25 October 2011 External T.I. 2011-0424081E5 - Interest income

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.

Principal Issues: What is the reporting requirement of interest income on an interest bearing demand note?

Position: Interest to be reported on accrual basis pursuant to subsection 12(4) of the Act.

Reasons: Operations of the Act.

XXXXXXXXXX
							2011-042408
							V. Srikanth

October 25, 2011

Dear XXXXXXXXXX :

Re: Interest Income

This is in response to your correspondence dated October 13, 2011 wherein you requested our views on the reporting of interest income for income tax purposes. Specifically, you have described a situation wherein, in 1987, a taxpayer issued an interest bearing demand promissory note (the "Note") as consideration for a loan from his parents. Throughout the term of the loan, the taxpayer made neither principal nor interest payments, however, in 2007, the outstanding loan, i.e., principal and interest, was repaid. You would like our comments on what should have been the reporting of the interest income, for tax purposes.

Our Comments

This appears to be an actual situation. It should be noted that written confirmation of the tax implications inherent in actual proposed transactions is given by this Directorate only where the transactions are the subject of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, entitled Advance Income Tax Rulings dated May 17, 2002. This Information Circular and other Canada Revenue Agency ("CRA") publications can be accessed on our website at http://www.cra-arc.gc.ca. Your request was not submitted as an advance income tax ruling request, however, as stated in paragraph 22 of IC 70-6R5, we do provide written opinions on general enquiries and we are prepared to provide you with the following comments.

Paragraph 12(1)(c) of the Income Tax Act (the "Act"), provides that there shall be included in computing the income of a taxpayer from a business or property, any amount received or receivable by the taxpayer in the year (depending on the method regularly followed by the taxpayer in computing his income) as, on account of, in lieu of payment of or in satisfaction of, interest to the extent that the interest was not included in computing his or her income for a preceding taxation year. Interest is considered receivable by a taxpayer when there is a clear legal right to receive it. The provisions of paragraph 12(1)(c) are, however, subject to some overriding provisions, inter alia, subsection 12(4) of the Act. Subsection 12(4) of the Act states that:

"Subject to subsection (4.1), where in a taxation year a taxpayer (other than a taxpayer to whom subsection (3) applies) holds an interest in an investment contract on any anniversary day of the contract, there shall be included in computing the taxpayer's income for the year the interest that accrued to the taxpayer to the end of that day with respect to the investment contract, to the extent that the interest was not otherwise included in computing the taxpayer's income for the year or any preceding taxation year."

An investment contract is defined in subsection 12(11) (former paragraph 12(11)(a)) of the Act for the purposes of the interest accrual rules. These rules, which were introduced for taxation years commencing after 1981, required accrued interest on such contracts to be included in income to the anniversary date of the contract at least every third year with respect to investment contracts acquired before 1989, and, annually, with respect to investment contracts acquired after 1989. So, in a situation where a debt obligation constitutes an investment contract under subsection 12(4) of the Act, while it is outstanding, accrued interest income would be required to be reported for tax purposes either triennially or annually, depending on when the contract was acquired, pursuant to paragraph 12(1)(c) of the Act.

In a situation such as that described above where an investment contract was acquired before 1989, and provided that the investment contract was not materially altered after 1989, interest should have been reported at least every third year. Accordingly, interest income should have been reported by the holders of the Note in 1990, 1993, 1996, 1999, 2002, 2005 and the balance of the interest income paid and not previously reported, in the year of maturity, that is, in 2007. However, if the investment contract was materially altered after 1989, the interest income should be reported annually henceforth. Whether a contract is materially altered is a question of fact. Further, where the investment contract is owned by more than one taxpayer, each taxpayer would need to report their appropriate share of the accrued interest income.

Where a taxpayer has failed to report income, and it is determined as a result of a compliance action by CRA, that the taxpayer "knowingly, or under circumstances amounting to gross negligence" has made a false statement or omission in a return, the CRA would apply the 'gross negligence' penalty under subsection 163(2) of the Act. In such case, the penalty generally consists of 50% of the total of the tax exigible on the income understatement, with a minimum penalty of $100.

However, a taxpayer may choose to voluntarily disclose unreported income under the Voluntary Disclosure Program ("VDP"). Under the VDP, taxpayers who have not reported all of their income can voluntarily correct their tax affairs. They will not be penalized or prosecuted if they make a valid disclosure before they become aware of compliance actions being started by the CRA against them. These individuals may only have to pay the taxes owing, plus interest. However, if enforcement action has already been undertaken to investigate the activities of the taxpayer or a third party, the penalty will not be waived. As stated in the Canadian Tax Foundation conference's CRA Round Table held in Montreal on June 10, 2011, "[t]here are no legislative restrictions to assessing any year if the adjustments are in line with the applicable legislation. We will apply the legislation as it relates to statute-barred years and assess income in the year it was earned. As a result, the CRA will not provide assurances that they will not assess beyond 10 years. With regards to penalty and interest relief, the legislation limits such relief to the preceding 10 years."

A taxpayer who wants to make a voluntary disclosure should contact the CRA in person or in writing, providing the details of the disclosure to the nearest taxation services office. More information on the VDP can be found on the CRA Web site at www.cra.gc.ca/voluntarydisclosures.

You may be aware that based on the facts of a situation, where interest income is accrued but not received, the claiming of a reserve pursuant to paragraph 20(1)(l) of the Act could be considered. Such a reserve for doubtful debts would be based on the accrued portion of the interest not paid, not likely to be paid and not reimbursed by deposit insurance, if applicable. However, the onus of proof would rest with the taxpayers to establish that a debt was doubtful for collection. In a non-arm's length situation where payment is eventually made, it would likely be difficult for taxpayers to establish that the provisions of paragraphs 20(1)(l) were applicable.

We trust our comments will be of assistance to you.

Yours truly,

R.A. Albert, CA
For Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch