11 April 1990 External T.I. 58705 F - Tax Treatment of Bond Premium

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.

SUBJECT: 24(1) Tax Treatment of Bond Premium

We are writing further to the memorandum of our Division to our dated May 11, 1989 and the submissions of 19(1) 19(1) dated September 18, 1989 and March 9, 1990.  The issue involves the tax treatment under the Income Tax Act (the "Act") 24(1)

Our Position

We confirm our position on the tax treatment of the premiums received, which is as follows:

i)     24(1)

ii)     In accordance with the principals set out in Robertson Ltd. v. M.N.R. (1944) 2 DTC 655 (Exch.), the full amount of the premiums have the quality of income when received and therefore are included in income of the issuer under section 9 of the Act, as the premiums represent consideration for the issuance of the obligations and are received regardless of the period of time that the debt is outstanding.  We understand that the facts establish  24(1)

iii)     Generally accepted accounting principles (GAAP) apply in computing income for tax purposes except to the extent that the Act provides otherwise. The decision in Burrard Yarrows Corporation v. The Queen 86 DTC 6459 (FCTD) (affirmed by the Federal Court of Appeal in Versatile Pacific Shipyards Inc. v. The Queen 88 D T.C. 6352) indicates that the Act "provides otherwise" in  24(1) situation.

iv)     Paragraph 18(1)(e) of the Act prohibits a deduction for a reserve except as expressly permitted by the Act.  The reserve provisions of paragraph 20(1)(m) of the Act do not apply and the other reserve provisions of the Act do not allow the amortization of the premium.

Comments on Letter of September 18, 1989 from 24(1) Counsel

24(1)

Taxpayer's Counsel Position

24(1)

Comments on Position of Counsel for the Taxpayer

The position of counsel for the taxpayer is based on the view that GAAP should apply in determining whether premiums received on the issuance of a debt obligation form part of a taxpayer's income for the purposes of subsection 9(1) of the Act.

It is our view that, on the receipt side, GAAP is not the determining factor in computing income for tax purposes but rather the more appropriate test is that established in Robertson Ltd. v. M.N.R. wherein Mr. Justice Thorson stated:

     "The question remains whether all of the amounts received by the appellant during any year were received as income or became such during the year.  Did such amounts have, at the time of their receipt, or acquire, during the year of their receipt, the quality of income to use the phrase of Mr. Justice Bandeis in Brown v. Helvering...  In my judgment, the language used by him ... lays down an important test as to whether an amount received by a taxpayer has the quality of income.  Is his right to it absolute and under no restriction, contractual or otherwise, as to its disposition, use or enjoyment?"

In the decision of Dixie Lee (Maritimes) Ltd. v. The Queen 88 DTC 610 (F.C.T.D.), 24(1)  the taxpayer entered into franchise agreements with persons wishing to operate individual outlets.  The taxpayer attempted to amortize its receipts on granting a franchise over the period of the franchise.

Mr. Justice McNair summarized the taxpayer's position as follows at 6110:

     "The whole case of the plaintiff, as it seems to me, rests on the premise that the franchise fee revenue was entitled to de ferment on a straight line amortization basis over the life of the franchise agreement because the revenue was attributable in large measure to the obligation of the franchiser to protect its trade mark "Dixie Lee" for the benefit of its franchisees and to provide as well to the latter ongoing services as part of the franchise relationship.

     The plaintiff's principal submission is simply this.  If the franchise fee revenue is required to be included in income under paragraph 12(l)(a) of the Income Tax Act then it is entitled by virtue of paragraph 20(l)(m) of the Act to deduct the amount of $92,795 as a reasonable reserve in respect of its reasonably anticipated ongoing obligation to deliver goods and render services for the benefit of its franchisees over the life of the franchise agreements, including the use by them of its trade mark. Alternatively, the plaintiff submits that if the amount of $92,795 is to be included in its income for the 1977 taxation year under subsection 9(l) of the Act, the plaintiff' is entitled in accordance with generally accepted accounting principles to treat that franchise fee revenue as unearned income and claim a corresponding deduction in respect thereof."

