Principal Issues: [TaxInterpretations translation]
Can debts that have been excluded from the balance sheet (set-off) be included in the capital calculation for part I.3?
Position: No
Reasons: No amount appears on the balance sheet. In addition, the notes to the financial statements indicate that there is set off within the meaning of Section 3860 of the CICA Handbook and the financial statements are prepared in accordance with GAAP.
December 18, 2000
XXXXXXXXXX Tax Services Office Headquarters
Tax Avoidance Income Tax Rulings Directorate
Attention: XXXXXXXXXX Michel Lambert
(613) 957-89532000-002380
XXXXXXXXXX
Set-off and Part I.3 Tax
This is further to your memo of April 26, 2000 requesting our opinion regarding the application of Part 1.3 tax of the Income Tax Act in the case of a series of transactions involving loans with immigrants. The taxpayer, XXXXXXXXXX, received loans from various immigrants and with at least XXXXXXXXXX financial institutions. You asked us to analyze only the transactions involving XXXXXXXXXX. We have therefore limited ourselves to that series of transactions.
THE FACTS
The taxpayer received loans from immigrants who wished to obtain Canadian citizenship. Each immigrant loaned $XXXXXXXXXXX. The total amount of the loans was $XXXXXXXXXXX. Those loans were interest-free. They were contracted through XXXXXXXXXX. The proceeds of the loan enabled the taxpayer to acquire goodwill from a competitor.
The taxpayer set up a trust to guarantee repayment of the loans at maturity. This trust was set up in accordance with the requirements of a loan agreement entered into on XXXXXXXXXX between the taxpayer and the immigrant representatives.
Under this loan agreement, the taxpayer transferred $XXXXXXXXXX in bank notes to the trust. Those notes bear interest so that at maturity the principal and interest will have a value of $XXXXXXXXXX. The interest rates on the notes vary between XXXXXXXXXX per annum. Those notes mature at the same time as the immigrant loans.
The trust deed provides that the bank notes will be cashed and the immigrant loans repaid at the same time.
The loan agreement provides that the immigrants will have no recourse other than their beneficial interest in the trust if the taxpayer and the trustee respect their commitments under the agreement. The immigrants agree to be paid from the proceeds of the sale of the bank notes, whether or not such proceeds are sufficient to repay the loan.
To finance the acquisition of the $XXXXXXXXXX bank notes assigned to the trust, the taxpayer borrowed from XXXXXXXXXX. According to note XXXXXXXXXX to the XXXXXXXXXX financial statements, this loan from the bank is repayable in monthly instalments of $XXXXXXXXXX and is secured by the taxpayer's assets. The loan bears interest at XXXXXXXXXX% per annum.
In the taxpayer's financial statements as at XXXXXXXXXX, the loans payable to immigrants are not recorded as liabilities on the balance sheet. Note XXXXXXXXXX to the financial statements indicates that those loans were set off against the notes held in trust, since the maturity value of the notes will be equal to the amounts of the loans.
YOUR OPINION
You are of the view that the taxpayer cannot present the loans as it has done. In your view, accounting practices do not allow the taxpayer to offset the loans payable to immigrants, and the loans should be presented with the liabilities in the financial statements. Such a presentation would result in the loan being subject to tax under Part I.3 of the Act.
TAXPAYER'S OPINION
The taxpayer's representatives are of the view that the financial statements are presented in accordance with generally accepted accounting principles (GAAP). In this regard, they have provided you with the following two external opinions.
Under XXXXXXXXXX, the bank notes should be applied against the loans from immigrants because the immigrants have no recourse against the taxpayer in the event of default and because the bank notes and the loans from immigrants will mature at the same time.
XXXXXXXXXX is of the view that the taxpayer has a conventionally recognized right of set-off. In their view, it appears from the agreements that the parties clearly agreed that the taxpayer could set off at maturity the bank notes and promissory notes given to each of the immigrants.
OUR OPINION
Section 3860 of the CICA Handbook deals with offsetting a financial asset against a financial liability. Paragraph 34 stipulates the following (TaxInterpretations translation):
A financial asset and a financial liability shall be offset, and the net balance after offset shall be presented in the balance sheet, when the following conditions are met:
a) the entity has a legally enforceable right to set off the stated amounts;
b) the entity intends either to settle on a net basis after netting, or to realize the asset and settle the liability simultaneously.
Paragraph 37 of Section 3860 of the CICA Handbook specifies what is meant by a legally enforceable right of set-off.
