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.
Reasons:
Paragraph 20(1)(l) only permits a reserve with respect to identified doubtful loans or lending assets.
October 13, 1998
TORONTO EAST TSO HEADQUARTERS
Michael Cooke
Attention: R.L. Coker (613) 957-3498
Large File Case Manager
982160
Paragraph 20(1)(l) of the Income Tax Act ("Act")
This is in reply to your August 13, 1998 memorandum, wherein you are requested our comments with respect to XXXXXXXXXX submission to XXXXXXXXXX dated July 3, 1998 (the “submission”) concerning the computation and deductibility of XXXXXXXXXX reserve for doubtful debts pursuant to subparagraph 20(1)(l)(ii) of the Income Tax Act ("Act") for its 1994 and 1995 taxation years.
Summary
We understand that the taxpayer computed its reserve for doubtful debts in 1994 and 1995 by “pooling” all its retail loan receivables made in a particular year together and multiplying the amount of each such pool by a loss percentage factor applicable to that particular year. The pool of loans for any given year was comprised not only of retail loan receivables in respect of which interest and/or principal payments were in arrears (“doubtful loans”) but also retail loan receivables in respect of which interest and/or principal payments were not arrears (“good loans”). The taxpayer refers to their method of computing reserves as the "lag-to-liquidation" method.
In our previous memorandum to you on this matter (see our file #980074 dated January 30, 1998) we expressed our view that the lag-to liquidation method used by XXXXXXXXXX was not in accordance with paragraph 20(1)(l) of the Act and that you were correct in proposing to disallow the deduction of XXXXXXXXXX reserves for 1994 and 1995 unless they could otherwise identify the specific retail loans receivable that were doubtful loans and recompute its reserve based on those doubtful loans.
In their above noted submission, XXXXXXXXXX maintains that their computation of loan loss reserves for its 1994 and 1995 taxation years was correctly and properly determined in accordance with paragraph 20(1)(l) of the Act. They also argue that since they have used the lag-to-liquidation method since 1987 used (and the Department has not challenged such method prior to 1994) to disallow their reserves computed on that basis for 1994 and 1995 “...is not a fair and reasonable exercise of administrative authority”.
Our comments on the taxpayer’s submission will be limited solely to the technical merits of their arguments concerning paragraph 20(1)(l) of the Act and the related provisions in the Income Tax Regulations (the “Regulations”), rather than whether or not the Department’s proposed assessment based on these views represent a fair and reasonable exercise of administrative authority.
In short, while we have carefully considered the various arguments raised by XXXXXXXXXX in their submission, there is nothing contained in that submission that has caused us to change our view that the lag-to-liquidation method used by them is anything but a general reserve that is not deductible under subparagraph 20(1)(l)(ii) of the Act. Moreover, while it is our view that the taxpayer has not calculated its reserve in accordance with the Act, we have no basis to conclude one way or the other as to whether the amount XXXXXXXXXX actually claimed for its 1994 and 1995 taxation year are otherwise reasonable or not. However, notwithstanding the above, we would like to take the opportunity to respond to a few of the more important matters raised by the taxpayer.
The taxpayer, on page two of their submission, states that, “ ...XXXXXXXXXX.”
The Department does not require a taxpayer claiming a reserve under subparagraph 20(1)(l)(ii) of the Act to perform a detailed loan by loan review to establish with absolute certainty that each such loan is in fact seriously doubtful of collection where based on the number of loans outstanding, or some other factors, it is not possible to do so. However, what the Act does require is that for such a taxpayer to be able to claim such a reserve they must at least specifically identify each such loan as being doubtful of collection on some reasonable basis having regard to such factors such as the length of time required payments under the terms of the loan are in arrears. Once these loans have been specifically identified as being doubtful loans or doubtful lending assets, if such loans can be pooled or grouped together based on some common or similar characteristics, a reasonable reserve for the purpose of subparagraph 20(1)(l)(ii) of the Act may be established by applying a historical loss factor to each such pool or group of doubtful loans or doubtful lending assets. The historical loss experience must be based on the actual loss experience of the taxpayer in respect of each such pool or group of doubtful loans or lending assets.
It was in this regard that we noted in our January 30, 1998 memorandum that XXXXXXXXXX should at least provide you with aging schedules identifying the specific loans in respect of which payments of interest/principal were in arrears to support the reasonableness of their reserve. XXXXXXXXXX has admitted in their submission that it has not specifically identified loans that are doubtful loans based on the above noted criteria (and certainly not based on any criteria set out by any court) and indicate that they are unable to do so for practical reasons. With respect, it seems very odd to us that XXXXXXXXXX is unable to provide you with such information since we would expect large financial services corporations such as XXXXXXXXXX to produce and maintain such detailed records in the course of conducting its lending business.
The taxpayer also indicates in their submission that where doubtful loans, based on payment arrears, are included in a pool as provided by paragraph 8000(b) of the Regulations such a pool may contain certain loans that if a detailed loan-by-loan analysis was performed they may not be considered “doubtful” in accordance with the stricter guidelines set down by the courts. The taxpayer uses this analogy to conclude (on page 5 of their submission) that as long as they can establish that their pool of loans contains a significant number of “doubtful loans” they should be able to compute a deductible reserve on that pool using their historical loss experience factor even where it cannot follow the specific requirements set out in section 8000 of the Regulations.
As support for this view XXXXXXXXXX notes on page 4 of their submission that the Department of Finance’s (“Finance”) explanatory notes in the 1987 tax reform white paper, stated that:
“Doubtful debts may be established, depending on the nature of the loan, on the basis of a loan-by-loan examination, or where this is not feasible, on a pooled basis.”
XXXXXXXXXX also states on page 5 of their submission that, “ ...XXXXXXXXXX.”
It is our view that the above noted 1987 comments of Finance only referred to pools of doubtful loans or doubtful lending assets where, short of a detailed loan by loan review, the doubtfulness of the full collection of the debt could reasonably be established by other means (i.e. based on payment arrears). Such rules were ultimately provided in paragraph 8000(b) of the Regulations. Even if the XXXXXXXXXX interpretation of Finance’s comments was correct, and in our view they are not, the taxpayer has apparently failed to consider that paragraph 18(1)(e) of the Act specifically denies a taxpayer a deduction for any reserve unless such reserve is expressly permitted under Part I of the Act. As noted above, it is our view that the lag-to-liquidation method used by the taxpayer is not expressly permitted under subparagraph 20(1)(l)(ii) of the Act (i.e. paragraph 8000(b) of the Regulations).
The taxpayer notes on pages 3, 6 and 7 of their submission that the Bill C-28 amendments to paragraph 20(1)(l) of the Act (enacted on June 18, 1998) appear to require for the first time that a reserve pursuant to paragraph 20(1)(l) of the Act must be determined with respect to identified doubtful loans or lending assets. With respect this is simply not correct and we pointed this fact out to you in our January 30, 1998 memorandum.
Finance introduced the changes to paragraph 20(1)(l) of the Act to bring the income tax treatment of doubtful debt reserves more in line with the changes in the accounting treatment of impaired loans under generally accepted accounting principles (“GAAP”) with some specific exceptions. This reason for the change was specifically mentioned on page 153 of the explanatory notes that accompanied the legislation contained in Bill C-28 dated December 1997 wherein Finance stated:
“The following proposed amendments to paragraph 20(1)(l) reflect the 1995 accounting changes announced by the Canadian Institute of Chartered Accountants, and adopted by the Superintendent of Financial Institutions.”
The new legislation now specifically provides that a sectoral reserve, as defined in subsection 20(2.3) of the Act, is not to be included in the computation of the reserve determined pursuant to paragraph 20(1)(l) of the Act. Under the new rules clause 20(1)(l)(ii)(D) of the Act specifically provides that the key component in computing the income tax reserve is the reserve determined in accordance with GAAP. However, the “old” rules did not refer to GAAP since GAAP based reserves were not permitted under the Act. Therefore, Finance had to specifically exclude sectoral reserves under the new rules since while they are permitted under GAAP they are not determined on a property-by-property (i.e. loan by loan) basis (see page 157 of the above noted explanatory notes). Therefore, it is our understanding that the elimination of sectoral reserves does not represent a change in tax policy.
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 your client request a copy of this memorandum, they can be provided with the LAD version or they 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 client.
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 Michael Cooke at (613) 957-3498.
F. Lee Workman
Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy & Legislation Branch
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