In dealing with the question as to whether the apportionment of franchise fee revenue over the period of the franchise was acceptable under the circumstances for purposes of subsection 9(1) of the Act, Mr. Justice McNair commented at 6112-6113:

     "By subsection 9(1) of the Act, a taxpayer's income for a taxation year from a business or property is his profit therefrom for the year.

     Mr. Justice Cartwright alluded to the predecessor provision [s. 4] in Dominion Taxicab Assn. v M.N.R., 54 DTC 1020 (S.C.C.), stating at p. 1021:

     ...The expression "profit" is not defined in the Act.  It has not a technical meaning and whether or not the sum in question constitutes profit must be determined on ordinary commercial principles unless the provisions of the Income Tax Act require a departure from such  principles ...It is well settled that in considering whether a particular transaction brings a party within the terms of the Income Tax Act its substance rather than its form is to be regarded.

     Edwin C. Harris, Canadian Income Taxation, 4th ed., makes the following statement in reference to subsection 9(1) at p. 430:

     ...This rule has been interpreted to mean that the taxpayer must adopt the method for computing his annual income that most nearly accurately reflects his profit - which is essentially a question of following "generally accepted accounting principles" except where the Act, or a limited number of court decisions that follow no clear principle, requires otherwise.  Speaking in accounting terms, the rule requires that there be a reasonable "matching" of revenues and related expenses in any fiscal period.

     Generally speaking, an amount received by a taxpayer in a taxation year is taxable income in his hands if his right to it is absolute and subject to no restriction as to its disposition, use or enjoyment, regardless of whether or not it is earned in that particular year: Robertson Ltd. v. Minister of National Revenue, 2 DTC 655, 1944 Ex. C.R. 170.  It is always useful in cases where there is an argument over the applicability of any particular system of accounting from the standpoint of ordinary commercial principles to recall the statement of President Thorson in M.N.R. v. Publishers Guild of Canada Limited, 57 DTC 1017 (Ex. Ct.) at p. 1026

     ...What the court is concerned with is the ascertainment of the taxpayer's income tax liability. Thus the prime consideration, where there is a dispute about a system of accounting, is, in the first place, whether it is appropriate to the business to which it is applied and tells the truth about the taxpayer s income position and, if that condition is satisfied, whether there is any prohibition in the governing income tax law against its use.  If the law does not prohibit the use of a particular system of accounting then the opinion of accountancy experts that it is an accepted system and is appropriate the taxpayer's business and most nearly accurately reflects his income position should prevail with the Court if the reasons for the opinion commend themselves to it....

     Based on the totality of evidence, I consider that Mr. Henry's opinion is the more reasonable and acceptable one under the circumstances.  I find therefore that the plaintiff has not met the onus of establishing on balance of probability that its method of recognizing franchise fee revenue by straight line apportionment over the ten-year period is cognizable according to generally accepted accounting principles within the preview of subsection 9(1) of the Income Tax Act."

Conclusion

24(1) it can be considered to be realized income when received under section 9 of the Act.  Therefore, it is not necessary to consider the appropriate treatment under GAAP.  As paragraph 18(1)(e) of the Act preclude 24(1) from claiming a reserve on the premium, the full amount of the premium is subject to tax in the year of receipt.

Even if a successful argument could be made that the premium could be considered to be a receipt which is "unearned" and therefore lacking the quality of income, in the sense referred to by Joyal J. in Burrard Yarrows Corporation v.  The Queen, the general wording of subparagraph 12(1)(a)(i) of the Act" ...  that, for any other reason, may be regarded as not having been earned in the year or a previous year" would require inclusion of such receipt in income, for which no reserve would be permitted pursuant to any of the subparagraphs of paragraph 20(1)(m) of the Act.

J.C. ClarkChiefLeasing and Financing SectionFinancial Industries Division Rulings Directorate