25 February 1988 Income Tax Severed Letter 7-2053 - Sections 28 and section 78 of the Income Tax Act

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.

FEB 25 1988

TO Edmonton District Office Attention: J. R. O'Hara Manager 143-1

FROM HEAD OFFICE Small Business and General Division C. Tremblay Tel: (613)957-2139

RE: Sections 28 and section 78 of the Income Tax Act

This is in reply to your memorandum of August 20, 1987, in which you request our opinion concerning the application of section 78 of the Income Tax Act (the "Act") to the proposed reassessment of XXXXXXXX The Facts provided are as follows:

XXXX

Audit Review Position

XXXX

Our Comments

The cash basis method of reporting income, provided for in section 28 of the Act, applies to the revenues produced by the farming business itself. The same applies to expense deductions allowable in computing income from farming on the cash basis, the expenses must be for the purposes of generating business income from farming. In the case of interest expense, to be deductible on the cash basis, the proceeds of the loan on which the interest is payable must be used in the farm business itself.

It is our view that section 28 of the Act has no relevance in the situation at hand. In the case of XXXX the interest income which is accruing to him is property income and not business income. It is accruing to him as a result of the disposition of a capital property, that is, it is a result of the exchange of his farm property for a 1/3 interest in the partnership and two demand notes. The interest income is from the disposition of a capital property and is not something which was generated in the course of carrying on the farm business. As stated in IT-396 paragraph 28, such a taxpayer is subject to the provisions of 12(1)(c) and 12(4) of the Act with respect to this interest income from a source other than from the farm business.

We note that while the provisions of 12(4) of the Act as amended are applicable to taxation years commencing after 1982, this does not preclude interest which has accrued prior to 1983 from being brought into income after 1982.

It is also our view that section 28 of the Act has no relevance to the interest expenses incurred by XXXX. This interest expense was incurred in connection with the acquisition of a capital property, not in connection with a loan, the proceeds of which were directly used in the farm business, nor in the course of carrying on the farm business. Consequently, it would seem that they are entitled to deduct their interest expenses on the notes on the accrual basis as long as they comply with the provisions of subparagraph 20(1)(c)(ii) of the Act. However, if this amount is not paid within the time stipulated in section 78 of the Act, the amount "shall be included in computing the taxpayers income" for the third taxation year in which the expense was incurred.

We have some reservations regarding the last point which arises from the facts presented to us. We are told that paragraph 3(d) was deleted by agreement dated XXXX. This paragraph provided that interest would be at the rate of XXXX payable annually with principal to be amortized over XXXX years. In the face of this XXXX which appears to have been equal to about three years interest at XXXX. We can only assume that paragraph 3(d) was replaced in part by some other arrangement. It is possible that the notes issued also stipulated a rate of XXXX and these were never changed and it was not intended that they be changed. Thus, while annual payments were no longer required, interest presumably continued to accrue. This you may verify by audit.

We trust our comments will be of assistance.

ORIGINAL SIGNED BY

for Director Small Business and General Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch