29 April 1994 External T.I. 9336625 F - Attribution Rules

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:

A brief summary of the situation is that an individual (the Transferee) has acquired an income producing property from his or her spouse (the Transferor).  The Transferor accepted a demand promissory note bearing interest at the prescribed rate in effect at the time of the time of the transfer.

(a)     Following the transfer, the interest rate is reset at the prescribed rate in effect at that subsequent time (lower than the initial rate).

(b)     A second alternative is that the Transferee and the Transferor would enter into an agreement that would  involve a loan in respect of which the proceeds would be used to repay the demand promissory note.  Interest would be charged at the prescribed in effect at the time the loan was made.

(c)     Original demand promissory note is forgiven. Tax consequences of (a), (b), and (c) in relation to attribution rules?

POSITION TAKEN:

(a)       and (b)  The attribution rules would become applicable.

(c)     If the indebtedness not genuine, attribution would be regarded as always being applicable.  If the indebtedness considered genuine, attribution would be applicable following forgiveness.

REASONS FOR POSITION TAKEN:

(a)     The condition in 74.5(1)(b)(i) would no longer be satisfied because interest was not being charged at the  prescribed in effect at the time the indebtedness was  incurred.

(b)       The exception in subsection 74.5(2), inter alia, refers to income or a gain from loaned property.  Since the proceeds are used to repay the promissory note, the exception is inapplicable.  Therefore, attribution rules apply from the time the loan was made.

(c)     If facts indicated that the loan was not genuine, the exception in paragraph 74.5(1)(b)(i) would be inapplicable.

On the other hand, it the loan was considered genuine, the requirement in subparagraph 74.5(1)(b)(i) would no longer be satisfied.

Attention:  XXXXXXXXXX

April 29, 1994

Dear Sirs:

Re:  Attribution Rules

This is in reply to your letter of December 3, 1993 in which you requested our views on an interspousal transfer of property.

The situation with which you are concerned appears to relate to specific taxpayers and involves proposed transactions. Confirmation of the tax consequences of such transactions will only be provided in response to a request for an advance income tax ruling request.  The procedures for requesting an advance income tax ruling are set out in Information Circular 70-6R2 and the related Special Release dated September 30, 1993.  We are, however, providing you with the following general comments.

Our Comments

You are concerned with the type of situation where an individual (the Transferee) has acquired an income producing property from his or her spouse (the Transferor).  With respect to the transfer of the property, the Transferor accepted a demand promissory note.

In the comments that follow, unless otherwise stated, all statute references are to the Income Tax Act S.C. 1970-71- 72, c.63 as amended, consolidated to June 10, 1993 (the Act).

In relation to the above circumstances, we wish to clarify the nature of the promissory note.  Where a note is accepted with respect to the disposition of property, the original debt (i.e., an amount payable for property) is considered to exist where the note is considered to represent a conditional payment.  On the other hand, where a promissory note has been accepted as absolute payment, no amount is due in respect of the disposition since the debt is considered to have been paid or satisfied by the receipt of the promissory note.  These principles are discussed in paragraphs 2 and 3 of Interpretation  Bulletin IT-436R "Reserves  —  Where Promissory Notes are Included in Disposal Proceeds".  In our view, a note which represents absolute or conditional payment constitutes "consideration for the transferred property" for the purposes of subsection 74.5(1) of the Act.  In such circumstances, it is our view that a loan with respect to the purchase of the property was not made.  Our comments set out below are so based.

With respect to the note, paragraph 74.5(1)(b) of the Act requires that interest be charged at a rate not less than the lesser of the prescribed rate that was in effect at the time the loan or indebtedness was incurred and the rate that would be agreed upon between arm's length parties under similar circumstances at the time the loan or indebtedness was incurred.  For the purposes of our comments set out below, we have assumed that the prescribed rate was the lower of the two rates.  In addition, we have assumed that the conditions in subsection 74.1(1) of the Act have been satisfied at all relevant times subject to our comments set out below, that the indebtedness was equal to the proceeds of disposition of the property, and that the amount of the indebtedness remained constant.

