Dear Sirs:
Re: Debt Obligations
This is in reply to your letter of May 2, 1991, requesting our views on whether it is acceptable for a Corporation that acquires a debt obligation at a significant discount to adopt the Cost Recovery Method in reporting its gain on the repayment of the debt, consistent with the position set forth in paragraph 8 of IT-114, or whether the corporation must adopt the Part Disposition Method in reporting its gain on the repayment of the debt as suggested by IT-264R.
The hypothetical facts given are as follows:
A debt obligation owed by Debtorco, under a debenture, is acquired by Purchaseco at a significant discount from its face amount.
You request our comments as to what is the appropriate method of accounting for the cost of the debt in calculating the gain to Purchaseco in respect of periodic repayments which eventually result in Purchaseco recovering the full face amount of the debt. The Cost Recovery Method of accounting for the repayments of the debt would result in Purchaseco realizing a gain in respect of Debterco's repayment of the debt only after it recovered the entire amount it paid to acquire the debt. An alternative method of accounting for the repayments would be the Part Disposition Method whereby each repayment of the portion of the amount owing under the debt would give rise to a gain in Purchaseco computed by reference to its ACB of that debt instrument allocated to each principal repayment on a pro rata basis based on the face amount of the debt.
Our Comments
The general guidelines for the treatment of discounts are set out in Interpretation Bulletin IT-114. Paragraph 8 of that bulletin is located in a portion of the bulletin which applies to a taxpayer recognizing the discount on income account. The amount of any discount is ordinarily included in computing income at the time the debt obligation is redeemed or disposed of in some manner. In the case of those obligations that are redeemed by instalment payments, the amount of any discount may be included in the income of the taxpayer only after he has recovered the whole amount that he paid for the obligation; but if he wishes to bring the discount into income on the basis that part of it is received at the time each payment on account of principal is received, that basis is acceptable. Thus, the taxpayer who reports the discount on income account may use the Cost Recovery Method.
Paragraph 16 of IT-114 sets out the Department's assessing policy on discounted debt obligations if the taxpayer reports the discount on capital account. If the taxpayer's activities can be classified as those of an investor the amount of any realized discount or bonus is treated as a capital gain. The amount of the particular taxable capital gain is determined in the normal manner under the provision of subdivision c of Division B of the Act. Consequently, the Cost Recovery Method is not available to those taxpayers. Our understanding of the rules for part dispositions under subdivision c is set out in IT-264R.
The comments in this letter are of a general nature only and do not take into account considerations that might arise in connection with a specific transaction or event. In accordance with paragraph 24 of Information Circular 70-6R, the comments expressed herein do not constitute advance income tax rulings and consequently are not binding on the Department.
Yours truly,
for Director Business and General DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch