8 May 1998 Internal T.I. 9806837 - REIMBURSEMENT OF AMOUNTS TAXED UNDER IT-256R

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:

1) whether paragraph 4 of IT-256R applies with respect to repayments of misappropriated funds made by a taxpayer who does not admit liability,
2) whether amounts are "repaid" when they are paid into court under a prejudgment garnishment,

3) how do we calculate the deduction for amounts repaid when part of the amounts taxable under IT-256R were not included into income.

Position:

1) IT-256R applies even if the employee does not admit his liability to his employer, if evidence supports the repayments relate to the misappropriated funds,
2) amounts are paid when the sums paid into court are released to the creditor,

3) repayments are applied on a first-in first out basis. Only the portion that was included into income will be deductible.

Reasons:

1) The basis for the reassessment was IT-256R and this was not objected to by the taxpayer,
2) on the basis of the Garnishee Act of PEI and literature on prejudgment garnishment, there is no payment to the creditor until the sums are released from the court; also, this is evidenced by the fact the taxpayer must consent to release the amounts in the agreement in 1997,

3) when there is no allocation by either the debtor or the creditor of the payments, the law will apply it to the earliest debt. This is consistent with business and commercial practice and the Department’s position as stated in paragraph 24 of IT-119R3.

		May 8, 1998

	Sharon Bulger	HEADQUARTERS
	Client Services	Nicole Mondou, M.Fisc.
	TSO02 Charlottetown	(613) 957-8961
		980683

Repayment of funds misappropriated by employee

This is in reply to your memorandum of March 17, 1998, in which you requested our views in respect of paragraph 3(a) of the Income Tax Act (the “Act”) and Interpretation Bulletin IT-256R (“Gains from Theft, Defalcation or Embezzlement”).

The situation you describe involves a claim by an employer of sums that were purportedly misappropriated by the taxpayer. According to your files, the following sums were not reported as income by the taxpayer:

Year		Total Misappropriated	Reported	Unreported

XXXXXXXXXX

The taxpayer was reassessed for the unreported income for the years 1991 to 1994 (for a total of $XXXXXXXXXX ) on the basis of the Interpretation Bulletin mentioned above. The taxpayer did not object to the reassessment.

In 1997, the taxpayer agreed to reimburse $XXXXXXXXXX to his employer: $XXXXXXXXXX was garnisheed in 1995, paid to the County Sheriff’s Office and released in 1997 to the employer at the taxpayer’s direction, and the balance of $XXXXXXXXXX was paid by the taxpayer to the employer in 1997.

With respect to the repayment provided in the agreement, you raise the following issues:

1. When the employee does not admit liability in the agreement for the repayment of amounts to the employer, are the amounts repaid considered a repayment of amounts previously included in income?

2. Did the repayment of $XXXXXXXXXX occur at the time it was remitted to the County Sheriff’s Office under the garnishment proceedings in 1995 or at the time the agreement released the funds to the creditor in 1997?

3. As part of the amounts “misappropriated” were not assessed by Revenue Canada as unreported income, how do we determine the portion that is deductible:

a) on a prorated basis based on the income added for 1991-1994 divided by the total unreported income for 1988-1994,

b) by applying the repayments on a first-in, first-out basis, or

c) by applying the repayments on a last-in, first-out basis?

Our comments

1. Although the employee did not admit to his employer his liability, the amounts repaid are deductible as provided for under Interpretation Bulletin IT-256R. The taxpayer was assessed unreported income under that bulletin and did not object to the reassessment. He should therefore benefit from the administrative relief provided therein.

2. Subsection 6(2) of the Garnishee Act, R.S.P.E.I 1988, cap. G-2, provides that the sheriff shall pay into court any amount recovered by the execution against the garnishee if judgment has not been recovered in respect of the principal debt. Also, section 7 provides that where the debtor confess the claim and the sums garnisheed and paid into court are sufficient to satisfy the amount of the creditor’s claim, the court may make an order for the payment to the creditor of the amount so confessed. This indicates that in the case of a prejudgment garnishment, the creditor is not entitled to the sums paid into court until the court orders the payment. C. R. B. Dunlop, in Creditor-Debtor Law in Canada, 2nd Ed. (1994), states at page 371 that the purpose of the prejudgment garnishment is to freeze moneys owed to the defendant until the court can determine whether or not the defendant owes money to the plaintiff. The garnishment process itself would not effect any change in the legal relationship between plaintiff and defendant. In addition to the provisions of the Garnishee Act, the settlement agreement supports a finding that no payment was made to the creditor until the taxpayer authorized the release of the funds in 1997.

On that basis and for tax purposes, the repayment of the sums by the taxpayer would not occur until the amounts garnisheed paid into court were released to the creditor in 1997.

3. In our view, the payments made by the taxpayer should be applied first against the earliest debt in time. C. R. B. Dunlop, again in Creditor-Debtor Law in Canada, 2nd Ed., states that in the event that neither the debtor nor the creditor appropriates the payment to a particular debt, the law will take that step, usually by appropriating the payment to the earliest debt in time. A specific example of this principle would be the rule in Devaynes v. Noble; Clayton’s Case (1816), 35 E.R. 781 which applies to the situation of a current account of “one blended fund” into which are entered the various debts incurred and payments made by the debtor in order of date”. This position is consistent with both business and commercial practice and the Department’s position set out in paragraph 24 of Interpretation Bulletin IT-119R3 (“Debts of shareholders, certain persons connected with shareholders, etc.”).

As a result, $XXXXXXXXXX of the repayments would not be deductible as this amount was not included into income under the reassessments issued to the taxpayer. The balance of the repayments would however be deductible in 1997, i.e. in the year they were made. Since the income assessed was from a source that is income from office, employment, business or property, should the deduction of the amounts repaid create a loss in 1997, this loss will be a non-capital loss that can be carried back or forward as provided for under paragraph 111(1)(a) of the Act.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department’s mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should the taxpayer request a copy of this memorandum, he can be provided with the LAD version or he may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Jackie Page at 613 957-0682. The severed copy will be sent to you for delivery to the taxpayer.

We trust that these comments are of assistance.

P. Spice
for Director
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch

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