3 June 1997 Internal T.I. 9703437 - payment made by trust-exchanging cheques beneficiary

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.

Principal Issues:

Will there be a payment of the trust's income made by the trust to a beneficiary where cheques are exchanged between the two parties on the same day without there being sufficient funds available in the account of either party to cover the amount of the cheques?

Position TAKEN:

Depends on the facts of the situation.

Reasons:

The courts have considered whether the payer's cheque would have been honoured by its financial institution and whether the transactions are legally effective.

			June 3, 1997

	Kitchener-Waterloo Tax Services Office		Trusts Section
	Tax Audit Division         				C.R. Bowen
	Dick Beech							(613) 957-8585
	Assistant Director Audit

	Attention:  Gary Huenemoeder
									970343

Amount Payable under Subsection 104(24)

We are writing in reply to a memorandum of November 8, 1995 from Mr. Huenemoeder and further to our telephone conversations (Huenemoeder\Bowen) of May 2 and June 14, 1996, and April 15, 1997, wherein he requested our comments on various issues related to whether an amount has become payable to the beneficiary of a trust. Some of these issues were addressed in our memorandum to you dated February 26, 1997 #952964 ("Our Memo"). Since Mr. Huenemoeder's questions concerning the preferred beneficiary election have already been answered verbally, we have not provided a written response to them. We apologize for the long delay in responding to the outstanding query.

Outstanding Question

A discretionary trust issues a cheque to its beneficiary as payment of the trust's income without having sufficient funds in its account to cover the amount of the cheque. The beneficiary deposits the cheque into his or her personal account and then, on the same day, issues a cheque for the same amount to the trust as a loan. The trust issues a non-interest bearing demand promissory note to the beneficiary as evidence of the loan. Will the trust have made a payment of the trust's income to the beneficiary as a result of the exchange of cheques?

Our Comments

A) Jurisprudence

The issue of whether a payment has been made as a result of parties exchanging cheques has been addressed several times by the courts as indicated below:

In an estate tax case, M.N.R. v. Cox Estate, 71 DTC 5150, (S.C.C.), a husband, who later died, assigned a life insurance policy held by him to his wife. The husband delivered to his wife the assignment, the policy and his cheque payable to her. On the same day, the wife wrote a cheque to her husband in payment for the cash surrender value of the insurance policy. At the time the cheques were written and cashed, there were insufficient funds in the accounts of both the husband and the wife to cover the amount of the cheque that each had issued.

The court held, after the husband's death, that:

I am in complete agreement with the Minister's contention that the exchange of cheques was merely the machinery used to effect a gift of the policy by the deceased to his wife. The simultaneous exchange of cheques where neither would be honoured due to insufficient funds were it not for the offsetting entry of the other cheque, can only be viewed as a single transaction. In substance, the deceased transferred to his wife the policy of life assurance plus the exact amount of next year's premium.... The deceased received no consideration for this transfer, thereby constituting a gift of the policy within the provisions of the Estate Tax Act..."

Although not explicitly stated, it appears that the court did not consider the exchange of cheques to be legally effective.

In Produits L.D.G. Products Inc. v. M.N.R., 73 DTC 5222, (F.C.T.D.), several cheques were issued by the company to a pension plan and, simultaneously, the pension plan wrote cheques to the company for the purchase of the company's shares. The Minister (at page 5228) pointed out that when the company issued the cheques, it did not have sufficient funds in its bank account to cover the cheques and relied on Cox Estate as authority that the exchange of cheques between the company and the pension plan did not really constitute payment by either party. However, the judge distinguished (at page 5228) this situation from Cox Estate on the basis that the cheques issued by the company would have been honoured because of the company's good credit rating (i.e., the company had a line credit available for the amount of the cheques). For other reasons, the court disallowed the payments made by the company to the pension plan.

In W. Vézina et Fils Ltée v. M.N.R., 73 DTC 149, (T.R.B.), a cheque was issued by the company to a pension plan for which a deduction was claimed and the pension plan wrote a cheque to the company for the purchase of the company's shares. The Minister disallowed the deduction on the grounds that the transaction was a sham as there were insufficient funds available in the company's bank account to honour the cheque (as supported by the decision in Cox Estate). However, the court cited with approval Mr. Justice Walsh's comments in Produits L.D.G. Products Inc. and concluded (at page 153) that since the company could have obtained credit from the bank (based on the company's accounts receivable) in the amount of the payment, the payment was not a sham and the deduction should be allowed to the company.

Regarding the matter of whether transactions are legally effective, in Distillers Corporation Ltd. v. M.N.R., 74 D.T.C. 1197, (T.R.B.), several persons exchanged a number of cheques all on the same day in a series of transactions that resulted in considerable tax savings. The court held that the end result of all the transactions was acceptable due to the fact that each transaction between the parties was executed in a proper manner so as to be valid and legally binding on the parties. (Note: there were sufficient funds available in the account of the party who issued the first cheque to cover the amount of the cheque.)

The findings of the above case contrast to those in Orenstein & Partners Inc. v. The Queen, 96 DTC 6237, (F.C.T.D.), where the court examined the matter of whether a cheque issued by a taxpayer created a payment for scientific research and experimental development ("SR&ED"). The source of funds for the cheque was a loan obtained from a non-arm's length party. The court found that the recipient of the cheque did not intend to act upon it, and there was no substance or reality to the cheque (or to the contract pursuant to which the cheque was issued). Therefore, the payer's claim for an SR&ED expenditure was disallowed.

B) Loss consolidation

The exchange of cheques between parties can arise where there is a loss consolidation within a corporate group, an example of which is described in paragraph 5 of Information Circular 88-2 Supplement 1. Typically, Profitco will use funds borrowed from a financial institution, normally on a daylight basis, to subscribe for Lossco's common shares. On the same day, Lossco will lend the money back to Profitco who then repays the loan from the financial institution. The amount of the share subscription is not in excess of the amount of monies that Lossco could reasonably be expected to be able to borrow for use in its business on the basis solely of its credit from an arm's length lender. In this type of arrangement, not only is there an initial source of funds for the payment made by Profitco to Lossco for the purchase of Lossco's shares, but each transaction must be done in a legally effective manner.

C) Conclusion

Our Memo indicates the requirements to be met in order for a discretionary trust to create an amount payable in the year to a beneficiary for the purposes of subsection 104(24) of the Act. Where a trust issues a promissory note payable on demand without restriction to a beneficiary as evidence of an amount payable to the beneficiary (i.e., an amount to which the beneficiary has a legal right to enforce payment of) in the manner described in Our Memo, it will not be necessary for the trust to attempt to create a "payment" by having the trust and the beneficiary exchange cheques for the same amount on the same day.

As noted above, when determining whether or not to accept that payment of an amount has been made, consideration must be given to: i) whether the payer's cheque would have been honoured by its financial institution where there were insufficient funds available in its account to cover the amount of the cheque, and ii) whether the transactions between the parties are legally effective. If you have a particular fact situation that you would like to obtain our comments on, please forward it to us.

We trust that our comments will be of assistance.

for Director
Resources, Partnerships and
Trusts Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch