14 December 1993 Income Tax Severed Letter 9318147 - Bad Debt Deduction for Part of a Loan

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.

                 RULINGS DIRECTORATE
                CORRESPONDENCE SUMMARY

DOCUMENT TYPE:

         District Office Memo

PRINCIPAL ISSUES:

         1. Whether paragraph 20(1)(p) permits a bad debt
         deduction for part of a loan.

         2. Whether subsection 18(13) applies on a sale from
         a resident to a non-resident.

POSITION TAKEN:

         1. Yes.

         2. Yes—not covered in response to D.O. but see
         research on file on this issue.

REASONS FOR POSITION TAKEN:

         Wording of subparagraph 20(1)(p)(ii) and subsection
         248(1) definition of "amortized cost" and case law
         on former paragraph 20(1)(p).

LEGAL:

         N/A

FINANCE OPINION:

         N/A

JURISPRUDENCE:

         See references in text of memorandum.

RCT PUBLICATIONS:

         Interpretation Bulletin 
IT-442R
—Bad Debts and
         Reserves for Doubtful Debts (see paragraph 5).

HAA NUMBER:

         5749—1

                                       December 14, 1993

     North York District Office        Head Office
     G. Troy, Director                 Rulings Directorate
                                       (613) 957-8953
     Attention:  Mr. D.W. Mitchell
                 Banking Specialist
                 Industry Specialist Services

                                       931814

Write-Off of Part of A DebtXXXXXXXXXX

This is in reply to your memoranda of June 8 and October 22, 1993, concerning the request by the above-named taxpayer for an interpretation of paragraph 20(1)(p) of the Income Tax Act (the "Act"). As discussed in our telephone conversation of December 8, 1993 (Spice/Mitchell), the taxpayer initially asked for our views concerning subsection 18(13) of the Act and its application to a sale by a resident corporate taxpayer to a non-resident, but has since conceded that it will apply. We, therefore, have limited the following remarks to the paragraph 20(1)(p) problem.

BACKGROUND

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PROPOSAL

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LAW

Subparagraph 20(1)(p)(ii) permits a deduction for the total of

"all amounts each of which is that part of the amortized cost to the taxpayer at the end of the year of a loan ... made ... by a taxpayer ... whose ordinary business included the lending of money established by him to have become uncollectible in the year."

The "amortized cost" at any time of a loan made in the year is defined in subsection 248(1) of the Act to mean

"the amount by which the total of

           1) all amounts advanced in respect of the loan at
           or before that time, and

           2) all amounts each of which is an amount in
           respect to the loan that was included under
           paragraph 12(1)(i) in computing the taxpayer's
           income for any taxation year ending at or before
           that time

exceeds the total of

           1) all amounts that, at or before that time, the
           taxpayer had received as or on account or in lieu
           of payment of or in satisfaction of the principal
           amount of the loan, and

           2) all amounts each of which is an amount in
           respect of the loan deducted under paragraph
           20(1)(p) in computing the taxpayer's income for
           any taxation year ending at or before that time."

The "amortized cost" of the loan is relevant for purposes of calculating both the reserve that can be taken for doubtful accounts under paragraph 20(1)(l) of the Act and the deduction under paragraph 20(1)(p).

ANALYSIS

The Department's position on bad debts is contained in Interpretation Bulletin IT-442R which, at paragraph 5, states:

"Where it is considered that a part of a debt is collectible and a part is not, a portion only of the debt may be viewed as a bad debt".

(Interestingly enough, this statement relates to an interpretation of subparagraph 20(1)(p)(i), a provision which makes no reference to a part or portion of the debt. In any event, paragraph 5 is applicable to subparagraph 20(1)(p)(ii) of the Act by reason of paragraph 10 of the Bulletin.)

The case law on paragraph 20(1)(p) pertains to the wording prior to the 1988 amendments, but is instructive. The primary case on the issue of debt write-downs is Hogan v. M.N.R. ( 56 DTC 183) a decision of the Tax Appeal Board.

In Hogan the taxpayer furrier claimed a bad debt with respect to a customer who had returned a new fur coat on which amounts were still owing. Another debt owed by the same customer for a second-hand coat was not claimed as a bad debt. The furrier claimed that in his opinion the customer was still likely to pay off the outstanding debt on the second hand coat. The Court agreed with the taxpayer with respect to this customer and with respect to other accounts which are not described in the case. The statement which is used to support the position that a debt can be partially bad is as follows:

"Respondent's (M.N.R.) counsel contended, also, that an account receivable could not be partially bad and partially doubtful, or even partially bad and partially collectable. I have stated above the circumstances given by the appellant in respect of at least one account which he felt was partially bad and partially recoverable. Other examples were given by the appellant in the course of his evidence, and I am satisfied that an account receivable may be considered to be partially bad and partially recoverable in certain circumstances, which may vary in each case." (at 193)

The situation with an account receivable, where all the amounts owing by one debtor/customer are aggregated, is not analogous to loans which are treated individually. There may indeed by situations where two loans to the same debtor may legitimately be treated differently by the creditor. But Hogan should not be cited as authority for the proposition that one loan can be separated into parts or portions with differing prognoses for collectability.

Granby Construction & Equipment Ltd. v. M.N.R. ( 89 DTC 456) (Tax Court of Canada) applied the Hogan case but only with respect to the general principles on determining when a debt is bad. The Granby case did not deal with a part debt for which the taxpayer was attempting to claim bad debt deduction and, therefore, is not a precedent for our purposes.

In Wesco Property Developments Ltd. v. M.N.R. ( 89 DTC 590), however, the Tax Court of Canada clearly agreed with the taxpayer that a portion of debt could be established to be bad. In that case shareholders made advances to a land development company in proportion to their shareholdings; they were advised approximately nine months later by the managing director of the debtor that they were unlikely to recover all their loans and that they should write off half of the advances. The Court held as follows:

"We have the testimony of (Wesco's) president who was really familiar with the situation. He made the judgment call that the portion of (Wesco's) indebtedness in the three years in issue that it deducted could simply not be recovered. On the evidence, and with the benefit of hindsight respecting what happened in subsequent years there can be no question that Mr. Trouth's decision was fully supported by the evidence at hand. He took into account the proper factors and came to the right conclusion. The argument advanced by counsel for the (Minister) that a debt cannot be bad in part only is, in my view, clearly not tenable. (The Court then goes on to cite Hogan as authority.)" (at 593)

Fradet v. The Queen ( 83 DTC 5445) is also cited as authority for the proposition that a bad debt can be claimed for a part of the debt, but the Federal Court (Trial Division) did not have to decide this question. It was advanced by the taxpayer, but it was not necessary for the Court to come to any conclusion on this issue although it surveyed the case law.

Although not raised, it might have been more beneficial to the Department to insist on a partial bad debt deduction in the case of Boudreault et al. v. The Queen (93 ETC 211). The synopsis of this Tax Court of Canada case (judgment rendered in French) reveals that the Minister wanted the taxpayer to take a bad debt deduction in an earlier year, but the taxpayer argued that there was still a chance of recovering the investment and the bad debt claim should be delayed until the year the debtor company was dissolved. The Court agreed with the taxpayer.

From a review of the foregoing caselaw, only Hogan and
Wesco have held that a part bad debt deduction is possible under
(now) paragraph 20(1)(p) of the Act, and Hogan did not deal with
one loan, but rather with two debts arising from separate transactions
between the same debtor and creditor. But, conversely, neither Court was
dealing with the legislation as amended in 1988 when the definition of
"amortized cost" and the reference to "part of the amortized cost" of
the loan were added.
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CONCLUSION

As discussed in the above-noted telephone conversation, it is your opinion that the Department has not been provided with sufficient information to take a position on the valuation of the bad debt at his time. You, therefore, intend to advise the taxpayer that a claim for a part bad debt is permitted under the legislation but that any such claim will be subject to later review by the Department. Since the substantiation of the amount of a bad debt is dependent on the facts and is also a matter of the creditor's judgement, we concur with your proposed approach to this matter.

We trust that the foregoing comments will assist.

for Director Financial Industries Division Rulings Directorate

c.c. B.A. Chisholm, Coordinator Financial Institutions, ISS