JUL 22 1988 C. Tremblay (613) 957-2139
SUBJECT: XXXX
This is in reply to your memorandum of March 17, 1988, requesting our comments concerning the deductibility of accrued interest in a situation where a farmer, reporting on the cash basis, has filed a quit claim deed transferring his interest in land to a lending institution in full satisfaction of the principal and interest owing on the loan. You state that Head Office Appeals has advised the local Appeals division that a farmer computing income on the cash basis would be allowed to deduct the interest owing under paragraph 20(1)(c) of the Income Tax Act (the "Act") in the year the quit claim is filed.
We also make reference to the November 27, 1987 letter from our Minister to XXXX concerning the interest deduction of XXXX disallowed to XXXX
Your example 2, which illustrates a number of situations of concern to you is as follows:
Interest owing to lender $80,000 Principal owing $100,000 Fair market value of land $70,000
The interest owing to the lender is greater than the fair market value of the land, and after having considered Information Circular IC 87-5, you feel that the farmer should not be allowed to claim interest greater than the fair market value of the land.
Our Comments
It is our position that where a taxpayer utilizing the cash method of reporting income files a quit claim deed transferring his interest to a lending institution, section 79 of the Act applies. In a case where the interest due and payable in respect of the debt is extinguished, there are no tax implications to the debtor. The interest is not deductible because it is not considered paid. The creditor, however, may claim a deduction for the unpaid interest to the extent that it was previously included in income (see paragraph 10, IT-505 ).
Although the general rule of law states that any payment by a debtor to his creditor is imputed first to interest and thereafter to principal, where section 79 of the Act applies, the rules found in that section are used to determine any tax implications. The farmer, reporting on the cash basis, is subject to those rules and his proceeds of disposition is the principal amount, as defined in subsection 248(1) of the Act. This position is clearly set out in Interpretation Bulletin, IT-505 .
In our view there is no need for you to consider the maximum amount of interest-allowable or the fair-market value of the land reacquired through foreclosure, repossession or quit claim. In example #2, there is no interest deduction allowable unless of course and amount has been paid in cash specifically to cover interest as in the XXXX matter. In example #2, the principal amount owing of $100,000 is the debtor's only proceeds of disposition pursuant to section 79 of the Act and it relates solely to the principal amount of the taxpayer's claim (see also paragraph 13 of IT-505 ).
We are aware that our conclusion differs from that in the December 8, 1987 hand written memo prepared by S. Ngan of the Appeals Branch, however, he has indicated that he did not fully consider the implications of section 79.
In our view the foregoing conclusion would also apply to your example #1 where the fair market value of the land exceeds the principal amount of the debt by $10,000. However, in a particular fact situation it could possibly be claimed that, as a negotiated settlement has taken place, section 79 has no application. Should such a situation arise you may wish to send us the facts in order that we may obtain a legal opinion in the matter.
We trust our comments will be of assistance.
for Director Small Business and General Division Specialty Rulings Directorate Legislative ant Intergovernmental Affairs Branch