Principal Issues: Does subparagraph 40(2)(g)(ii) deem a loss on a non-interest bearing loan to be nil?
Position: No
Reasons: Application of the Byram decision.
June 21, 2007
Shawinigan-south Tax Centre Headquarters
Audit office Income Tax Rulings Directorate
Section 564-1-1
Attention: Mr. Jean Chorel Michel Lambert, CA, M.Fisc.
(613) 957-89682007-023968
Subject: Loss on loan recognised as uncollectible
This is in response to your email of June 7, 2007, asking whether losses on uncollectible loans will be deemed to be nil under subparagraph 40(2)(g)(ii).
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (the "Act").
The Facts
In 1999, an individual, Mr. A, acquired shares of a small business corporation (the "Corporation") through his registered retirement savings plan (RRSP).
Subsequently, Mr. A personally made loans to the Corporation. Those loans were interest-free.
In December 2005, the RRSP sold the shares for $1. Mr. A declared the Corporation insolvent.
For his 2005 taxation year, Mr. A claimed a business investment loss in respect of loans that he determined to be uncollectible.
Mr. A is a resident of Ontario.
Your Question
You wish to know whether the capital losses on the uncollectible loans will be deemed to be nil in computing Mr. A's income by reason of the application of subparagraph 40(2)(g)(ii).
Our Opinion
A loss on the disposition of a debt or other right to receive an amount is nil by virtue of subparagraph 40(2)(g)(ii) unless the debt was acquired for the purpose of earning income from a business or property.
The Federal Court of Appeal considered the application of subparagraph 40(2)(g)(ii) in Edwin J. Byram v. The Queen, 99 DTC 5117. The issue in that case was whether a taxpayer had acquired a debt for the purpose of earning income from business or property where the debt was a non-interest-bearing loan made to a corporation of which he was a shareholder. In his analysis, Justice McDonald made the following comments:
[16] The language of section 40 is clear. The issue is not the use of the debt, but rather the purpose for which it was acquired. While subparagraph 40(2)(g)(ii) requires a linkage between the taxpayer (i.e. the lender) and the income, there is no need for the income to flow directly to the taxpayer from the loan.
[17] Such an approach is also consistent with commercial reality. Frequently, shareholders make such loans on an interest-free basis anticipating dividends to flow from the activities financed by the loan. [...]
[18] The ultimate purpose of a parent company or a significant shareholder providing a loan to a corporation is, without question, to facilitate the performance of that corporation thereby increasing the potential dividends issued by the company. This purpose is clearly within the scope of both the text and the purpose of subparagraph 40(2)(g)(ii) … […]
[19] There is a growing body of jurisprudence that considers current corporate reality as being sufficient to demonstrate that the expectation of dividend income justifies a capital loss deduction under subparagraph 40(2)(g)(ii). As articulated above, this approach is consistent with current corporate realities and the purpose of subparagraph 40(2)(g)(ii).
[...]
[22] The shareholders of a company are directly linked to that corporation’s future earnings and its payment of dividends. Where a shareholder provides a guarantee or an interest free loan to that company in order to provide capital to that company, a clear nexus exists between the taxpayer and the potential future income. Where a loan is made for the purpose of earning income through the payment of dividends, this connection is sufficient to satisfy the purpose requirement of subparagraph 40(2)(g)(ii).
In our view, the comments of McDonald J. above may apply to the present situation so that the debt may have been acquired for the purpose of earning income from business or property. Indeed, Mr. A appears to have advanced the funds to the Corporation for the purpose of providing capital to the Corporation, and he probably expected to realize income from the Corporation through his RRSP which is property.
Given the Court's comments in Byram, we do not believe that Mr. A's loss should be deemed to be nil solely because the Corporation's shares were acquired by the RRSP and not personally by Mr. A.
Access to Information
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the electronic library version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
We hope that these comments are of assistance.
Manager
Financial Sector and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.