14 February 1991 Internal T.I. 903667 F - Changes in the Terms of Debt Obligations

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.

Dear Sirs:

Re:  Sub paragraph 40(1)(a)(iii) & Paragraph 79(e) of the Income Tax Act (the Act)

This is in response to your letter dated December 12, 1990 requesting  clarification on the operation of the above noted sections.  The hypothetical situation described in your letter follows:

1.     The vendor, a Canadian resident individual, sells a non-depreciable capital property to a purchaser (a Canadian resident corporation) in 19X0.  The vendor and purchaser are at arm's length.

2.     Under the terms of the sale agreement, the vendor takes back a mortgage as part of the consideration.  The terms of the mortgage are as follows:

-     5 year term

-      Interest rate at 10%, payable semi-annually

-     Principal payments of 10% of the balance outstanding, payable annually

3.     In the following year (19Xl) the purchaser requested the following amendments to the terms of the mortgage:

-     Change the mortgage to non-interest bearing.

-      Waive the annual principal payments.

Specifically you have asked whether these amendments would result in a disposal of the debt by the vendor precluding him from claiming a reserve under subparagraph 40(1)(a)(iii) of the Act.

Our Comments

Paragraph 7 of Interpretation Bulletin IT-448, Dispositions -Changes in Terms of Securities, states the Department's position on changes in the terms of debt obligations:

7.  "The following changes in respect of the debt obligation itself(unless carried out pursuant to an authorizing provision in its original terms) are considered to be so fundamental to the holder's economic interest in the property that they almost invariably precipitate a disposition:

(a) a change from interest-bearing to interest-free or vice-versa,

(b) a change in repayment schedule or maturity date,..."

The chances in mortgage terms that you have described will result in a disposition of the original debt as explained above.  Whether a reserve under 40(1)(a) would still be available in this case depends on whether the renewed mortgage is accepted as continuing evidence of the original debt.  Consistent with paragraphs 2 and 3 of Interpretation Bulletin IT-436R if the renewed mortgage is accepted as absolute payment of the original debt so that the vendor no longer has legal recourse with respect to the original debt (and therefore with respect to the proceeds on the original disposition) no reserve would be permitted thereon.  Whether the new debt represents absolute payment or continuing evidence of the existence of the old debt would be determined upon examining the facts of each case.

Your second question asks whether a vendor would be entitled to a reserve under subparagraph 40(1)(a)(iii) in a year where a vendor instigated foreclosure procedures (19X1), but did not actually acquire the property until after the year end (19X2).

If the debt obligation becomes due in 19X1 (e.g. through an acceleration clause or if the creditor exercises his right to demand the full amount as due), the creditor will not be entitled to claim a reserve under subparagraph 40(1)(a)(iii) in 19X1.  In addition he must include in his 19X1 income any amount claimed as a reserve in the previous year.

The full recognition of the gain would occur in 19X1.  This gain would be reflected in the cost of the property reacquired in 19X2 pursuant to paragraph 79(f) of the Act.

We trust this information will be of assistance.

Yours truly,

for DirectorBusiness and General DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch