23 September 2011 Ruling 2011-0411151R3 - Tax Treatment of a Payment under a Guarantee

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: 1. Is a judgment against the guarantors a second loan or a continuation of the initial loan?
2. What is the tax treatment for a payment under a guarantee of indebtedness of a corporation?

Position: 1. No.
2. The payment could be treated as a capital loss, a business investment loss, or a non-capital loss.

Reasons: 1.It is neither a second loan nor a continuation of the initial loan. If the judgment is paid, the guarantors would generally be considered to have acquired the rights of the creditor and would have recourse against the corporation to the extent of the payment.
2. Case law.

									September 23, 2011

	Financial Sector & Exempt Entities Division	HEADQUARTERS
									Income Tax Rulings
									  Directorate
	Attention: Roberta Albert, Manager			Lindsay Frank
	                 Corporate Financing Section	(613) 948-2227

									2011-041115

Tax Treatment of a Payment under a Guarantee

This is in reply to a request from Vyjayanthi Srikanth for assistance in deciding the tax treatment of a judgment against a taxpayer, who failed to make good on a guarantee.

Two creditors provided a corporation with financing, which was secured by mortgages on the corporation’s buildings, and personal guarantees from the corporation’s beneficial owners. Subsequently, the creditors declared the loans to be in default and placed the company in receivership. The amount recovered from the receivership was insufficient to satisfy the amount provided as financing, and one of the creditors called on the beneficial owners under the guarantees for payment of the deficiency. To that effect, two years after the receivership, the creditor obtained judgment plus interest against the guarantors.

One of the guarantors has claimed a deduction under paragraph 20(1)(c) of the Act for the interest portion of the judgment. It is unclear, however, if the guarantor made any payments on the judgment.

Ms Srikanth has posed the following questions:

1. Is the judgment against the guarantors a second loan or is it a continuation of the initial loan?

2. What is the tax treatment for a payment under a guarantee of indebtedness of a corporation?

Answers

1. Is the judgment a second loan or a continuation of the initial loan?

The judgment is neither a second loan nor a continuation of the initial loan. A judgment is the decision or sentence of a court in a legal proceeding. In the instant case, it is the final determination by the court of the rights and obligations of the litigants. A taxpayer, who makes a payment under a guarantee of indebtedness of a corporation, will generally be considered to have acquired the rights of the creditor in respect of the indebtedness at the time of payment, see Abrametz v. The Queen, [2009] 4 C.T.C. 173, 2009 D.T.C. 5083 (F.C.A.). It is unclear whether in this case the taxpayer made an actual payment. If a payment was made, the taxpayer could have recourse against the corporation, to the extent of the payment.

2. What is the tax treatment for a payment under a guarantee of indebtedness of a corporation?

An amount paid by a guarantor under a guarantee of indebtedness of a corporation creates an account receivable against the corporation. If the account receivable becomes uncollectible, a bad debt would result, and the bad debt could be treated either as a capital loss or as an allowable business investment loss (“ABIL”). In M.N.R. v. Steer, [1966] C.T.C. 731, 66 D.T.C. 5481 (S.C.C.), it was held that the loss is a capital loss, if incurred in honouring a guarantee on a loan negotiated by a company in which the guarantor held an equity interest. However, the judgment in Armstrong v. The Queen, [1977] 2 C.T.C. 2615 (T.C.C.), stands for the proposition that an ABIL is available to a guarantor, who makes a payment under a guarantee, provided that there is compliance with subsection 39(12) of the Act. But see Abrametz above, wherein it was held that a guarantor could claim an ABIL without satisfying subsection 39(12), as long as paragraph 39(1)(c) has been met.

It goes without saying, however, that the foregoing tax treatment cannot be considered unless it has been determined that the guarantor did indeed make a payment.

In closing, although not relevant to this interpretation, it should be noted that a guarantor could realise a non-capital loss, as well, from honouring a guarantee. Such would arise if the guarantee were given in the ordinary course of the taxpayer’s business for the purpose of earning an ongoing and increasing income stream, see Lachapelle v. M.N.R., [1990] 2 C.T.C. 2396, 90 D.T.C. 1876 (T.C.C.).

Should you have any questions or require additional information, please do not hesitate to contact Lindsay Frank at the number provided at the outset of this memorandum.

B.J. Skulski
Manager
Insolvency and Administrative Law Section
International & Trusts Division
Income Tax Rulings Directorate

c.c. Vyjayanthi Srikanth
Corporate Financing Section
Financial Sector & Exempt Entities Division