7 July 1990 Income Tax Severed Letter - Repayment of debt with low adjusted cost base

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.

Dear Sirs:

Re: Repayment of Debt with low Adjusted Cost Base

We are writing in response to your letter of March 1, 1990 in which you requested our opinions regarding the application of subsections 111(4) and 85(4) of the Income Tax Act (the "Act") to the hypothetical situation described below.

In the hypothetical situation that you describe, ACo is a corporation that is resident in Canada and BCo, a wholly-owned subsidiary of ACo, is a corporation that is not resident in Canada. ACo had loaned $10 million to BCo by way of a demand loan payable without interest. The loan receivable is a capital property of ACo. The proceeds of the loan were used by BCo in its business for the purpose of gaining or producing income. control of ACo was acquired by a person or group of persons after January 15, 1987. After the loan was made but before control of ACo was so acquired, BCo had sustained substantial operating losses so that its assets exceeded its liabilities (other than in respect of the loan payable to ACo) by only $4 million at the time control of ACo was so acquired. Pursuant to paragraph 111(4)(c) of the Act, the adjusted cost base to ACo of the loan receivable will, at the time control of ACo was so acquired, be reduced to $4 million.

It is your view that, if BCo repays $2 million or 20% of the principal amount of the loan to ACo, ACo would realize a capital gain of $1.2 million (that is, $2 million less 20% of the adjusted cost base of $4 million) and the remaining loan receivable of $8 million would thereafter have an adjusted cost base to ACo equal to $3.2 million. It is also your view that, if BCo subsequently repays another $2 million to ACo, the loan would be considered to have been disposed of by ACo and ACo would realize a loss on such repayment equal to $1.2 million (that is, the adjusted cost base of $3.2 million less $2 million) and that such a loss would be deemed to be nil pursuant to subsection 85(4) of the Act.

We agree with your view that, if BCo repays $2 million or 20% of the principal amount of the loan to ACo, ACo would realize a capital gain of $1.2 million (that is, $2 million less 20% of the adjusted cost base of $4 million) and the remaining loan receivable would thereafter have an adjusted cost base to ACo equal to $3.2 million.

We do not agree with your views as to the tax consequences of a subsequent repayment of $2 million by BCo because it is our view that such a repayment would not, by itself, result in the loan being considered to have been settled or extinguished and, hence, to have been disposed of by ACo absent an agreement or other understanding to that effect between ACo and BCo.

Where the loan may be considered to have been so disposed of by ACo as a result of such an agreement or understanding between ACo and BCo, we agree with your view that the loss otherwise realized by ACo on such repayment would be equal to $1.2 million (that is, the adjusted cost base of $3.2 million less $2 million) and that such a loss would be deemed to be nil pursuant to subsection 85(4) of the Act. But, where there is no such understanding or agreement between ACo and BCo such as would result in the loan being considered to have been settled or extinguished, it is our view that such a repayment would result in ACo realizing a capital gain of $1.2 million and that the remaining loan of $6 million would thereafter have an adjusted cost base to ACo equal to $2.4 million. Subject to our comments in the next paragraph, where the remaining loan receivable of $6 million is subsequently disposed of by ACo as a result of an agreement or understanding between ACo and BCo to settle or extinguish the loan and ACo realizes a capital loss on such disposition, subsection 85(4) will apply to such subsequent disposition to deny such loss.

Provided that, after the second repayment of $2 million has been made, the remaining $6 million loan may be considered to have become a bad debt in a year for the purposes of paragraph 50(1)(a) of the Act, ACo will be deemed, pursuant to subsection 50(1) of the Act, to have disposed of the $6 million loan at the end of that year and to have reacquired it immediately thereafter at a cost equal to nil. Any loss realized by ACo on such disposition of the $6 million loan would not be deemed, pursuant to subparagraph 40(2)(g)(i) of the Act, to be nil because such loss would, by virtue of subparagraph 54(i)(iii) of the Act, be deemed not to be a superficial loss of ACo. Whether or not the remaining $6 million loan may be considered to have become a bad debt in a year is a question of fact that can only be determined by reference to all of the facts and circumstances of the particular case.

Our comments in this letter represent our general views with respect to the subject matter of your letter. The facts of a particular situation may lead to a different conclusion. Our comments in this letter are not rulings and, in accordance with the guidelines set out in Information Circular 70-6R dated December 18, 1978, are not binding on the Department.