NO: IT159R3
DATE: MAY 1, 1989
SUBJECT: INCOME TAX ACT
Capital Debts Established to be Bad Debts
REFERENCE: Paragraph 50(1)(a) and subsection 50(2) (Also subsections 20(4) and 41(3), paragraphs 20(1)(p), 39(1)(b), 40(2)(g) and 54(e), and subparagraphs 54(f)(ii) and 54(i)(iii)).
Application
This bulletin replaces and cancels Interpretation Bulletin IT-159R2 dated December 18, 1979. Current revisions are designated by vertical lines.
Summary
This bulletin discusses the tax implications when a taxpayer establishes that a debt on capital account is bad.
The commentary below explains the deemed disposition and reacquisition rules set out in paragraph 50(1)(a) for capital debts in general that are bad and in subsection 50(2) for such debts arising on the disposition of personal-use property. Also explained are the restrictions set out in paragraph 40(2)(g) where such a debt was acquired by a taxpayer other than for the purpose of earning income from a business or property, or is owing by a non-arm’s length party. Set out in 10 below are the Department’s views on when a debt is considered to have become bad and on the requirement that the whole amount of the debt, or the remainder thereof, must be bad.
Discussion and Interpretation
1. Where a taxpayer establishes that an amount receivable on capital account (other than in respect of the disposition of a personal-use property) has become a bad debt in a taxation year, paragraph 50(1)(a) provides for a deemed disposition at the end of the year and a reacquisition immediately thereafter at a cost of nil. This normally results in a bad debt being a capital loss for the year with any recovery of the debt being a capital gain.
2. Under subparagraph 40(2)(g)(ii), a taxpayer’s capital loss on the disposition of a debt or other right to receive an amount is nil unless
(a) the debt or right was acquired by the taxpayer for the purpose of gaining or producing income (other than exempt income) from a business or property, or
(b) the debt or right was acquired by the taxpayer as consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm’s length.
Where an amount receivable can be established by the taxpayer to be a bad debt in a year but subparagraph 40(2)(g)(ii) would apply to deny the resulting capital loss, the Department takes the view that paragraph 50(1)(a) will not apply. The result of not applying paragraph 50(1)(a) is that there is no deemed disposition or reacquisition of the debt and any realization of the debt in future years will reduce the adjusted cost base thereof rather than produce a capital gain. This view is not affected by the fact that the debt is written off for accounting purposes. (Where the debt in question is a loan bearing less than a reasonable rate of interest, refer to IT-239R2 “Deductibility of Capital Losses from Guaranteeing Loans for Inadequate Consideration and from Loaning Funds at less than a Reasonable Rate of Interest in Non-arm’s Length Circumstances”.)
3. To illustrate the comments in 2 above, assume that a taxpayer establishes a note receivable for $1,000 to be a bad debt in 1988. The debt was not acquired by the taxpayer for the purpose of gaining or producing income or as consideration for the disposition of capital property to an arm’s length person, so that subparagraph 40(2)(g)(ii) prevents a claim in respect of a $1,000 capital loss. If paragraph 50(1)(a) were to be applied, there would be a deemed reacquisition of the debt at a nil adjusted cost base and any subsequent recovery of all or a portion of the debt would be treated as a capital gain. In these circumstances, the taxpayer is not required to establish that the debt is bad in 1988, so that any subsequent recovery of all or a portion of the debt will reduce its adjusted cost base rather than be treated as a capital gain.
4. Where a taxpayer establishes a debt to be a bad debt under section 50, the loss will be deemed under subparagraph 54(i)(iii) not to be “a superficial loss”.
5. Where a debt which arose from the disposition of personal-use property (see IT-332R “Personal-Use Property”) is owing to a taxpayer by a person dealing at arm’s length with the taxpayer, subsection 50(2) contains deemed disposition and reacquisition rules that allow a claim to be made in respect of a capital loss for the taxation year in which the debt is established to be bad. This capital loss cannot exceed the capital gain realized on the disposition that gave rise to the debt. Under subsection 50(2), the debt is deemed to have been disposed of for proceeds equal to the amount by which its adjusted cost base immediately before the end of the year exceeds the amount of the gain on the disposition of the personal-use property, and the taxpayer is deemed to have reacquired the debt immediately after the end of the year at a cost equal to those proceeds.
6. Where a debt which arose from the disposition of personal-use property is owing to a taxpayer by a person not dealing at arm’s length with the taxpayer, the comments in 5 above do not apply and any loss resulting on the disposition of the debt is denied under subparagraph 40(2)(g)(iii).
7. A debt arising on the disposition of a listed personal property is not one of the items listed under the definition of listed personal property in paragraph 54(e). Rather, it is included under subparagraph 54(f)(ii) in the definition of personal-use property. Thus when such debts are established to be bad, any capital loss is calculated as in 5 above rather than as a “listed personal property” loss under subsection 41(3).
8. An example to illustrate the comments in 7 above follows:
Assume that a taxpayer sells a listed personal property at arm’s length for $10,000 and that the adjusted cost base of that property is $6,000. Of the sale price, $5,000 is paid at the date of sale and a note receivable is taken back for the remainder. The note receivable is subsequently established to be a bad debt. A capital loss on the debt is determined pursuant to subsection 50(2) as follows:
Adjusted Cost Base of Debt $5,000 Less: gain on disposition of Property $4,000
Deemed Proceeds of Disposition $1,000
Less: Adjusted Cost Base of Debt 5,000
Capital Loss $4,000
As can be seen from this example, if the loss from the deemed disposition of the debt were considered to be a loss from the disposition of listed personal property, a loss of $5,000 would have been available to net against gains from listed personal property. However, by reason of subsection 50(2), the loss in this example is considered to be $4,000 and is treated as an ordinary capital loss and the debt is deemed to be reacquired at a cost of $1,000.
9. Where a debt is established to have become a bad debt, any capital loss that results will be reduced under paragraph 39(1)(b) by the amount of any deduction made in respect of the loss under any provision of the Act. For example, refer to IT-220R “Capital Cost Allowance-Proceeds of Disposition of Depreciable Property” which discusses the situation where a capital loss would be reduced by the amount deducted under subsection 20(4) as an uncollectible portion of proceeds of disposition of depreciable property and IT-123R4 “Dispositions of and Transactions Involving Eligible Capital Property” which discusses the situation where a capital loss would be reduced by an amount deductible under paragraph 20(1)(p) as a result of a bad debt arising on the sale of eligible capital property.
10. The time at which a debt becomes a bad debt is a question of fact and any decision made must be dependent upon the circumstances in each case. A determination by a creditor that a debt has become bad in a particular taxation year must be supported by all relevant and material facts. Generally, a debt will not be uncollectible at the end of a particular taxation year unless the creditor has exhausted all legal means of collecting it or where the debtor has become insolvent and has no means of paying it. A debt is considered bad for the purpose of section 50 only when the whole amount is uncollectible or when a portion of it has been settled and the remainder is uncollectible. Otherwise, where a portion of a debt can be considered uncollectible, this portion is not considered to be bad for the purpose of section 50 even though accounting practice may require a write-down to realizable value. Where an amount owing by one debtor consists of more than one debt, each debt is considered separately in determining the extent to which the above comments apply. For example, one debt may be secured and collectible whereas another debt may be unsecured and uncollectible and, therefore, qualify as a bad debt.
Link to Source: https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/it159r3/archived-capital-debts-established-debts.html