ARCHIVED - Debtor's Gain on Settlement of Debt
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DATE: July 16, 1979
SUBJECT: INCOME TAX ACT
Debtor's Gain on Settlement of Debt
REFERENCE: Section 80 (also sections 9 and 78 and subsection 26(1.1) of the Income Tax Application Rules, 1971 (ITAR))
This bulletin replaces and cancels Interpretation Bulletin IT-293 dated February 23, 1976. Changes and additions are indicated by a vertical line.
1. Where a debt or other obligation is settled after 1971 otherwise than by payment in full of the principal amount by the debtor, the debtor's gain is subject to the rules set out in section 80 unless the exclusions listed in 15 below apply. Under these rules the gain is applied to reduce, in the following order, the debtor's
(a) non-capital losses,
(b) applicable to 1983 and subsequent taxation years, farm losses,
(c) net capital losses, and
(d) restricted farm losses,
of the years preceding the year of settlement, to the extent that these losses would otherwise be deductible in computing the debtor's taxable income for the year of settlement or a subsequent year. Any remaining portion of the gain is applied, in the manner prescribed in part LIV of the Regulations, to the capital cost of depreciable property and the adjusted cost base of capital property. Since it is neither a depreciable property nor a capital property, an eligible capital property is not affected by the application of the provisions of section 80.
2. Where the debt or obligation was outstanding at January 1, 1972, the provisions of the ITAR 26(1.1) effectively exclude the application of the rules described in 1 above to the amount by which the debt or obligation had diminished in value before 1972.
3. If any part of the gain remains after the procedure described in 1 above is followed, there are no provisions in the Act which deal specifically with it. However, depending on the circumstances, it is possible that subsection 245(2) (indirect payments or transfers) might apply to the remaining unapplied part of the gain if not negated by subsection 245(3).
4. Section 80 may apply to any type of debt or obligation, including a trade debt.
Time of Application
5. Any adjustment required under section 80 is made at the time during the taxation year when the debt or obligation is settled or extinguished. Even when a settlement is effected at the end of a taxation year, any resulting adjustments to losses of preceding years are considered to take place before any amount in respect of those losses is applied to reduce taxable income of the taxation year.
Time of Settlement
6. For a debt or obligation to be "settled or extinguished" all liability for payment must be terminated. Payment, cancellation, set-off, substitution of debtors and release are examples of some possible means of settlement. A debt or obligation is not settled where a creditor abandons his right to enforce payment or becomes statute-barred from enforcing his right to payment. However, a settlement does occurs where, by statute, the debtor's actual liability to pay is extinguished after a specified period of time has elapsed.
7. Where the terms of the debt require the debtor to make part payments of specified amounts at specified times, section 80 may apply even though the amount settled or extinguished represents only part of the total debt. For example, a taxpayer assumes a mortgage for $20,000 in 1973 on which he is to pay $100 monthly instalments of principal. In 1973 and 1974 the taxpayer makes all the required $100 monthly payments. For 1975, because of the taxpayer's financial difficulties, the mortgagee agrees to forgive $50 monthly (i.e. he cancels the $100 debt on receipt of $50 monthly). Since each obligation to pay $100 has been fully settled for $50 in 1975, the taxpayer is subject to section 80 in that year.
8. Where instalment payments are not required under the terms of the debt agreement, the provisions of section 80 are applied only when a final settlement is accepted by the creditor. When an arrangement for the settlement of such a debt is entered into, final settlement does not usually take place until the debtor has completely discharged his commitment under the arrangement. For example, a taxpayer incurs a debt of $400,000 in 1972 on which no instalment payments are required, but which is to be paid in full before 1976. In 1973 the parties agree to an arrangement whereby the debtor makes a payment of $200,000 immediately and undertakes to make a further payment of $100,000 in 1975 at which time the $400,000 debt will be extinguished. Application of the rules described in 1 above does not occur in 1973, but in 1975 when the debtor fulfills his obligation to pay $100,000. This view is not applicable if a reasonable evaluation of the particular facts indicate that a creditor accepted as full settlement a partial payment and a new obligation from the debtor. If, in the foregoing example, the arrangement required an immediate payment of $299,000 in 1973 and an undertaking by the debtor to pay $1,000 in 1999, the rules described in 1 above would be applied in 1973.
9. Where several debts are outstanding and the forgiveness relates to specific debts, the comments in 7 and 8 above are applicable in respect of each debt. However, where the amount owing consists of several debts and the forgiveness is not related to the particular separate debts (e.g. the partial forgiveness of a current account payable), any sum paid by the debtor on his account subsequent to the forgiveness is considered to be a payment on the balance of the account remaining at the time of the partial forgiveness.
Statement of Account Payable to A.B.C. Ltd.
|January 1||Balance forward||$100,000|
|January 2||Forgiveness granted||$20,000||80,000|
|June 30||Merchandise purchased||$40,000||80,000|
|January 15||Merchandise purchased||20,000||80,000|
In accordance with the foregoing position, the provisions of section 80 are applied on January 31, 1974 in respect of the forgiveness recorded on January 2, 1973.
Meaning of "Payment by Him"
10. The application of section 80 is not restricted to forgiven debts or obligations, but extends to
(a) debts or obligations that are settled or extinguished by any means other than by payment, and
(b) debts or obligations that are settled by payment made by persons other than the debtor.
11. The word "payment" is given its usual meaning and accordingly includes payment in kind. Where a debtor corporation issues its own shares to a creditor in settlement of a debt, the provisions of section 80 do not apply if the fair market value of the shares at that time is not less than the principal amount of the debt. However, the transfer of an amount owing to a shareholder to a contributed surplus account does not constitute a payment and section 80 may have application.
12. For the purposes of section 80 the Department considers set-off to constitute payment if it is reasonable in the circumstances to consider that the creditor received value equal to or exceeding the principal amount of the debt or obligation. This practice applies to settlement of debts of a corporation to its shareholders upon winding-up (see IT-142R) and a debt bequeathed to the debtor (see IT-382).
13. Although the assumption of a debt or obligation of a taxpayer by a third party may not constitute payment by the taxpayer in a strict sense, the rules described in 1 above are not applied if the third party receives consideration from the taxpayer at least equivalent to the principal amount of the debt or obligation assumed.
14. The payment of a debt or obligation by a guarantor or insurer makes the debtor subject to the application of section 80 since payment is not made by the debtor. However, where payment is made by a guarantor entitled to use all the remedies that were available to the creditor in enforcing payment by the debtor, the rules described in 1 above are not applied, unless, of course, the guarantor forgives all or any portion of the debtor's obligation to indemnify him. IT-430 discusses the Department's position with respect to settlement of a debt or obligation from proceeds of a life insurance policy arising on death.
15. In accordance with paragraphs 80(c) to (f), the rules described in 1 above do not apply where
(a) the debtor is a bankrupt at the time of settlement (see 16 below),
(b) the debt was such that, if interest had been paid on it, the interest would not be deductible in computing income (see 17 and 18 below),
(c) the provisions covering mortgage foreclosures and conditional sales repossessions (section 79) apply to the debt, or
(d) the gain is otherwise required to be
(i) included in computing the debtor's income for the year (see 19 below), or
(ii) deducted in computing the debtor's capital cost of any depreciable property or his adjusted cost base of any capital property (see 20 below).
16. Section 2 of the Bankruptcy Act defines a "Bankrupt" as "a person who has made an assignment or against whom a receiving order has been made or the legal status of such a person'. When a bankrupt (the debtor) makes a proposal under Part III of the Bankruptcy Act and this proposal is approved by the court, the bankruptcy is rendered void; thus such a debtor does not come within the exclusion in 15(a) above, and the provisions in 1 above may apply. These provisions may also apply to an insolvent person who has a gain on settlement of a debt by virtue of an approved proposal under Part III of the Bankruptcy Act since such a person is not a bankrupt.
Interest Not Deductible
17. In applying the test in 15(b) above, all of the taxation years during which the debt or obligation was outstanding must be considered. If any amount of interest was deductible (or would have been deductible had interest been paid) in respect of any of these years, the conditions for exclusion are not satisfied.
18. The exclusion described in 15(b) above includes:
(a) any loan not made for the purpose of earning business or property income,
(b) a debt incurred to acquire a property that is not income producing,
(c) a debt or obligation incurred for the purpose of acquiring a life insurance policy or an interest therein, and
(d) a debt or obligation incurred for the purpose of earning income that is tax exempt.
Debts or obligations not exempted from the application of the rules described in 1 above by this exclusion include:
(e) debts of a corporation where the interest payable thereon is not fully deductible by reason of the "thin capitalization" rules contained in subsection 18(4), and
(f) a loan extended to a developer to acquire land if any interest thereon is deductible in the current taxation year or was deductible in an earlier taxation year.
Excess Otherwise Required to be Included in Income
19. The exclusion described in 15(d)(i) above includes:
(a) the gain realized by the issuer of bonds, debentures or other similar obligations when purchased in the open market at an amount below the issue price (subsection 39(3)),
(b) amounts required to be included in the income of a taxpayer in respect of unpaid remuneration or other unpaid expenses in accordance with section 78 (see IT-109),
(c) cash, volume, performance or similar discounts or rebates on trade debts (included in the computation of profit under section 9),
(d) adjustment of trade debts for lost or defective merchandise (included in the computation of profit under section 9),
(e) the forgiveness of a trade debt in respect of an expense that was deducted in computing income for tax purposes in the same year, since the rules governing the computation of profit under section 9 require that the forgiveness offset the expense,
(f) an amount included in computing the income of a debtor by reason of subsection 245(2) in respect of the forgiveness of a trade debt owing to a creditor with whom he does not deal at arm's length, and
(g) a debt owing by an employee to a corporation that is forgiven and included in the employee's income by virtue of subsection 5(1), paragraph 6(1)(a) or subparagraph 56(1)(a)(ii) (see IT-222R at paragraph 6).
Excess Otherwise Required to be Deducted from Cost of Property
20. The exclusion described in 15(d)(ii) above includes:
(a) a government loan where any gain on its forgiveness in whole or in part is required by subsection 13(7.1) or paragraph 53(2)(k) to be applied to reduce the capital cost or adjusted cost base of a capital property (see 28 below), and
(b) a debt that is reduced as a result of a genuine downward adjustment of the purchase price of a capital property or an eligible capital property (see IT-174R at paragraph 6).
21. If the adjustment described in 20(b) above can be regarded as a true forgiveness of debt, the rules described in 1 above apply. An adjustment is usually considered to be a true forgiveness of debt if it
(a) was not made by the creditor because of value received by him in some other way,
(b) does not represent a cash or other discount of a reasonable amount or an adjustment for lost or defective property, and
(c) can be attributed to financial difficulties of the debtor.
22. Section 80 only applies where the amount paid is less than the principal amount of the debt or obligation. Since the definition of "principal amount" in subsection 248(1) specifically excludes interest, section 80 is not applicable to the forgiveness of interest.
23. Since paragraph 80(f) refers only to amounts otherwise required to be included in income for the taxation year in which the forgiveness takes place, it is possible to apply the rules described in 1 above at that time, even though the same amount is included in income of a preceding or subsequent year (under section 78 for example). However, in such circumstances, section 80 is considered not to be applicable.
24. The provisions of section 80 are not applied in respect of inter-company debt extinguished on an amalgamation that is subject to the provisions of section 87.
Trade Debts Forgiven
25. As mentioned in 19(e) above, forgiveness of a trade debt in the same taxation year in which it was incurred is required to be included in computing the debtor's income for that year under the general rules for computing profit from a business or property. Where the debt forgiven is in respect of merchandise or other property in which the debtor deals, the cost of the property acquired is reduced by the amount of forgiveness whether or not it was sold in the year in which the debt was forgiven. Where the forgiveness occurs in a taxation year subsequent to that in which the debt was incurred, the same general rules of profit computation require that an amount be included in the profit computation for the year of forgiveness equal to that portion of the forgiven debt that relates to the inventory of merchandise on hand at the beginning of that year. In other circumstances under which a trade debt is forgiven, the rules described in 1 above apply (subject to any applicable exclusions described in 15 above).
26. Contrary to the comments in 25 above (and in 19(e) above), the provisions of section 80 apply to situations where there is a bona fide compromise on a trade debt under Part III of the Bankruptcy Act or under other federal or provincial legislation relating to creditors, arrangements and the gain is excluded from the computation of income.
27. The rules described in 1 above are not considered applicable to a payer corporation where a shareholder has unconditionally waived his right to a declared dividend (see IT-208).
Forgivable Government Loans
28. Where the terms of a government loan include a forgiveness feature contingent upon the happening of an event that is considered remote at the time the loan is negotiated, the provisions of subsection 13(7.1) and paragraph 53(2)(k) with respect to "forgivable loans" are not considered applicable. Thus, if the forgiveness feature becomes operative, the provisions of section 80 apply. One example of a loan of this type is the 1976 Assisted Rental Program of Central Mortgage and Housing Corporation.
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