Principal Issues: In a statute barred year, a partnership transferred inventory to a family farm corporation. The partners, who report their farming income on a cash basis, have been including in income each year their respective portion of the note collected in the year.
1. Did subsection 76(1) apply to the transfer of the inventory?
2. Can paragraph 18(1)(e) be used to deny the "deduction" of the outstanding portion of the note in a non-statute-barred year?
Position: 1. No.
2. No.
Reasons: 1. The conditions of subsection 76(1) have been met.
2. Paragraph 18(1)(e) cannot require a cash-basis farmer to include in income an amount not otherwise required to be included in income at that time.
June 18, 2004
Jim Randall HEADQUARTERS Tax Avoidance Section Terry Young, CA Ottawa Tax Services Office 952-1506 1730 St. Laurent Blvd., 7th Floor 2004-007306
Transfer of Farm Inventory
We are writing in response to your memorandum of April 21, 2004, concerning the above-mentioned subject.
You outlined a situation in which a husband and wife (the "Taxpayers") operated a farming business through a partnership (the "Partnership"). The Partnership calculated its income on a "cash-basis" pursuant to subsection 28(1) of the Income Tax Act (the "Act"). In XXXXXXXXXX, the Partnership transferred the assets of the farming business to a corporation (the "Corporation") owned by the Taxpayers. The assets transferred included inventory with a fair market value of $XXXXXXXXXX. As consideration for the inventory, the Partnership received a "note" from the Corporation. There is no documentation in support of the transfer of inventory other than the accounting records of the Corporation, which include a reference in the financial statements to "Inventory note payable to [the Partnership], no specific terms of repayment". The Corporation also reports income on a cash basis and, in each taxation year since the transfer, has claimed a deduction in accordance with paragraph 28(1)(a) of the Act for the portion of the note paid in the year to the Partnership. The Taxpayers have included in income their respective share of the payments received by the Partnership.
In your view, subsection 76(1) of the Act applied to the Partnership's receipt of the note in XXXXXXXXXX. As a result, the Taxpayers should have included in income in XXXXXXXXXX their respective share of the proceeds of the sale of the inventory. The XXXXXXXXXX taxation year of the Taxpayers is now statute-barred and there is no basis for reopening the year under subsection 152(4) of the Act. Therefore, you have proposed that each of the Taxpayers include their share of the unpaid balance of the note in income in the earliest taxation year that is not statute-barred. The basis for your position is that you are of the view that the Taxpayers have claimed a reserve for the uncollected portion of the note, which is not deductible by virtue of paragraph 18(1)(e) of the Act.
Our Comments
Interpretation bulletin IT-77R, Securities in Satisfaction of an Income Debt, discusses the position of the CRA with respect to the application of subsection 76(1) of the Act. Paragraph 1 of IT-77R states:
Subsection 76(1) provides that the value, or the applicable portion thereof, of a security or other right or a certificate of indebtedness (hereinafter collectively referred to as "the security") which is received by the taxpayer either wholly or partially as or in lieu of payment of, or wholly or partially in satisfaction of, a debt that was then payable and the amount of which would have been included in his income if it had been paid, is to be included in his income for the taxation year in which the security is received.
It is our general view that subsection 76(1) of the Act would not apply to a cash basis farmer who receives a debt as a result of the sale of inventory, but does apply where an existing debt is replaced at a later point in time by a different security or right. However, paragraph 9 of IT-77R states, "[s]ubsection 76(1) can apply where a security is received concurrently with the creation of a debt provided the security in not merely evidence of the existence of the debt, but is received in absolute payment of the debt." In A. Lloyd Clark & Co. Ltd. (1970 CarswellNat 142), the Tax Appeal Board stated: "...that payment of a purchase price is basically not effected by the delivery of a promissory note unless the governing agreement for sale provides specifically for that particular mode of payment..." On this basis, we are of the view that it must be clear that a promissory note is received in absolute payment of a debt for subsection 76(1) of the Act to apply.
In the situation described in your letter, there is no documentation to show that the Partnership received either a note or other security. Further, even if such security were received, there is no indication as to its terms. Therefore, in our view, subsection 76(1) does not apply to the transfer of the inventory and consequently, the Taxpayers and the Corporation are correctly accounting for the payments on the outstanding debt for income tax purposes. Furthermore, we are of the opinion that paragraph 18(1)(e) of the Act cannot be applied in the manner suggested.
We trust our comments will be of assistance to you.
Randy Hewlett, B. Comm.
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Planning Branch