A right of set-off is a legally enforceable right, established by contract or otherwise, under which a debtor may settle or otherwise extinguish all or part of an amount it owes to a creditor by deducting from that amount an amount owed to it by the creditor. In exceptional cases, a debtor may have a legally recognized right to set off an amount owed to it by a third party against an amount owed to it by a creditor provided that all three parties involved have agreed that the debtor has a clear right of set-off. Since the right of set-off is a legally recognized right, its conditions may vary from one legal area to another. Care must therefore be taken to determine which legal rules govern the relationship between the parties in question.
Paragraph 41 of Section 3860 of the CICA Handbook provides for situations where set-off is generally not permitted. This is the case, for example, when financial assets are transferred in trust by a debtor who wishes to discharge an obligation without the creditor having accepted the assets in settlement of the obligation.
In our view, the taxpayer's representatives have good arguments to support their contention that the financial statements were prepared in accordance with GAAP. In light of the documents provided to us, we are of the view that the parties have agreed to effect set off. We are also of the opinion that the parties are not covered by the exception described in the preceding paragraph since the immigrants, the bank, the trustee and the taxpayer agreed to create the trust and to limit the immigrants' right to the trust property. Unless a chartered accountant can demonstrate that the financial statements are not prepared in accordance with GAAP, we are of the view that they should be accepted as prepared.
Capital for the purposes of Part I.3 must be calculated, as required by subsection 181(3), taking into account the amounts shown in the balance sheet prepared in accordance with GAAP. In certain circumstances, there may be more than one method of accounting for a transaction under GAAP. In such a case, capital must be calculated taking into account the amounts reflected in the balance sheet prepared in accordance with the accounting method used to prepare the financial statements, as long as it complies with GAAP.
In our view, no amount relating to loans payable to immigrants should be included in the taxpayer's capital for Part I.3 tax purposes since the balance sheet was prepared in accordance with GAAP and those loans do not appear on the balance sheet. The notes to the financial statements form an integral part of the financial statements. However, note 23 on financial instruments specifically states that the taxpayer has offset the bank notes and loans payable to immigrants. The loans payable to the immigrants create a conditional obligation for the taxpayer to pay only in certain circumstances. The immigrants agreed that the trust notes would settle their loans. Consequently, we are of the view that the amount of the loans due to the immigrants does not constitute a debt of the taxpayer for the purposes of Part I.3 of the Act.
In closing, we wish to make a general comment on the application of paragraph 20(1)(c). The taxpayer borrowed money, bearing interest at a rate of XXXXXXXXXX%, in order to acquire the $XXXXXXXXXX bank notes and, presumably, to pay the financing, commission and brokerage fees of $XXXXXXXXXX. Since the rate of return on the bank notes acquired is lower than the rate of return on the loan (XXXXXXXXXX), we are of the view that interest expense should be denied for the portion of the loan relating to the acquisition of the bank notes that were transferred to the trust. Paragraph 20(1)(c) allows a deduction for interest paid or payable on money borrowed to earn income from a business or property.
The decision of the Supreme Court of Canada in Her Majesty the Queen v. Phyllis Barbara Bronfman Trust, 87 DTC 5059, which considered the deductibility of interest, adopted the following criteria:
1. It is the current use of the borrowed funds that must be considered in determining whether the interest is deductible;
2. it must be established whether the borrowed funds has been put to an eligible use to earn income from a business or property; and
3. the deduction of interest requires a determination of the taxpayer's purpose in using the borrowed funds rather than the purpose of the borrowing itself. Eligibility for the deduction is conditional on the taxpayer's use of the borrowed funds for the purpose of earning income.
In addition, an interest deduction must be related to a source of income from a business or property. That requirement is not satisfied where there is no expectation of profit.
In this case, the taxpayer used part of the funds borrowed in XXXXXXXXXX to acquire bank notes that were transferred to a trust. It is this latter use that must be examined to determine whether the borrowed funds were used by the taxpayer to earn income. We are of the view that the taxpayer cannot deduct the interest on the portion of the loan invested in the trust following the transfer of the bank notes because there is no expectation of profit.
ACCESS TO INFORMATION
For your information, a copy of this memorandum will be severed using the Access to Information Act and will be available in the Legislative Access Database (LAD) located on the mainframe of the Canada Customs and Revenue Agency. 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 Legislative Access Bank 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 (613) 957-0682. A copy that has been severed in accordance with the Privacy Act will be sent to you for delivery to the client.
We hope you find our comments of assistance.
Acting Manager
Financing and Plans Section
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch