22 January 1988 Income Tax Severed Letter

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.

January 22, 1988

TO WINNIPEG Chief of Audit Chief of Audit

D. Putz

FROM Small Business and General Division E. Mikhail

This is in reply to your memorandum of July 29, 1987 in which you asked for clarification of certain comments made by us in our memorandum to you dated July 13, 1987.

In our memorandum to you we had suggested that the letters patent and by-laws of both XXXX be examined in order to gain a better understanding of the relationship existing between these two corporations and of the terms attached to patronage dividends. In the absence of this information we felt it was reasonable to make the assumptions we had made in order to reply to your questions. We note that by the time we received your second memorandum these documents had still not been examined. You have now obtained these documents and given us the opportunity to examine them. Our replies to your questions are presented in the same order as your questions.

#1. We had previously recommended that the XXXX reserve for doubtful accounts be allowed as a deduction to XXXX under subparagraph 20(1)(1). This recommendation remains unchanged. With respect to a reserve for doubtful accounts of XXXX claimed by the XXXX our answer is not that straight forward. We do not know how the XXXX payable by XXXX to the XXXXXXXX arose. This is a question of fact which you will have to determine. However, we foresee two possiblities which are as follows:

XXXX made an allocation in proportion to patronage as that phrase is defined in 135(4) (a) of the Act which was not in fact paid or which was not paid within the extended meaning of the term "payment" in subparagraph 135(4)(g)(i), that is, a certificate of indebtedness was issued but no appropriate disbursement was made. If this is the case, then XXXX would not be entitled to a deduction pursuant to 135(1) of the Act. However, the XXXX would be required to include this amount in income pursuant to subsection 135(7) of the Act. To the extent the amount is included in income and has in fact become doubtful for collection a reserve can be claimed under subparagraph 20(l)(1)(i).

In our view this is not a likely scenario but this you may verify by audit; or

XXXX made an allocation in proportion to patronage and in fact paid the patronage dividend or paid the patronage dividend within the extended meaning of subparagraph 135(4)(g)(i) on the condition that the XXXX loan back the money to XXXX. Under these circumstances the dividend was in fact received or constructively received by the XXXX and no reserve for doubtful debts can be claimed under subparagraph 20(l)(1)(i) and no bad debt can be claimed under paragraph 20(l)(p). Then the relevant question to consider is whether the money loaned that has become doubtful for collection can be claimed as a reserve under subparagraph 20(l)(1)(ii). To succeed under this provision it is necessary to show that the doubtful debt arose from loans made in the ordinary course of business by a taxpayer part of whose ordinary business was the lending of money between

XXXX

Under these circumstances the loans could not likely be considered arising from loans made by the XXXX in their ordinary course of business whose ordinary business was the lending of money, unless of course the XXXX can show that they were indeed in the business of loaning money. While we doubt this is the case, this is a question of fact which you can establish by audit. If no deduction can be claimed under subparagraph 20(1)(1)(ii) either, then the debt owing, provided it is a capital property and it in fact became a bad debt in a particular year, may qualify as a capital loss in that particular year under subsection 50(1) subject to subparagraph 40(2)(g)(ii) (see IT-159R2 and IT-239R2 ).

#2. (a) The Head Office reply to the Regina District Office made the assumption that XXXX conducts itself in the same manner as other co-operatives in the context of deciding whether the dividends declared by XXXX qualify as patronage dividends for purposes of section 135. Section 135 sets out the conditions that have to be met to qualify a dividend as a patronage dividend. Subsection 135(1) provides that a "payment", within the meaning of paragraph 135(4)(g), of a patronage dividend may be made by any taxpayer. Such a taxpayer often is a co-operative corporation but it need not be one. An ordinary corporation such as XXXX may declare a patronage dividend. Since you are not questioning the validity of the patronage dividend declared by XXXX in respect of which in turn the reserve for doubtful accounts is claimed by XXXX and indirectly by the various XXXX we fail to see the relevance of your concern that XXXX is not a co-operative corporation.

XXXX

We are not aware of the existence of audited information on this point. We believe that if the taxpayers were asked to provide evidence on this point, they will likely come up with evidence that the making of loans was a requirement of membership. Accordingly, we have difficulty accepting your assertion that the making of loans was merely dealing with the financial structure of a subsidiary corporation. Also, we do not believe that the changes in a member's account as explained by you are relevant factors in deciding whether the making of loans is a condition of membership.

We do not believe that the basis in which you wish to distinguish XXXXXXXX from the Regina District Office for referral is strong enough to support a reassessment.

#3. Our comments on the meaning of constructive receipt were made for the purpose of determining whether XXXX received the patronage dividends. And if it received the patronage dividends it cannot claim a reserve for doubtful debts under subparagraph 20(1)(1)(i) but may be able to do so under subparagraph 20(l)(1)(ii). A reserve claimed under subparagraph 20(1)(1)(11) requires that the doubtful debts arise from loans made in the ordinary course of business by a taxpayer part of whose ordinary business was the lending of money. In the case of XXXXXXXX, we concluded that the conversion of a patronage dividend into a loan would constitute a constructive receipt of a patronage dividend and consequently a reserve for doubtful debts would have to be claimed under subparagraph 20(l)(1)(ii). For a discussion of the phrase "whose ordinary business was the lending of money" as it applies in this case see paragraph 7 below.