Subsequent to the transfer of the property, the Transferee and the Transferor will proceed to reset the rate of interest being charged on the indebtedness.  The new rate would be the rate set out in paragraph 4301(a) of the Income Tax Regulations that is applicable at the time the interest rate is reset and would be lower than the rate that was previously in effect.

A second alternative is that the Transferee and the Transferor would enter into an agreement that would involve a loan.  The proceeds of the loan would be used to repay the demand promissory note.  Interest would be charged on the loan at the rate described in the preceding paragraph.

With respect to the change to the interest rate charged in respect of the promissory note, it is our view that the condition in subparagraph 74.5(1)(b)(i) of the Act would no longer be satisfied because interest was not being charged at the prescribed rate in effect at the time the indebtedness was incurred.  Accordingly, the attribution rules in subsections 74.1(1) and (2) of the Act in question would be applicable in respect of the property from the time that the interest rate is reset.

In the case of the second alternative, the exception in subsection 74.5(2) of the Act, inter alia, refers to income or a gain from loaned property or property substituted therefor.  Since the proceeds of the loan are used to repay the demand promissory note (i.e., the proceeds would never generate any income or result in a gain), it is our view that the exception is inapplicable.  In our view, it would follow that the provisions of subsection 74.1(3) of the Act would be applicable with the result that the attribution rules in subsections 74.1(1) and (2) of the Act would apply from the time that the loan was made.

The above result is also similar to that which would occur if two loans were involved.  If an individual loaned funds to his or her spouse and charged interest at the prescribed rate in effect at the time the loan was made and the loan was described in subsection 75.5(2) of the Act, the income from the property acquired with the borrowed funds would not be subject to the attribution rules.  Subsequently, the individual makes a new loan at the prescribed rate in effect at the time this new loan is made, which rate is lower than the rate charged on the first loan and the proceeds are used to repay the first loan.  In these circumstances, it is our view that, based on the reasoning set out in the preceding paragraph, the exception in 74.5(2) of the Act would cease to be applicable.  Accordingly, it would follow that from the time the second loan was made, the attribution rules in subsections 74.1(1) and (2) of the Act would apply by virtue of subsection 74.1(3) of the Act.

With respect to the demand promissory note initially accepted by the Transferee on the transfer of the property, you state that another possibility is that the Transferor could use loaned or transferred property from a related individual other than the Transferor to repay the demand note.  The fair market value of the property used to repay the demand note would be equal to the amount of the demand note.

Assuming that the only parties involved with the transfer or loan of property are the Transferee and the non-arm's length individual (e.g., the ultimate source of funds is not the Transferor), it is our view that the attribution rules would no longer apply to the Transferor once the loan has been repaid.  However, inasmuch as the original transfer of property appears to have been for income splitting purposes, it also appears that the provisions of subsections 56(4.1) to (4.3) of the Act would apply to attribute income to the non-arm's length individual.

The final alternative which we have considered occurs where the demand note in its original form is forgiven by the transferor.

In relation to this alternative, the Courts could hold that the indebtedness was not genuine.  If this were to be the case, the exception in paragraph 74.5(1)(b)(i) would not assist the Transferor with the result that an outright transfer of property would have occurred.  It would follow that the attribution rules in 74.1(1) and (2) would be applicable.

On the other hand, if the loan was considered to be genuine, it is our opinion that the requirement in subparagraph 74.5(1)(b)(i) would no longer be satisfied.  Accordingly, the provisions of subsections 74.1(1) and (2) would apply following the forgiveness.  We also wish to note that these comments are consistent with the last sentence in paragraph 22 of Interpretation Bulletin IT-511 "Interspousal Transfers and Loans of Property made after May 22, 1985" which states that "When such a loan is forgiven the exemption in subsection 74.5(2) ceases to apply and section 80 becomes applicable".

These comments represent a general interpretation of the law and, as such, may not be applicable in every situation.  The determination of the tax consequences can only be made following a review of all the relevant facts and documentation.

We trust that our comments will be of assistance to you.

Yours truly,

P.D. Fuocofor DirectorBusiness and General DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch