25 June 1999 External T.I. 9911525 - LOSS ON DISPOSITION - NON-ARM'S LENGTH DEBT

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 the loss on the write-off of a loan to a non-arm's length individual to him to start a business can be claimed as an allowable capital loss.

Position: Question of fact.

Reasons: According to sub-paragraph 40(2)((g)(ii), a loss on a settlement of debt is deemed to be nil unless the debt was acquired for the purpose of gaining or producing income from a business or property. According to IT-239R2, money which has been loaned at a reasonable rate of interest generally constitutes a debt acquired for the purpose of gaining or producing income, and any capital loss which arises because it has become uncollectible is generally not deemed to be nil by virtue of paragraph 40(2)(g)(ii). Also, section 80 may apply if the debtor has a gain on the settlement of debt.

XXXXXXXXXX 		J. Gibbons
			5-991152
June 25, 1999

Dear XXXXXXXXXX:

Your letter of November 3, 1998, addressed to the Ottawa Tax Services Office, in which you requested their views on whether a loss on the write-down of an investment in your son's business venture qualifies as a capital loss for income tax purposes, was forwarded to us for reply. We apologise for the delay in responding.

As indicated in paragraph 22 of Information Circular 70-6R3 dated December 30, 1996, a request for a written opinion on a completed transaction is normally considered by the local tax services office. However, because your letter was forwarded to us by the Ottawa Tax Services Office, we have provided the following general comments. If after reviewing them, you have further concerns, please contact the Assistant Director, Client Services Division of the Ottawa Tax Services Office.

Briefly, the facts, as we understand them, are as follows:

1. In XXXXXXXXXX, you loaned your son $XXXXXXXXXX to assist him in the purchase of a XXXXXXXXXX business, operating under the name, "XXXXXXXXXX" . The balance of the purchase price was to be financed through your son's own resources and a loan under the Small Business Loans Act from the XXXXXXXXXX.

2. A loan agreement setting out the terms and conditions of the loan was drawn up with the aid of legal counsel so that, in your view, it met the requirements of the Income Tax Act.

3. The agreement stipulated that the loan would rank below the claims of other creditors so that it would not impair the ability of the business to obtain credit from commercial sources.

4. The loan called for an interest rate of XXXXXXXXXX percent annually on any outstanding balance, payable on the last day of each year. The loan agreement also stipulated that, unless otherwise agreed with your son, you were not entitled to receive payment for interest in any year in which the profits of the business, including drawings by your son, were less than $XXXXXXXXXX.

5. The loan could be repaid at any time.

6. The business operated with some success until XXXXXXXXXX, at which time, for personal and business reasons, the business was wound up.

7. Your son was unable to repay the initial investment and some interest.

Opinion Requested

You want our views on whether you are entitled to a capital loss of $XXXXXXXXXX, for income tax purposes, since there is no reasonable prospect of recovering that amount from your son.

Our comments

Subparagraph 40(2)(g)(ii) of the Act deems a loss on the disposition of a debt to be nil unless the debt was acquired for the purpose of gaining or producing income from a business or property. In this regard, we refer you to the comments in paragraph 5 of Interpretation Bulletin IT-239R2, "Deductibility of Capital Losses from Guaranteeing Loans for Inadequate Consideration and from Loaning Funds at less than a Reasonable Rate of Interest in Non-Arm's Length Circumstances," a copy of which is enclosed. This bulletin states that money which has been loaned at a reasonable rate of interest generally constitutes a debt acquired for the purpose of gaining or producing income, and any capital loss which arises because it has become uncollectible is generally not deemed to be nil by virtue of paragraph 40(2)(g)(ii). Whether money has been loaned at a reasonable rate of interest is a question of fact that can only be answered after reviewing all of the relevant facts and documentation. However, as noted in IT-239R2, it is the Department's view that money has not been loaned at a reasonable rate of interest where a taxpayer borrows money at interest and loans that money to an non-arm's length party at a lesser rate of interest than that at which the taxpayer borrows the money.

In order to claim a capital loss on a bad debt, the creditor must file an election with his or her income tax return. An election is made by attaching a signed letter to the individual's income tax return stating that subsection 50(1) of the Act is to apply to the bad debt. Generally, a debt becomes a bad debt if it remains unpaid after all means to collect it have been exhausted or if the debtor (in this case, your son) has become insolvent and has no means of repaying it. There was no indication in your letter that your son's debt had become a bad debt. Rather, it appeared that you had settled your son's debt for no consideration. If this is the case, it may be that you could still claim a capital loss, subject to other provisions in the Act, including subparagraph 40(2)(g)(ii), since a settlement is still considered a disposition. However, if this is the case, your son would be subject to the rules in section 80 of the Act dealing with gains on the settlement of debts.

In general terms, section 80 of the Act provides that a debtor who experiences a gain on the settlement of a debt is required to offset a number of tax balances such as non-capital losses, net capital losses, capital cost of depreciable property, and undepreciated capital cost allowance, by the amount of that gain. Any remaining balance after this, would be included in income pursuant to subsection 80(13). The specific ordering of these offsets is provided by paragraph 80(1)(c).

The rules discussed above are specific rules dealing with a loss on the disposition of a debt. You have stated in your letter that the loan to your son was made for legitimate investment purposes and that it was not a tax avoidance scheme for which the non-arm's length rules were devised. The Act contains a general anti-avoidance provision in section 245, which is directed at preventing certain tax avoidance transactions. Whether a particular transaction or series of transactions was tax motivated, can only be determined after a review of all of the facts.

We trust that these comments will be of assistance.

Yours truly,

J.F. Oulton, CA
for Director
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate