Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.
PRINCIPAL ISSUE: Whether the loss incurred on honouring the loan of a company that is insolvent and has ceased operations is deductible by the taxpayer that has personally guaranteed the loan for no consideration. All the shares of the company are held by a discretionary trust of which the taxpayer is the sole trustee. The beneficiaries of the trust are the taxpayer, his wife and two minor children.
Position:
Subparagraph 40(2)(g)(ii) of the Act applies to deny the capital loss.
REASON:
The guarantee was not given by the taxpayer for the purpose of gaining or producing income for himself but for the trust. Also, the possibility to receive income was too remote since he could totally allocate the trust income to other members of his family.
May 18, 1999
XXXXXXXXXX TSO HEADQUARTERS
Financial Industries
Attention: XXXXXXXXXX Division
L. J. Roy, CGA
7-983092
Loss on guarantee
This is in reply to your round trip memorandum of November 23, 1998, wherein you requested our views in respect of the application of subparagraph 40(2)(g)(ii) of the Income Tax Act (the "Act") and paragraph 6 of Interpretation Bulletin IT-239R2.
Our understanding of the facts is as follow:
FACTS
1. In XXXXXXXXXX had personally guaranteed the bank debt of the company, XXXXXXXXXX, by pledging his family home as collateral. He received no consideration for making the guarantee.
2. XXXXXXXXXX.
3. XXXXXXXXXX is the sole trustee of the family trust with full discretionary power as to the allocation of both income and capital. The trust document states that the trustee may in his absolute discretion exclude any one or more of the beneficiaries from receiving any income or capital from the trust.
4. In XXXXXXXXXX became insolvent and has now ceased operations. Then, the bank requested that XXXXXXXXXX make good on the guarantee. Consequently, XXXXXXXXXX borrowed money to make the loan guarantee payments.
QUESTION
Whether paragraph 6 of Interpretation Bulletin IT-239R2 can be applied to allow the capital loss incurred on honoring the guarantee.
OUR COMMENTS
Subparagraph 40(2)(g)(ii) of the Act deems a loss from the disposition of a debt or other right to receive an amount to be nil unless the debt or right was acquired for the purpose of gaining or producing income from a business or property.
As indicated in paragraph 4 of Interpretation Bulletin IT-239R2, where an individual is required to honour a guarantee of a corporation's debt, the individual is considered to have acquired a debt at the time of honouring the guarantee equal to the amount paid under the guarantee. It is a question of fact as to whether this debt represents a bad debt to which subsection 50(1) of the Act applies. If the guarantee has been given for adequate consideration, it will generally be considered to have been given for the purpose of gaining or producing income. Therefore, if the acquisition of a debt in these circumstances gives rise to a bad debt, any loss arising from a payment required of the guarantor under that guarantee will be considered to be a deductible capital loss within the meaning of paragraph 39(1)(b) of the Act.
Where a taxpayer has guaranteed the debts of a corporation for inadequate consideration, the Department has taken the position that it was not given for the purpose of gaining or producing income from a business or property. However, the Department has taken the position, on an administrative basis, that if the conditions listed in paragraph 6 of IT-239R2 were satisfied, it was overlooking the purpose test and allowing the loss.
The Department's position regarding guarantees or loan for inadequate consideration has been challenged successfully in such cases as Business Art Inc. v. M.N.R., 86 D.T.C. 1842 (T.C.C.), Burns et al. v. The Queen, 94 D.T.C. 1370 (T.C.C.), Steckel v. M.N.R., 92 D.T.C. 1904 (T.C.C.), which have held that the failure to recover a fee for a guarantee or interest on a loan is not fatal, if the guarantee or the loan will assist a corporation to earn income and to pay that income to the taxpayer by way of dividends.
Recently, the Federal Court of Appeal upheld the decision of the Federal Court -Trial Decision in the case Edwin J. Byram v. The Queen, 95 DTC 5069. In that case, the taxpayer made non-interest bearing advances to a U.S. corporation. Some advances were made while he was a direct shareholder of the U.S. corporation and others while he was only an officer and director. At those latter times, the direct shareholdings were held by a Canadian corporation of which the plaintiff, his wife and his son were the shareholders. The taxpayer claimed a capital loss on these advances when the U.S. corporation became insolvent.
The Federal Court of Appeal held that the sole requirement of subparagraph 40(2)(g)(ii) of the Act was that the purpose of lending be to earn income and the statutory language did not import a direct or indirect concept. The Court further went on to hold that, in situations where the taxpayer does not hold shares in the debtor and thereby is not entitled to dividend income directly from the debtor, the burden of demonstrating a sufficient nexus between the taxpayer and the income will generally speaking, be higher than in situations where the taxpayer is entitled to dividend income directly. The sufficiency of the connection will be decided on a case by case basis.
The Department has accepted the decision and it will be considered during the next update of the bulletin.
In the present situation, since XXXXXXXXXX did not hold shares of XXXXXXXXXX, he has to demonstrate that there was sufficient connection between him and the income that could have been generated by XXXXXXXXXX.
In that regard, it is our view that we could relied on the decisions in Judy O'Blenes v. M.N.R, 90 DTC 1068 (T.C.C.) and Owen D. Ellis v. M.N.R., 88 DTC 1070 (T.C.C.) to deny the loss.
In the Judy O'Blenes v. M.N.R., 90 DTC 1068 (T.C.C.), the taxpayer guaranteed a loan of a corporation of which her husband was a shareholder and it was held that the taxpayer's motivation in guaranteeing was to help a family member, not to earn income and that 40(2)(g)(ii) applies. There may have been advantage to the taxpayer, but there was no business purpose.
In Owen D. Ellis v. M.N.R., 88 DTC 1070 (T.C.C), where an individual taxpayer guaranteed a loan to a hotel corporation, in which his company was merely a minority shareholder, the Court found that since the taxpayer would be in no position to assume that dividends be paid from the hotel corporation, the possibility of benefit was too remote to say that the guarantee was given for the purpose of earning income from a business or property.
Consequently, since the trust is fully discretionary, as to the payment of income and capital and the fact that XXXXXXXXXX as the sole trustee may never have been or become entitled to any income from the trust, we are of the view that the guarantee was not given by XXXXXXXXXX for the purpose of gaining or producing income for himself but for the trust. Also, we believe the possibility of the taxpayer to receive income is too remote to demonstrate that there is a sufficient connection between the taxpayer and the income that could have been earned.
Therefore, unless the taxpayer could prove otherwise, we would deny the loss pursuant to subparagraph 40(2)(g)(ii) of the Act.
For your information, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department's mainframe computer. 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, they can be provided with the LAD version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Jackie Page at (819) 994-2898. The severed copy will be sent to you for delivery to the client.
We hope that our comments are of assistance.
Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
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