6 July 1994 Administrative Letter 9323826 F - Bonds Issued in Lieu of Interest

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.

PRINCIPAL ISSUES:

1. Whether receipt of bonds issued in lieu of interest on non-performing loans constitutes receipt of a payment of interest.

2. What are the resulting tax implications.

POSITION TAKEN:

1. No.

2. Various  —  see summary at beginning of reply.

REASONS FOR POSITION TAKEN:

1. Bonds were issued because the interest was not paid.

2. Various  —  see reply.

July 6, 1994

Head Office	Head Office
Audit Technical Support Division	Rulings Directorate
Industry Specialist Services	B.G. Dodd
	957-8953

Att: B.A. Chisholm, Coordinator       Financial Institutions

932382

Subject: Bonds Received in lieu of Interest

We are writing in reply to your memorandum (per Doug Mitchell, North York District Office) dated August 19, 1993.

We apologize for the delay. Unless as otherwise stated, all references to statute are to the Income Tax Act S.C. 1970-71-72, c. 63 as amended, consolidated to June 10, 1993 (the "Act") or regulations thereunder (the "Regulations").

Summary of Conclusions

In view of the length of this memorandum, we are including at this point a brief summary of our views on the major items as follows:

(a)     interest on the underlying non-performing loans is required to be included in income in the year in which such interest accrues (eg. 1989 and 1990), pursuant to subsection 12(3);

(b)     to the extent collection of that interest was or is doubtful, a reserve under subparagraph 20(1)(l)(i) was or is available;

(c)     the bonds issued in settlement of the arrears interest on the underlying loans do not constitute payment of that interest; the arrears interest remains outstanding, to be paid in the form of "principal" payments under the bonds;

(d)     in the year of receipt of the bonds, the amount of any subparagraph 20(1)(l)(i) reserve in respect of the arrears interest on the underlying loans should not exceed the amount by which the arrears interest exceeds the fair market value of the bonds at the time of receipt;

(e)     subsection 76(1) is unlikely to have any application with respect to the receipt of the bonds because the interest was (will have been) included in income in the preceding years in which it accrued, as described in (a) above;

(f)     a reserve is not available under paragraph 20(1)(l) in respect of the bonds themselves (other than with respect to interest thereon, if doubtful  —  such interest must be included in income pursuant to subsection 12(3));

(g)     a writedown under section 10 is not available with respect to the bonds;

(h)     receipt of the bonds does not constitute payment of the interest on the underlying loans and so does not give rise to tax sparing; and

(i)     tax sparing applies to the initial holder with respect to principal payments made under the bonds, as well as to interest payments thereunder (if tax sparing is otherwise applicable).

FACTSWe understand the situation to be as follows.

XXXXXXXXXX was unable to pay interest which it owed to various lenders, including the XXXXXXXXXX (the "Bank") which has requested your views in connection with the ensuing arrangements.

We assume that the loans in respect of which the interest is owing by XXXXXXXXXX are, relative to the Bank (and presumably other affected Canadian banks), included as part of its "exposure to designated countries" as referred to in section 8000 of the Regulations.

IDU Bonds

Interest was due and unpaid as of December 31, 1990. This is referred to as "PDI" (past due interest). There was also interest on past due interest and interest on past due principal, which is referred to as "IOA" (interest on overdue accounts). Together these amounts are referred to as IDU.

     XXXXXXXXXX

EI Bonds

The international financial community entered into an agreement (the 1992 Financing Plan) on December 29, 1992 which included arrangements related to interest arrears accruing during 1991, 1992 and 1993 (up to the date of exchange). The arrangement provides that a portion of outstanding interest is to be paid in cash, with the balance, referred to as "eligible interest", to be exchanged for "EI Bonds". Pursuant to the arrangement, upon receipt of its portion of EI Bonds, a lender's eligible interest is to be discharged. The characteristics of the EI Bonds are generally similar to those described above with respect toIDU Bonds (and it is expected that there will similarly be a market for them).

