Principal Issue: [TaxInterpretations translation]
Given the comments in Redclay Holdings Ltd on the position set out in paragraph 12(a) of IT-109R, should the provisions of paragraph 78(1)(a) of the Act apply to the debtor where the debtor and a non-arm's length creditor otherwise account for their income on an accrual basis?
Position:
No.
Reasons:
The position expressed in paragraph 12(a) of IT-109R (repeated in paragraph 15(a) of IT-109R2) has not been revised and continues to apply. The purpose of this position is to exclude from the application of subsection 78(1) of the Act situations where a creditor and a debtor, not dealing at arm's length, report their income on an accrual basis. If this context is respected in a particular situation, the "symmetry" effect resulting from the recognition of income by the creditor and of an expense by the debtor in the same taxation year (without claiming, among other things, a reserve described in paragraph 20(1)(p) of the Act) results, in our opinion, in equitable tax treatment for both parties and thus the provisions of paragraph 78(1)(a) should not be applied.
However, in all situations similar to Redclay Holdings, the provisions of paragraph 78(1)(a) of the Act apply.
November 28, 2002
Sherbrooke Tax Services Office Headquarters Danielle Bouffard Mr. Alain Ste-Croix (613) 957-8953 Audit and Implementation Division 2002-015383
Request for Technical Interpretation: Paragraph 78(1)(a) of the Income Tax Act
This is further to your memo of July 19, 2002, in which you requested our opinion on the application of paragraph 78(1)(a) of the Income Tax Act (the "Act") in the situation described below.
Your request arises from our memo 2000-0022027 of July 10, 2000, in which we suggested various points of verification so that you could determine, among other things, whether the debtor was entitled to deduct the total amount of the debt in the year in which the agreement was signed, as an expense incurred for the purpose of earning income from its business.
In summary, your request for an opinion concerned two corporations (the "debtor" and the "creditor") that did not deal at arm's length and that reported their income using the accrual method. During the 1998 taxation year, the debtor undertook to pay the creditor an amount under certain terms and conditions and claimed the amount as a current expense in computing its income. The debtor made a partial payment in 1998 and 1999. Since then, the balance owing has remained unchanged. The creditor has included only the amounts collected in computing its income.
You wish to know whether, in such a situation, you can apply paragraph 78(1)(a) and consequently include in computing the debtor's income for the 2001 taxation year the portion of the amount that was deductible by the debtor as an expense in 1998 and that still remains unpaid. You stated that no agreement, on Form T2047, has been filed in accordance with paragraph 78(1)(b).
In addition, in situations where paragraph 78(1)(a) applies, you asked whether the debtor can deduct the amount subsequently paid to the creditor again in computing its income.
Your Comments
You cited paragraph 15 of Interpretation Bulletin IT-109R2 Unpaid Amounts, which states:
(a) Debtor and Creditor on the Accrual Basis
Generally, where an unpaid amount exists between a debtor and creditor who are not dealing at arm's length and both taxpayers account for income on the accrual basis, subsection 78(1) will not be invoked. An exception occurs where the unpaid amount in question appears to be part of a tax avoidance scheme which, for example, may involve transactions such as
- claiming a reserve under paragraph 20(1)(l) or (n), or a deduction under paragraph 20(1)(p), or
- deferring tax under Part XIII of the Act where the creditor is a non-resident.
Also, subsection 78(1) will not be applied to the debtor taxpayer if an unpaid amount is reported as income in the year by a creditor who is on the cash basis of reporting income.
In this case, you consider that all the conditions for the application of paragraph 78(1)(a) have been satisfied. The amount claimed by the debtor was a deductible expense; it was owed to the creditor, a person with whom the debtor was not dealing at arm's length, at the time the expense was incurred, i.e., in 1998, and at the end of the second taxation year following the one in which the expense was incurred, i.e. in 2000. Finally, a large portion of the amount was still unpaid at the end of the 2000 taxation year. Considering that the creditor did not declare in income the unpaid portion of the amount owing to it, you are of the view that the general rule described in paragraph 15 of the Bulletin does not apply to your situation and that you may apply paragraph 78(1)(a) to include the unpaid portion of the amount in computing the debtor's income for the 2001 taxation year. You refer to Redclay Holdings Ltd (TCC), 96 DTC 1207, in support of your position.
Our Comments
As you stated, the CCRA's position expressed in paragraph 12(b) of Interpretation Bulletin IT-109R (essentially that expressed and repeated in paragraph 15(a) of Interpretation Bulletin IT-109R2) was analyzed by the Tax Court of Canada in the previously cited Redclay Holdings case.
Essentially, in that case, for the years 1983 to 1985, Redclay deducted interest payable on loans made to it by Blacklay Holdings Limited, a company with which Redclay did not deal at arm's length, and that interest remained unpaid due to insufficient income. Blacklay included the interest in income under paragraph 12(1)(c) and claimed a deduction under paragraph 20(1)(p) for bad debts, which was accepted by Revenue Canada (now the CCRA). Revenue Canada applied paragraph 78(1)(a) to the portion of the interest deducted and unpaid that increased Redclay's income for the years 1986 to 1988. Since Redclay accounted for its revenues and expenses on an accrual basis, it referred to the position expressed in paragraph 12(a) of IT-109R to support its position that section 78 should not apply.
While upholding the application of paragraph 78(1)(a) in Redclay, the Honourable Justice G. J. Rip made the following comments:
Subsection 78(1) deals with a particular relationship, that of parties not dealing at arm's length.
...
Parliament has assumed that persons who do not deal with each other at arm's length do not have opposing interests and may tolerate situations that parties who deal at arm's length would not tolerate. The Act sometimes takes transactions between persons not at arm's length out of the normal scheme of the Act. Subsection 78(1) is such a provision.
Paragraph 78(1)(a) does not suggest any words that are not specifically expressed in that provision. Parliament did not distinguish between debtors or creditors who report income on an accrual or cash basis. I hesitate in reading in such words when the words of subsection 78(1) are clear and plain and where the legal and practical effect of what transpired is undisputed: Antosko, supra, pp. 326-27.
The Directorate's interpretation of the judge's comments in this case is that the position taken in paragraph 15(a) of IT-109R2 is not founded in law. In all situations similar to Redclay Holdings, we must therefore apply the provisions of paragraph 78(1)(a). On the other hand, as you know, the position set out in paragraph 15(a) of IT-109R2 has not been revised and should still apply in other situations. The purpose of this position is to exclude from the application of subsection 78(1) situations where a creditor and a debtor, who are not dealing at arm's length, report their income on an accrual basis. If this context is respected in a particular situation, the "symmetry" effect resulting from the recognition of income by the creditor and an expense by the debtor in the same taxation year (without claiming, among other things, a reserve described in paragraph 20(1)(p)) results, in our view, in equitable tax treatment for both parties and thus the provisions of paragraph 78(1)(a) should not be applied.
In your situation, we note that the creditor did not include in computing its income the total amount received or receivable in 1998 pursuant to section 9 and/or paragraph 12(1)(b). It has not been demonstrated in this case that the debtor had a legal obligation to pay amounts in 1998 and that the creditor did not have an absolute right to amounts that were not necessarily due. Without this information, it is impossible for us to conclude that this situation is similar to the one described in Redclay Holdings and consequently we cannot support your intention to depart from the position expressed in paragraph 15(a) of IT-109R2.
In response to your second question, in cases where the provisions of paragraph 78(1)(a) otherwise apply, the debtor cannot deduct again in computing its income the amount subsequently paid to the creditor.
For your information, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and 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 you find these comments of assistance. Should you require additional information regarding the content of this document, please do not hesitate to contact us.
Ghislaine Landry, CGA
for the Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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