#4. We fail to find any information in your working papers in support of your assertion that the making of loans is not a condition of doing business with XXXX. Indeed, your working papers are silent on this matter. Moreover, it appears to us that this information would have to be supplied XXXX. In this regard we are not aware that XXXXXXXX has been asked to make representations on this subject so that at this time the answer to this question would appear to be unknown. However, given the peculiar relationship between XXXX and XXXX it appears reasonable to us to assume that the making of loans was likely a condition of carrying on business. We think so because

the patronage dividend allocation made by XXXX would have to meet the meaning of "payment" of subparagraph 135(4)(g)(ii) and that meaning appears to imply that this condition exists. XXXX by-laws and the statutory authority under which it was incorporated are silent on the subject of patronage dividends. Under the circumstances the conversion of patronage dividends into loans would have to be made at the request of XXXX. The appropriate words in subparagraph 135(4)(g)(ii) applicable to your set of circumstances after substituting "the taxpayer" with XXXX and "a member" or "the member" with XXXX would then read: "the application by CSP Foods XXXX of an amount to XXXX liability to XXXX (including, without restricting the generality of the foregoing, an amount applied in fulfilment of an obligation of XXXX to make a loan to XXXX at the request of XXXX". Even assuming this condition does not exist, we would still maintain the position that XXXX is entitled to claim a reserve for doubtful debts under paragraph 20(1)(1). This was also the opinion expressed by XXXX (see your working paper I) although on page 6 of your memorandum dated April 3, 1987 you conclude the opposite. However, XXXX appear to suggest the reserve for doubtful loans should be claimed under subparagraph 20(l)(1)(i) whereas we believe subparagraph 20(1)(1)(ii) is the appropriate provision.

#5. Like XXXX makes patronage dividend allocations to its members. As explained above, the members of XXXX are also its shareholders. Like the members of XXXX, the members of XXXX are able to reduce their costs because of savings generated from quantity buying by XXXX. The receipt of a patronage dividend by a member should have the impact of reducing costs of a member whether the patronage dividend is declared by XXXX or by XXXX.

#6. We believe the reference to paragraph 20(l)(p) in the second paragraph on page two of our memorandum dated July 13, 1987 is unfortunate and should be read as a reference to paragraph 20(1)(1). In our reply to you we addressed the question of the deductibility of loans funded out of patronage dividends declared by XXXX. Our recommendation to accept these loans as a deduction under paragraph 20(l)(1) was limited to these loans. It is our understanding that no other loans were claimed under paragraph 20(1)(1). The tax-treatment of other loans would have to be determined depending on the facts which are not known to us using the guidelines in IT-442 .

7. We believe that XXXX is in a strong position to establish that the loans made to XXXX and claimed as a reserve for doubtful debts were made as an integral part of its business operations consistent with the requirement of IT-442 paragraph 10. XXXX conducts itself like a co-operative corporation. It is common for co-operative corporations pursuant to their by-laws to require members to loan an amount equal to unpaid patronage dividends to the co-operative corporation that declared the dividend. In the same vein, the agreement between XXXX provided for similar terms although it appears the agreement was handled with less formality. Although these loans are interest bearing we believe the real compensation expected to be earned for making these loans are future patronage dividends which are of course business income to the recipient. This business income in turn is available for patronage dividends payable to customers of XXXX. Furthermore, we believe there is a certain system and continuity in the making of these loans which are within the requirements mentioned in IT-442 paragraph 10. These loans arose in XXXX whenever patronage dividends were declared. We believe that these facts show the existence of a continuing pattern of converting unpaid patronage dividends into loans. This pattern discontinued when XXXX got into financial difficulties and discontinued declaring patronage dividends. IT-442 paragraphs 14 and 15 provide general comments on the tax consequences of property accepted in full settlement of a trade debt or loan receivable. These paragraphs are not helpful in deciding what criteria determine whether the property so accepted was or was not held as a capital property. We believe that some of the factors listed by you on page 7 of your memorandum dated April 3, 1987 and used in support of your opinion that the loans "even if originally made as a part of a business operation were converted to capital property" are not on point. It seems to us the facts listed by you merely explain that loans originally issued as demand loans were converted to long term loans because of financial difficulties experienced by XXXX. Whether a loan is a demand loan or long-term loan should by itself not be a relevant factor for deciding whether the loans made by XXXX are loans made in the ordinary course of business and whether part of XXXX ordinary business was the lending of money for purposes of subparagraph 20(1)(1)(ii).

#8. The XXXX case is not accepted as a precedent by the Department.

We trust the above comments will help explain in greater detail the reasons in support of our previous recommendations.

ORIGINAL SIGNED BY

Chief Services, Public Utilities and Exempt Corporations Small Business and General Division Legislative and Intergovernmental Affair Branch