10 February 1998 Internal T.I. 9732317 - PARAGRAPH 20(1)(L)

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:

Whether or not a general reserve can be claimed pursuant to paragraph 20(1)(l) of the Income Tax Act.

Various issues with respect to the computation of a reserve pursuant to paragraph 20(1)(l).

Position:

A general reserve is not allowed
See attached document

Reasons:

Paragraph 20(1)(l) only permits a reserve with respect to identified doubtful loans or lending assets
See attached document

								February 10, 1998

	 							HEADQUARTERS
	XXXXXXXXXX					Michèle Trotier
(613) 957-8953

	Attention: XXXXXXXXXX
									973231

Paragraph 20(1)(l) of the Income Tax Act ("Act")

This is in reply to your October 28, 1997 memorandum which, for reasons unknown, was not received in our Directorate until December 9, 1997. You are requesting our views with respect to the computation of the deduction claimed by the taxpayer pursuant to paragraph 20(1)(l) of the Income Tax Act ("Act") for its 1994 taxation year.

It is our understanding that the taxpayer has claimed a reserve pursuant to paragraph 20(1)(l) of the Act with respect to both retail and wholesale receivables. For the purposes of this response we are accepting that the taxpayer qualifies as a money lender and that these receivables are loans or lending assets of the taxpayer for purposes of paragraph 20(1)(l) of the Act. It is our understanding that based on the information you have provided us the taxpayer has claimed a general reserve which is not permitted pursuant to paragraph 20(1)(l) of the Act. XXXXXXXXXX

In a letter dated August 6, 1997 from XXXXXXXXXX you were provided with some details as to the computation of this general reserve. It was indicated that the amount claimed by the taxpayer as a reserve with respect to its retail receivables was calculated "...

XXXXXXXXXX

"

The provisions of paragraph 20(1)(l) of the Act and the related provisions in the Income Tax Regulations do not provide for a general reserve as computed by the taxpayer and described above. The loans which are referred to in paragraph 20(1)(l) of the Act are identified doubtful loans. Given that the taxpayer has calculated its reserve with respect to all of its outstanding receivables we have no basis to conclude that the taxpayer's claim is a reasonable amount in respect of the amortized cost of doubtful loans at year-end for purposes of paragraph 20(1)(l) of the Act. We disagree with the taxpayer's arguments that it can compute a general reserve on the basis that it cannot follow the requirements set out in section 8000 of the Regulations to compute a reserve with respect to identified doubtful loans or lending assets since "XXXXXXXXXX" Where the taxpayer is unable or unwilling to identify the receivables which are doubtful at the end of a particular taxation year no reserve is permitted pursuant to paragraph 20(1)(l) of the Act.

The following are our general comments with respect to a number of issues you have raised in the course of your review of the taxpayer's claim pursuant to paragraph 20(1)(l) of the Act and more specifically with respect to clauses 20(1)(l)(ii)(A) and (B) of the Act.

The first point is clarification with respect to the use of the word "and" which is used between clauses 20(1)(l)(ii)(A) and (B) of the Act. It is our view that a reasonable reserve can be computed using a combination of clauses 20(1)(l)(ii)(A) and (B). This interpretation has been discussed with officials of the Department of Finance. It is our understanding that the legislator intended that a taxpayer be able to choose certain types of doubtful loans or lending assets with respect to which it could claim a reserve pursuant to clause 20(1)(l)(ii)(A) of the Act and to choose other types of doubtful loans or lending assets in respect of which it could claim a reserve pursuant to clause 20(1)(l)(ii)(B) of the Act. It is to be noted as well that unless this interpretation is accepted, banks, who are required to claim a reserve under clause 20(1)(l)(ii)(A) of the Act in respect of certain loans, would never be able to claim a reserve under clause 20(1)(l)(ii)(B) of the Act.

The second point is clarification with respect to the meaning of the words "by reason of" which are found in the preamble to clause 20(1)(l)(ii)(B) of the Act. It appears to us that the legislator had to use the wording "by reason of" since the amount calculated pursuant to clause 20(1)(l)(ii)(A) of the Act and paragraph 8000(b) of the Regulations is arrived at by multiplying the aggregate of the amortized cost of the doubtful loans or lending assets within a particular class by a historical loss experience percentage in respect of that class as opposed to a loan-by-loan basis. Accordingly, where a doubtful loan was included in a particular class which formed part of the calculation under paragraph 8000(b) of the Regulations such a doubtful loan would be excluded from the application of clause 20(1)(l)(ii)(B) of the Act because a reserve in respect of such a doubtful loan was deducted "by reason of" clause 20(1)(l)(ii)(A) of the Act.

The third point applies with respect to both clauses 20(1)(l)(ii)(A) and (B) of the Act. The issue is whether a taxpayer may include in computing the amortized cost of the receivables the interest which is to be earned over the term of the contract. Such interest would not form part of the amortized cost of a loan or a lending asset pursuant to the definition of "amortized cost" in subsection 248(1) of the Act. A taxpayer is entitled to a deduction pursuant to subparagraph 20(1)(l)(i) of the Act with respect to interest included in its income to the extent collection thereof becomes doubtful.

The fourth and fifth points deal with the application of section 8004 of the Regulations. The fourth point debates the use of a 5 year instead of a 7 year historical average in computing a historical loss experience for purposes of section 8004 of the Regulations. We note that pursuant to section 8004 of the Regulations there is no mention on the number of prior years to be taken into account in computing a historical loss experience percentage. However, it does indicate that this percentage should represent a reasonable percentage. Consequently, the determination of the reasonableness of a particular historical loss experience percentage used by a taxpayer for purposes of paragraph 8000(b) is a question of fact. We note that in making this determination one has to consider whether or not the inclusion of a particular year's losses in the computation of this historical loss experience percentage is appropriate in the circumstances. In other words, would this inclusion be representative of the normal business loss experiences of the taxpayer. As an example, if the taxpayer wishes to take into account the last 7 years instead of the last 5 years because the earliest two years reflected unusual losses it may be considered unreasonable to take into account these two years.

The fifth point relates to the use of the current year's losses in computing a historical loss experience percentage pursuant to section 8004 of the Regulations. Section 8004 of the Regulations refers to the percentage being a representation of prior year losses net of recoveries. Accordingly the current year's losses should not be included in the calculation.

The sixth point deals with the entitlement of the above taxpayer to a reserve pursuant to paragraph 20(1)(l) of the Act given that the taxpayer has collateral which may cover the total amount outstanding with respect to the majority of the receivables. It appears to you that perhaps the taxpayer should only be claiming actual losses and should not be entitled to claim a reserve pursuant to paragraph 20(1)(l) of the Act. It is our view that where the taxpayer can identify specific receivables which are doubtful as to collection it should be entitled to claim a reasonable reserve pursuant to paragraph 20(1)(l) of the Act but after taking account any collateral it holds with respect to these specific doubtful receivables.

We trust that the above comments will be of assistance. If you require further information or would like to discuss the above please do not hesitate to contact either F. Lee Workman at (613) 957-3497 or Michele Trotier at (613) 957-3494.

F. Lee Workman
Section Chief
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy & Legislation Branch