At the time of your writing, the EI Bonds had not yet been issued.

Policy of the Regulatory Authority

You advise as follows:

     "The recognition of any portion of the income on the loan is subject to the rules established for the treatment of payments received on non-accrual loans (OSFI Guideline C-2-2 and C-2-3). The regulatory authority's policy is that banks should follow the accounting treatment outlined in the non-performing loans guideline (OSFI Guideline C-1-7). This guideline permits the recognition of interest payments on non-accrual sovereign risk loans only when the payments are received in cash. Since bonds were received, rather than cash, they have recommended that the bonds not be reflected in the taxpayer's books. The Canadian Bankers Association have stated that the tax treatment should parallel the accounting treatment dictated by the Office of the Superintendent of Financial Institutions. When the Department requested further information regarding this particular issue from OSFI, they referred us to the guideline on non-performing loans."

DISCUSSION

For purposes of this discussion

-     we generally refer to the IDU Bonds but our comments would apply equally to the EI Bonds with suitable modifications for such things as the relevant taxation year, and

-     the relevant authority is referred to as "OSFI".

Our comments on the issues which you raised as well as related matters are set out below.

Interest on Non-performing Loans

Assuming there is no disagreement on the underlying Brazilian loans being debt obligations, subsection 12(3) is applicable and requires the inclusion in the income of the Bank of interest accrued on the loans to the end of the particular year.

On this basis, it is our view that the arrears interest on the underlying loans which accrued in the years 1989 and 1990 should already have been included in the Bank's income for those years. In the event that this has not been the case for a particular year or years, we would think that reassessments of the applicable years would be in order. Where a particular year is statute barred, an open year may be selected (presumably the first available year) and all unpaid interest accrued to the Bank to the end of that year on the loans, which would include any unpaid interest accrued from prior years, should be included. In this regard, subsection 12(3) is cumulative in nature in that it contemplates all interest that accrued to date and then excludes amounts thereof which have been included in income in preceding years.

To the extent the amount is so included in income and is doubtful of collection, a reserve under subparagraph 20(1)(l)(i) would be available and should be allowed in conjunction with any reassessments noted above. Once the accrued interest has been included in income and a reserve, if any, allowed, subsequent years would involve the add-back under paragraph 12(1)(d) of the prior year's reserve and the establishment of a new reserve. Whether the initial or subsequent reserves would necessarily offset the income inclusion is uncertain but presumably would be resolved in the course of an audit. (The Bank might argue that a full reserve for the 1990 accrued interest, for example, is warranted in the 1990 taxation year. However, when determining the reserve for that interest for the following year, prospects for collecting on the debt might have improved with the restructuring discussions which were then taking place.)

Effect of Receipt of the IDU Bonds

The question of whether the issuance of a promise-to-pay, such as a bond, in satisfaction of an income debt constitutes payment can be a difficult one.

XXXXXXXXXX      notwithstanding that the parties intended that the IDU Bonds were to be issued and accepted in complete satisfaction of the related interest arrears, and that there evidently exists a market for the IDU Bonds, we have concluded that the issuance and receipt of the IDU Bonds did not constitute payment by XXXXXXXXXX  and receipt by the Bank of interest on the underlying loans. In this regard, it is our view that the IDU Bonds were issued precisely because the interest was not paid.

In Cross v. London and Provincial Trust Limited (1938) I.K.B. 792, the respondents had surrendered the interest coupons on their bonds for funding bonds, which funding bonds had a value in the market at the date of receipt. The respondents sold the funding bonds from time to time. The respondents were assessed to income tax in sums intended to represent the value as at the dates of issue of funding bonds received, but successfully challenged such assessments. At page 792, the court noted:

     "It is not open to question that income can be in the form of money's worth. Nor is it open to question that if the holder of a security, the contractual income of which is money, receives from the person liable to pay that money something of money's worth, namely goods, instead of the money, such goods are income arising from the security. Compare Scottish and Canadian General InvestmentCo. Ltd. v. Easson, where debentures of a new company were received in place of interest due on bonds issued by an old company. On the other hand where there is a mere substitution of a promise to pay at a later date for the obligation to make an  interest payment presently due, the owner of the security cannot be said to have received income from it. In such a case in truth that is exactly what has not happened, since the payment has been postponed instead of being made on its due date. Nor do I see how it can make any difference if upon the true reading of the transaction the original obligation is extinguished and the promise to pay at a later date is accepted in its place. If the holder of a mortgage agrees to accept a post-dated cheque in lieu of interest which has accrued due, it would surely be a misuse of language to say that he had received income from the mortgage, and that notwithstanding the fact (which I will assume) that the post-dated cheque was a thing of money's worth."

Accordingly we are of the view that the issuance of the IDU Bonds did not constitute payment of the arrears interest on the underlying loans and such arrears interest remained outstanding, to be paid in the form of "principal" payments under the IDU Bonds.

(Although we would agree that subsection 76(1) could possibly have some application in this type of situation, it would apply with respect to the receipt of the IDU Bonds only to the extent that the arrears interest on the underlying loans would have been included in the Bank's income if it had been paid. As noted earlier, most, if not all, of that interest was (or will have been) included in income prior to 1992 (the year of receipt of the IDU Bonds) on an accrual basis pursuant to subsection 12(3) and to that extent, subsection 76(1) would not be applicable.)

Reserve for Doubtful Loans or Lending Assets

On the basis that the Bank's IDU Bonds are reported neither to the OSFI nor in the Bank's financial statements, we agree that a reserve is not available in respect of the IDU Bonds under either of clause 20(1)(l)(ii)(A) or (B).

This is appropriate, however, because to the extent that collection of the arrears interest on the underlying loans (in the form of principal payments under the IDU Bonds) was, or continued to be, doubtful following the restructuring and the receipt of the IDU Bonds, a reserve under subparagraph 20(1)(l)(i) would (continue to) be available in respect of such arrears interest. If otherwise available, in our view a reasonable reserve in 1992 (the year the bonds were received) could not exceed the difference between the related arrears interest and the fair market value of the IDU Bonds at the time of receipt. We would think it unlikely, however, that a reserve would continue to be available in respect of interest on the underlying loans where the IDU Bonds achieve performing status.

Proceeds Greater/Less than Fair Market Value of IDU Bonds

It is our view that a disposition of the IDU Bonds by the Bank will not generally result in a gain or loss to be reflected directly as income or loss, but rather, will result in:

-     no further reserve under subparagraph 20(1)(l)(i) and a final add-back of the preceding year's reserve, pursuant to paragraph 12(1)(d), and

-     a bad debt deduction under subparagraph 20(1)(p)(i) equal to the amount by which the related arrears interest on the underlying loans exceeds the proceeds of disposition of the IDU Bonds.

Presumably it is unlikely that the proceeds would exceed the related arrears interest on the underlying loans, but in that eventuality, such excess would be income under section 9.

Whether the IDU Bonds Constitute Inventory

You indicate that the IDU Bonds are not reported by the Bank as "trading assets" to the OSFI. As such, they do not fall within the definition of "prescribed security" in paragraph 6209(b) of the Regulations and are not thereby excluded from the definition of "lending asset" in subsection 248(1) of the Act. Otherwise, the IDU Bonds appear to constitute lending assets under one or more of the categories included in the definition thereof, particularly "bond", "note" or "any other indebtedness".

Although this is not certain, it would appear from the approach that the OSFI is taking that it does not require a bank to mark to market the IDU Bonds and thus no adjustment is reflected in computing profit for the year, nor income for tax purposes. Unless disposed of in the year, we would therefore tend to think the IDU Bonds are not inventory.

We note however that, to the extent the IDU Bonds constitute lending assets, whether or not they might be inventory, paragraph 18(1)(s) would preclude any inventory write-down under section 10.

