7 August 1991 Income Tax Severed Letter - Accrued Interest from Investment Contracts

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: Subsections 12(4) and 78(1) of the Income Tax Act (the "Act")

This is in reply to your letter of July 17, 1991 requesting a technical interpretation with respect to the interaction, if any, between the above noted subsections. In connection with the above and some hypothetical facts you ask that we determine anniversary dates for four situations and in a related matter ask with respect to three scenarios, whether in our opinion the loan had been "materially altered" as that term is used in the coming into force provisions of subsection 12(4) in Bill C-28 (June 1989).

Your main concern is that unpaid interest owing to a shareholder by the shareholder's company is required to be taken back into income or reported by the individual to whom the interest is accruing, in the third taxation year after being accrued. Subsection 12(4), however, requires individuals to report accrued interest from investment contracts last acquired after 1989 on an annual basis.

Our Comments

The Department's published opinion on some matters related to the application of section 78 to unpaid amounts is contained in Interpretation Bulletin IT-109R. Paragraph 12 of IT-109R provides that where non-arm's length debtors and creditors both account for income on the accrual basis and bring such unpaid amounts into their income, it is not the Department's practice to invoke section 78 of the Act. Subsection 12(4) of the Act now requires that interest income be reported on an annual basis thus putting most debtors and creditors on the accrual basis. This presumably would be true in your examples I(a), (b) and (c). Notwithstanding the foregoing, we made the following comments with respect to "anniversary dates" referred to above.

• 1. A loan of $300,000 @ 10% provided by the shareholder to the company on January 1, 1980, with no specific terms of repayment and unchanged to date, would have an anniversary date of December 31, 1980 for purposes of subsection 12(4). (see paragraph 12(11)(b)).
• 2. A loan as in 1. above, but increased to $500,000 on July 1, 1990 could, depending on the facts, have the same anniversary date as 1. for the initial $300,000 or any part remaining thereof, and an anniversary date of June 30, 1991 for the additional $200,000. This is so because the Department views each advance by the shareholder as a separate debt obligation issued and retired on a FIFO basis. However, also depending on the facts, a disposition and reacquisition may be triggered by the increase in the principal amount and an anniversary may occur on and be dated from the date the contract was disposed of. (See paragraph 7 of Interpretation Bulletin IT-448 and subparagraph 12(11)(b)(ii) of the Act.)
• 3. Where interest on the loan in 1. is compounded into additional principal instead of being paid out, a disposition and reacquisition may take place as in 2. above depending on the facts. (See paragraph 7(c) of IT-448). The anniversary date would not likely change from 1. above where the change is carried out pursuant to an authorizing provision in the original terms of the debt obligation. (See the preamble in paragraph 7 of IT-448).
• 4. It is a question of fact whether or not a particular arrangement creates a "debt obligation". Generally speaking, a debt obligation is considered to arise whenever a binding liability is created and the principal amount of the liability can be quantified. Assuming that the floating line of credit carrying interest at 12% per annum arranged with the shareholder in 1985 (which is increased from time to time by out-of-pocket company expenses paid personally by the shareholder, and decreased by drawings and other repayments) is a formal arrangement it would appear to be a debt obligation. If the increases and decreases are nominal it would probably be in order to retain the 1985 date as the basis for subsequent anniversary dates. However, if the increases are material each subsequent increase could represent a separate "debt obligation" and anniversary dates would be calculated from the dates of those increases. Those acquired after 1989 would be subject to the 1 year rule in subsection 12(4) of the Act. Any decreases would be applied on a FIFO basis to the earliest loan which in time would be considered disposed of, thus, triggering an anniversary date under subparagraph 12(11)(b)(iii) of the Act. As indicated the determination in these cases are questions of fact which can only be ascertained after an examination of all facts and transactions. This being the case we are unable to give you a definitive answer to your 4th example.

Regarding the words "acquired or materially altered after 1989" which are found in the coming into force provision of subsection 12(4) of the Act, in the comments under subsection 12(4) to (8) in the Department of Finance's Technical Notes, there is a statement following the words quoted above that reads, "those quoted words are amended to read `last acquired after 1989'." It appears that this statement is premature as those words are not law yet but appear as an amendment to the coming into force provision for subsection 12(4) of the Act in the next technical bill (see Bill C-18, section 250). In the absence of the proposed change, the Department would rely on its published position on changes in terms of debt obligations (referred to above) set out in paragraphs 6, 7 and 8 in IT-448 to make a determination as to whether or not an investment contract had been "materially altered".

We trust our comments will assist you in this matter.