18 May 1993 Income Tax Severed Letter 9238377 - Sectorial Reserve

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department. Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

                                               May 18, 1993

NORTH YORK DISTRICT OFFICE                     HEAD OFFICE
                                               Rulings Directorate
Attn: Doug Mitchell                            Financial Industries
      Industry Specialist Services               Division
                                               B.G. Dodd
                                               (613) 957-3495

                                               923837

Paragraph 20(1)(l) and Sectorial Reserves

We are writing in reply to your memoranda dated December 21, 1992 and January 6, 1993 on the question of whether a sectorial reserve of a bank may be included in the determination of the reserve in respect of doubtful loans or lending assets which is deductible pursuant to subparagraph 20(1)(l)(ii) of the Income Tax Act. All references to statute are to the Income Tax Act or, as specifically denoted, to the Regulations thereunder.

Sectorial Reserve Defined

You indicate that a "sectorial" reserve or provision (also described interchangeably as a prudential or contingent reserve) is one which is not supported with specifics of a current threat to the particular account. Your December 21, 1992 memorandum also states at page 3:

"In the case of institutions under the supervision of OSFI, the regulatory authority have "suggested" to many institutions that they should establish what I have seen referred to as "sectorial" reserves. In the case of agricultural loans and/or real estate loans they have "suggested" that a reserve be established computed on the basis of a number of base points applied to the loan balance outstanding... In the case of banks, the regulatory authority states that reserves of this type are to be included in the "provision for doubtful credits" in the analysis of "allowance for Credit Losses" in the notes to the financial statement."

The Office of the Superintendent of Financial Institutions has issued Guideline C-3, dated October 1990, setting out the accounting practices to be followed by banks with respect to loan loss provisioning for financial periods beginning November 1, 1989. This states, in part:

"Banks will establish an Allowance for Credit Losses account...

The balance in the Allowance for Credit Losses account will consist of specific provisions, provisions for doubtful credits (emphasis added) and general country risk provisions...

            Provisions for Doubtful Credits

The provisions for doubtful credits include all the accumulated provisions for losses (other than the general country risk provisions) which are prudential in nature and cannot be determined on an item-by-item basis (emphasis added). These provisions should be established to absorb credit losses in a portfolio of on- and off- balance sheet items on which specific provisions cannot yet be identified (emphasis added). The portfolio will include items that are current and those that are delinquent in payments of interest or principal and in respect of which, in management's opinion, probable losses exist. These provisions must be against particular industries or geographical regions or other identifiable groups (emphasis added) of credits where credit quality has deteriorated...

Establishing Specific Provisions

Management ... should establish specific provisions when doubt exists as to the ultimate collectibility of particular credits. Provisions for doubtful credits should not be established as a substitute for specific provisions (emphasis added)..."

The term "sectorial reserves" as used hereinafter refers to "provisions for doubtful credits" described in Guideline C-3 as set out above.

(It is noted that while the above Guideline C-3 superseded Guideline G-20, dated September 30, 1989, effective for financial periods beginning November 1, 1987, the commentary regarding "provisions for doubtful credits" did not materially change).

It is assumed for purposes of this discussion that a bank's sectorial reserves are included in its financial statements.

Issue

The specific issue is whether or not sub-subclause 20(1)(l)(ii)(B)(II)(1) can include a sectorial reserve.

Stated another way, the issue is whether or not a provision for loan losses which is reported on the bank's financial statements and which:

- is prudential in nature,

- cannot be determined on an item-by-item basis, and

- is against particular industries, geographical regions or other identifiable groups (eg agriculture loans or real estate loans) where credit quality has deteriorated

is contemplated by the words "that part of the reserve for the loans reported in the financial statements of the taxpayer for the year in respect of the amortized cost to the taxpayer at the end of the year of the loans" in sub- subclause 20(1)(l)(ii)(B)(II)(1).

At the same time, it is also appropriate to consider whether a sectorial reserve is contemplated by the provision for "a reasonable amount as a reserve" in subclause 20(1)(l)(ii)(B)(I).

                            DISCUSSION

Meaning of Doubtful Loans or Lending Assets

The Department's position as set out in paragraphs 23 and 24 of IT-442R is that to be included in a reserve for doubtful debts under paragraph 20(1)(l), there must be reasonable doubt about the collectibility of the debt, having regard to such factors as the period of arrears, the debtor's financial status, etc. In other words, this must be done on a loan-by-loan basis.

This view is confirmed by the jurisprudence dealing with doubtful debt reserves, which jurisprudence is summarized by the Federal Court—Trial Division in the relatively recent case of The Coppley Noyes & Randall Limited v. Her Majesty The Queen, 1991 C.T.C. 541, where Reed, J. said at pages 549 and 550:

       "    The jurisprudence which exists with respect to
       estimating reserves for doubtful debts, for tax
       purposes, indicates that delay in payment alone is not
       sufficient to justify including an amount in a
       reserve: No. 409 v. M.N.R. (1957), 16 Tax A.B.C. 409;

57 DTC 136 (T.A.B.). Among the factors which may be taken into account in estimating a reserve are the time element (the age of the overdue account), the history of the account, the financial position of the client, any increase or decrease in the client's total sales, the taxpayer's past bad debt experience, the general business condition in the country and the business condition in the particular locality: No. 81 v. M.N.R. (1953), 8 Tax A.B.C. 82; 53 DTC 98 (T.A.B.).

            It is conceded that in order for an amount to be
       included as a reserve for doubtful debts there has to
       be more than just some doubt that the account might
       not be paid: Picadilly Hotels Ltd. v. The Queen,
       (1978) C.T.C. 658; 
78 DTC 6444 (F.C.T.D.).  The
       decision in No. 81 v. M.N.R., supra, rejected the
       assertion that every debt which is overdue is a
       doubtful one against which a reserve must be set up;
       see also Brignall v. M.N.R. (1961), 27 A.B.C. 233; 61
       DTC 488 (T.A.B.).  There must be good and
       substantial reason to question the likelihood that
       the account will be paid.  The Interpretation
       Bulletin issued by the Minister of National Revenue
       (No. 
IT-442
, paragraph 22) describes the test as
       follows:

            For a debt to be classed as a bad debt there must
            be evidence that it has in fact become
            uncollectible.  For a debt to be included in a
            reserve for doubtful debts it is sufficient that
            there be reasonable doubt about the
            collectibility of it...

            In Highfield Corporation Ltd. v.
       M.N.R.,(1982) C.T.C. 2812; 
82 DTC 1835 (T.A.B.) at
       2828 (DTC 1847), it was said:

            A "Reserve for doubtful debts" established under
            section 20(1)(l) of the Act would seem to leave
            with the taxpayer a much greater degree of
            flexibility in using business judgement with
            regard to the inclusion of amounts in such a
            reserve that (sic) is permitted to a taxpayer in
            claiming a deduction under section 20(1)(p) of
            the Act for a "bad debt".  The term "doubtful
            debt" in itself can mean only what it says—the
            debt is owing and possible of collection, but
            that possibility is not sufficiently certain in
            the mind of the taxpayer that he wishes to be
            placed in the disadvantageous position of having
            to pay income tax thereon before that possibility
            has become more of a certainty."

The jurisprudence is quite clear that a reserve for doubtful debts can only be established on a debt-by-debt basis. As noted above, "There must be good and substantial reason to question the likelihood that the account will be paid".

There being no reason to distinguish between a doubtful debt and a doubtful loan/lending asset in this respect, the jurisprudence supports the view that a sectorial reserve is not a reserve in respect of doubtful loans/lending assets because, by definition in the case of a sectorial reserve, it cannot be determined that collectibility of the underlying loans/lending assets is doubtful.

Subparagraph 20(1)(l)(ii)

As part of the 1987 tax reform process, the various doubtful debt reserves available to financial institutions under the Act were revised and consolidated in paragraph 20(1)(l). In the course of amendment, subparagraph 20(1)(l)(ii) underwent significant structural change so that while it provides for a reserve "in respect of doubtful loans or lending assets" (for insurers and money lenders in their ordinary course of business), the reserve is the aggregate of various amounts determined under specific rules in clauses (A) and (B).

The reserve amounts at issue are those which are provided in clause 20(1)(l)(ii)(B), as follows:

       "... the lesser of
            (I)    a reasonable amount as a reserve for the
                  loans ... and 

            (II)   (90%) of that part of the reserve for the
                  loans reported in the financial statements
                  ..." 

The preamble to this clause provides that where the word "loans" appears therein, it means "doubtful loans or lending assets for which an amount was not deducted by reason of clause (A)". Accordingly, both the reasonable reserve and the financial statement reserve in clause 20(1)(l)(ii)(B) are specifically in respect of doubtful loans or lending assets and based on the jurisprudence, neither of these would include sectorial reserves.

As a matter of context, it is also useful to consider the other reserve amounts permitted under subparagraph 20(1)(l)(ii) in respect of doubtful loans or lending assets. These are provided for in clause (A) thereof, ie. the "prescribed reserve amount", which is the aggregate of the amounts determined under each of paragraphs 8000(a) and (b) of the Regulations. Of these two reserves, one is of a somewhat general nature, and the other is very specific, pertaining solely to banks and their loan exposures in respect of certain (lesser developed) countries designated by the regulatory authority for banks.

The general reserve, paragraph 8000(b) of the Regulations, is determined by pooling types of loans or lending assets based on the length of time in arrears and applying the relevant historical loan loss experience factor to each. It specifically refers to loans or lending assets which are doubtful, both in its preamble and in the first step in the calculation in which the eligible loans or lending assets are to be identified (ie. those which are eligible under clause 20(1)(l)(II)(B) of the Act which specifically uses the word "doubtful"). This is clearly inconsistent with the notion of a sectorial reserve.

The reserve provided in respect of a bank's exposure to designated countries, paragraph 8000(a) of the Regulations, does not, however, specifically refer to the eligible loans or lending assets as "doubtful". Rather, the main criterion is based on the reporting of designated country loans or lending assets "in accordance with the guidelines established by the relevant authority (OSFI)" and the acceptability of the related reserves by that authority. In addition to specific provisions, paragraph 8000(a) of the Regulations refers to a bank's general provisions, which, as set out in Guideline C-3, are prudential in nature and are against particular designated countries or groups thereof. (Such general provisions are thus similar to sectorial reserves). The amount allowable for tax purposes is then determined, in part, with reference to a formula in which a specified percentage is applied to such loans or lending assets.

Thus, while paragraph 20(1)(l)(ii) provides for various reserves in respect of doubtful loans or lending assets, which in our view precludes sectorial reserves, paragraph 8000(a) of the Regulations nevertheless permits a reserve of this nature. However, this occurs in the context of a special purpose reserve, the amount of which is determined under a separate regime in the Regulations involving a set of very specific, self-contained rules based in part on criteria established by the regulatory authority for banks. As such, it is the wording in the specific rules which governs.

                 OTHER COMMENTS

Accounting Developments

As discussed above, the jurisprudence is clear that to be included in a reserve for doubtful debts, there must be valid reasons for considering a particular debt to be doubtful as to its collectibility, and sectorial reserves are inconsistent with this principle.

However, the fact remains that OSFI has established the sectorial reserve as an accounting practice to be followed by banks with respect to loan loss provisioning. Moreover, the CICA Accounting Standards Board in its Exposure Draft on Impaired Loans, dated November 1992, recommends, among other things, the establishment of the same type of reserve. Articles .13 and .14 of the Exposure Draft state:

".13 In addition to recognizing impairment in relation to individual loans, impairment may also be recognized for groups of loans to borrowers that operate in a particular industry or geographic region, or that share other identifiable common characteristics. Recognition of impairment for such groups of loans is required when information available is inadequate to permit identification of each of the individual loans within the group that is impaired, and specific events or changes in economic conditions indicate a deterioration in credit quality to the extent that reasonable assurance of collection of principal and interest in accordance with the loan agreements no longer exists. In these circumstances, after allowing for impairment identified on an individual loan basis, an allowance for impairment is recognized against the remainder of the group...

.14 Allowances for impairment against groups of loans are replaced by allowances against specific loans as soon as adequate information becomes available to identify those that are impaired and to estimate the extent of impairment in each case. Allowances against groups of loans are not a substitute for the identification of adequate allowances against individual loans."

It is intended that the recommendations in the Exposure Draft take effect not later than fiscal periods beginning on or after November 1, 1993 "but the Board encourages earlier adoption".

Accounting principles, whether established by the regulatory authority for banks or the accounting profession itself, thus are evolving in the area of loan loss provisioning. While the validity of the sectorial reserve from an accounting perspective is not in question, it is nevertheless clear that it is something new and that it differs from a reserve in respect of doubtful debts or doubtful loans/lending assets.

At best, the sectorial reserve can be regarded as a reserve in respect of a group or class of potentially doubtful loans/lending assets; however, the Act does not recognize a group or class of loans/lending assets which might be doubtful, only those specific loans/lending assets that are in fact doubtful (except, as noted elsewhere, in the case of the LDC loans of banks). Paragraph 18(1)(e) denies a deduction in respect of an amount as a reserve except as expressly permitted by Part I of the Act. A reserve in respect of a group or class of potentially doubtful loans/lending assets is not permitted (expressly or otherwise) by subparagraph 20(1)(l)(ii) or any other Part I provision and is therefore not deductible.

In the No. 81 v. M.N.R. case referred to earlier, it is stated at page 104:

"It has been held repeatedly by the courts that general accounting principles are to govern unless they are in conflict with the Act".

Thus, although GAAP may call for sectorial reserves, such reserves conflict with the interpretation of "doubtful debts" which has been judicially established for purposes of the Act and a departure from GAAP is therefore warranted.

Tax Policy

Whether or not the sectorial reserve should be deductible is a matter of tax policy for which the Department of Finance is responsible. We note that you discussed the issue with Ron Simkover of Finance who indicated that the reference to the financial statement reserves was intended to be on a tax basis and that "doubtful loans" should have its normal tax meaning. This appears to be borne out by Finance commentary with respect to the 1987 tax reform measures for doubtful debts of financial institutions. The quotations noted below (bold type indicates emphasis added by us) are taken from documents tabled in the House of Commons by the Minister of Finance, identified by source as follows:

#1 Supplementary Information Relating to Tax Reform Measures, December 16, 1987;

#2 Explanatory Notes to Draft Legislation and Regulations Relating to Tax Reform, April 1988.

The government was concerned with the fact that many profitable financial institutions had been successful in reducing taxes to zero and that this could continue into the future. "To bring low-taxpaying financial institutions into a taxable position", three areas were targeted for reform, one of which was the reserves allowed for doubtful debts, which the government intended to reduce (see #1, pages 84 and 85).

The existing doubtful debt treatment for tax purposes by financial institutions was not based on actual loss experience (eg. the formula approach in section 26, 33, 137, etc.) and allowed opportunities for tax deferral. It was the government's intention with tax reform to establish a system based on actual loss experience:

"The White Paper proposed that the tax system treat the doubtful debts of financial intermediaries in a uniform basis across sectors, based on the actual loss experience of the taxpayer..." (#1, page 87).

This primary objective was effected through the reserve in paragraph 8000(b) of the Regulations in which types of doubtful loans/lending assets are pooled according to arrears and the taxpayer's historical loss experience factors applied (pooling as opposed to a loan-by-loan basis).

The government recognized that reserves of financial institutions were also established on a loan-by-loan basis, and that these were based on a prudent level which was expected to exceed actual losses. To bring such reserves into line with the new tax system based on actual loss experience, the prescribed recovery rate was introduced to effectively discount these reserves by a factor of 10%, thereby approximating expected actual losses:

"In those cases where a doubtful debt reserve is established by examining individual loans, a prescribed recovery rate would be applied in order to eliminate the deferral of tax arising from the difference between the prudential level of the reserve and the actual loss experience." (#1, page 87);

"The government proposes a prescribed recovery rate on doubtful debts that are determined on a loan-by-loan basis... The government will continue to monitor the recoveries of provisions taken by financial institutions on individual loans ... in establishing an appropriate prescribed recovery rate in future periods." (#1 page 88);

"The prescribed recovery rate is the percentage reduction required for a doubtful debt reserve determined under subparagraph 20(1)(l)(ii) on an asset by asset basis rather than a pooled basis". (#2, page 381).

This was effected by means of subclause 20(1)(l)(ii)(B)(II) in which the prescribed recovery rate is applied to that part of the financial statement reserve pertaining to doubtful loans/lending assets determined on an asset by asset basis. Not being established on an asset by asset basis, the notion of a sectorial reserve is completely inconsistent with the subclause 20(1)(l)(ii)(B)(II) reserve.

Moreover, the overall context of tax reform in this area as discussed above suggests that rather than opening up the reserves, a concerted effort was made to eliminate the ability of financial institutions to deduct reserves which were prudential in nature, except as expressly provided for.

Audit Concerns

As noted at the outset, our views on this issue are based on the sectorial reserve being that which is described in OSFI's Guideline C-3 as the "provision for doubtful credits". From as assessing standpoint, this would theoretically mean that the disallowance of sectorial reserves might be relatively straightforward, assuming they can be readily identified. (See for example the published 1991 annual report of the Bank of Nova Scotia which reflects a sectorial reserve of $200 million.)

However, notwithstanding the fact that pursuant to the Guideline, the sectorial reserve relates to situations in which specific provisions cannot yet be identified and the requirement that it not be used as a substitute for specific provisions, you advised that this is not always the case in practice. You discussed the prospect that while an auditor might challenge a sectorial reserve deduction, it is possible that the taxpayer could substantiate deductibility on the basis of specific provisions through examination of the specific loans/lending assets for the particular sector. To the extent this is the case, there is some concern that challenging sectorial reserves might not be a productive use of audit time.

It would seem to us that unless there is some indication to the contrary (such as a qualified audit opinion on the financial statements), the Department's auditors should assume that the financial statements are prepared in accordance with GAAP. Inasmuch as GAAP stipulates that specific provisions are not to be included in sectorial reserve provisions, our auditors should accept these reserves as such. This should require very little audit time. The onus should be on the taxpayer to substantiate that its financial statements were not prepared in accordance with GAAP and that there are additional specific provisions to be taken into account. Such additional reserves presumably would be audited in the same manner as any other reserve. As a result, we would not think this would be a major concern from an audit perspective.

We hope this will be of assistance.

for Director Financial Industries Division Rulings Directorate

c.c.: Mr. R. Roy Assistant Deputy Minister Taxation Programs Branch