions of subsection 8(1) of the Income Tax Act (the "Act) in computing his or her income for a taxation year from an office or employment. Further, subsection 8(2) of the Act provides that no deduction may be made in computing an individual's income from an office or employment, except as permitted under section 8 of the Act.
Under certain circumstances, paragraph 8(1)(f) of the Act allows for deductions pertaining to sales expenses where the taxpayer was employed in the year in connection with the selling of property or negotiating of contracts for the taxpayer's employer. One of the requirements for an amount to be deductible under paragraph 8(1)(f) of the Act, is that the amount must have been expended for the purpose of earning employment income. Another requirement is that the amount cannot be on account of capital such as, for instance, an expenditure made in order to protect a taxpayer's right to earn commissions (i.e., where the taxpayer's license as an agent was in jeopardy of being revoked). However, whether an expense is in the nature of income or capital is a question of fact.
An employee who is entitled to deduct expenses pursuant to paragraph 8(1)(f) of the Act, may deduct reasonable amounts paid during the year in respect of costs arising from an event that by its nature is a risk normally incidental to the income earning activity. For example, a real estate agent may deduct legal fees in a defence against charges of misrepresentation in connection with an aborted sale of property. The legal expenses would not be deductible, however, if they were of either a capital or personal nature.
In any situation, it is a question of fact whether particular amounts paid on account of damages by an employee meet the requirements of paragraph 8(1)(f) of the Act and are partly or entirely deductible. Further, it should be noted that, in a situation where an employee has an expense that satisfies the requirements of paragraph 8(1)(f) of the Act, a related forgivable loan has its own inherent tax consequences that should not generally affect the amount deductible under paragraph 8(1)(f).
In the given situation, we do not have sufficient information to comment further on the deductibility of the damage costs.
Pursuant to subsection 6(15) of the Act, where a loan to an employee is partially or fully forgiven, the forgiven amount is considered a taxable benefit to the employee and is included as employment income pursuant to paragraph 6(1)(a) of the Act. As an example, in the given situation, the forgiven amount in each of the XXXXXXXXXX years, i.e., $XXXXXXXXXX each year, will be considered a taxable benefit to the Broker pursuant to subsection 6(15), and included in income pursuant to paragraph 6(1)(a).
In the event the Broker leaves the current employment and repays the outstanding loan balance to the Firm, there will be no further tax consequences in relation to the loan.
Taxable benefit on the interest-free loan
Subsection 80.4(1) of the Act provides for an amount to be included in a taxpayer's income in respect of low interest or interest-free loans provided because of an individual's office or employment. This amount, which is basically interest at the prescribed rate on such a loan for the period it was outstanding during the year less any interest paid on such a loan, is deemed to be a benefit received in the year, and this benefit is brought into income under subsection 6(9) of the Act.
Subsection 80.4(3) of the Act provides two exclusions from the rules set out in subsection 80.4(1) of the Act. Firstly, paragraph 80.4(3)(a) provides that a benefit will not arise where the rate of interest payable on the debt is equal to or greater than the rate of interest that would have been agreed upon in an arm's length transaction at the time the obligation was incurred. Secondly, paragraph 80.4(3)(b) provides that subsection 80.4(1) does not apply if another provision of Part I of the Act brings the loan or debt into the income of the debtor.
The CRA's view on the income tax treatment of benefits arising from interest-free or low-interest loans and debts is discussed in Interpretation Bulletin IT-421R2, Benefits to Individuals, Corporations and Shareholders from Loans or Debt. This bulletin also discusses the tax consequences that may arise as a result of the forgiveness of these loans.
Paragraph 11 of the Interpretation Bulletin, IT-421R2, provides an example of the tax consequences of an interest-free forgivable loan as follows:
"Where a loan to an employee is partially or fully forgiven after February 17, 1987, the amount forgiven is income in the hands of the employee in accordance with subsection 6(15). However, paragraph 80.4(3)(b) would not apply so as to reduce any benefit included in the employee's income pursuant to subsection 80.4(1) in a prior year in respect of such a loan. In such prior year or years, no part of the loan would have been included in income and the employee would have enjoyed the use of the funds in those years. As an example, assume Mr. X, an employee of ABC Limited, receives an interest-free loan from his employer of $25,000 on January 1, 1987 by virtue of his employment. No principal repayments were made and the loan was settled in June, 1988 by a payment of $5,000. A benefit, calculated pursuant to subsection 80.4(1) on the full amount of the loan, would be included in Mr. X's 1987 income. Mr. X's 1988 income will include the amount forgiven of $20,000 pursuant to subsection 6(15), and a benefit computed under subsection 80.4(1) in respect of the $5,000 actually repaid, for the period this latter amount was outstanding in 1988. No benefit would be computed under section 80.4 for 1988 in respect of the amount forgiven, as a result of the application of paragraph 80.4(3)(b). However, this paragraph would not serve to reduce the 1987 benefit, as no part of the loan was included in Mr. X's income in 1987."
Thus, in the given situation, a taxable benefit pursuant to subsection 80.4(1) of the Act will be calculated and included in the income of the Broker pursuant to subsection 6(9) of the Act, for the amount of loan outstanding in each of the XXXXXXXXXX years. By virtue of subsection 80.4(3)(b), there will be no taxable benefit calculation under subsection 80.4(1) on the amount of the loan that is brought into income in that year as a result of loan forgiveness. However, if the Broker leaves the current employment, such that he repays the outstanding loan, the taxable benefit calculation under subsection 80.4(1), will be calculated for the period that the loan was outstanding during that year.
We trust our comments will be of assistance to you.
R.A. Albert, CA
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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