Foreign Tax Credit Issues

XXXXXXXXXX

With respect to the specific points raised in connection with the IDU Bonds, we have the following comments.

(a)     We are of the opinion that the issuance and receipt of the IDU Bonds was not a payment of interest for purposes of the Canada  — XXXXXXXXXX Income Tax Convention (the "Treaty").

     It is our view that payments of principal under the IDU Bonds would be payments of interest for purposes of the Treaty with respect to the Bank as initial holder.

(b)     In view of (a) above, it is our view that the tax sparing provisions of XXXXXXXXXX of the Treaty would be applicable with respect to the receipt by the Bank of principal payments under the IDU Bonds (but not receipt of the bonds themselves), provided XXXXXXXXXX of the Treaty in fact applies.

                  XXXXXXXXXX

(c)     On the assumption tax sparing is in fact applicable (see (b) above), payments of interest under the IDU Bonds to the Bank will also be subject to tax sparing as they occur.

(d)     In terms of whether a deduction under subsection 20(12), or a credit under subsection 126(2), is appropriate, XXXXXXXXXX of the Treaty  provides that Canada shall allow "as a deduction from the tax on the income" the amount of XXXXXXXXXX tax paid (both business-income tax and non-business-income tax). Inasmuch as subsection 20(12) is a deduction in computing income rather than tax, it is our view that it is not applicable. On the other hand, subsections 126(1) and (2) provide for deductions in computing tax and so may be applicable but this would depend of the facts of the particular situation.

(e)     For purposes of the related foreign tax credit calculation in subsections 126(1) or (2), it is our view that the interest income to which tax sparing  applies arose in the years in which such interest accrued, i.e., 1989 and 1990, and that foreign tax paid (spared) "for the year" is paid for those years.

     As and to the extent payments of principal are made under the IDU Bonds to the Bank, the tax spared amount relating thereto is to be determined and attributed to the 1989 and 1990 taxation years and any foreign tax credit determined.

     Whether those years are open, the existence of any (related) foreign income for those particular years for purposes of the tax credit calculation, and the      availability of any foreign tax credit carry back/forward are factors which would be relevant to this situation.

(f)     It is our view that tax sparing would not be applicable with respect to proceeds on a disposition (other than redemption or repayment by XXXXXXXXXX  of the IDU Bonds by the Bank. We would also think that tax sparing would not apply with respect to principal payments under the IDU Bonds in the hands of a subsequent holder.

Interest on IDU Bonds

With respect to interest on the IDU Bonds held by the Bank, it is our view that:

(a)     in as much as the IDU Bonds are debt obligations, subsection 12(3) would be applicable with respect to interest thereon;

(b)     to the extent collection of the interest included in income in (a) above is doubtful, a reserve would be available under subparagraph 20(1)(l)(i);

Intended Results

Our views with respect to the points made under this caption of your memorandum are reflected in our above comments.

Sale Implications

With respect to the points made under this caption of your memorandum:

-      see the comments above under the heading "Proceeds Greater/Less than Fair Market Value of IDU Bonds"; and

-     where the IDU Bonds are sold by a bank in a later year and income for book purposes includes the full amount received, we agree that an adjustment would be made, pursuant to subsection 4(4), to exclude for tax purposes any portion thereof which was included in income in a prior year (as well as appropriate adjustments with respect to any doubtful debt deductions).

Concluding Comments

As suggested above, the question of whether the issuance of the IDU Bonds constituted a payment is not free from doubt. However, even if it were argued by the Bank that the IDU Bonds did constitute payment, this would not greatly affect the recognition of income for Part I and while possibly advancing the occurrence of tax sparing, such tax sparing would in our view be based on the fair market value of the IDU Bonds at the time of receipt (rather than the face value), and such a position would not allow for future reserves under subparagraph 20(1)(l)(i) should the bonds decrease in value.

We hope this will be of assistance to you. As requested, your material is returned herewith.

for DirectorFinancial Industries DivisionRulings DirectorateAttachments