19 June 1996 External T.I. 9608715 - ABIL - DIRECTOR LIABILITY

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

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 Issues:

Whether an allowable business investment loss can be claimed by a director in respect of amounts paid as a result of his section 227.1 liability.

Position:

ABIL cannot be claimed, since the debt, if any, arising from the payment of unremitted source deductions is not considered to have been acquired for the purpose of gaining or producing income from a business or property.

Reasons:

Under paragraph 40(2)(g)(ii) of the Income Tax Act, a taxpayer's loss arising from the disposition of a debt is nil unless the debt was acquired by the taxpayer for the purpose of gaining or producing income from a business or property.

		8-960871
XXXXXXXXXX		C. Chouinard

Attention: XXXXXXXXXX

June 19, 1996

Dear XXXXXXXXXX:

Re: Section 227.1 Liability - Allowable Business Investment Loss

We are writing in reply to your letter of March 5, 1996, which was referred to us for our reply by the Appeals Division, wherein you requested our comments regarding the tax status under subparagraph 40(2)(g)(ii) and paragraph 39(1)(c) of the Income Tax Act (the "Act") of payments made by a director pursuant to section 227.1 of the Act.

In your opinion, such payments constitute a capital loss to which subparagraph 40(2)(g)(iii) of the Act does not apply and, if a corporation is a small business corporation at the time it becomes bankrupt, the capital loss will qualify as an allowable business investment loss within the meaning of paragraph 39(1)(c) of the Act. In support of your opinion, you refer us to question 48 of the Revenue Canada Round Table of the 1992 conference of the Association de planification fiscale et financière. Based on the response the Department provided to question 48, you argue that when an individual becomes a director of a corporation, the individual is guaranteeing the corporation's debts under section 153 of the Act. In your view, the fact that this guarantee arises by virtue of a statute, as opposed to a contract, is irrelevant as regards the Department's administrative position set out in paragraph 6 of Interpretation Bulletin IT-239R2. In addition, you submit that, based on the National Developments Ltd. v. R., 94 D.T.C. 1061 (T.C.C.) case, the income earning test for purposes of subparagraph 40(2)(g)(ii) of the Act applies at the time an individual becomes a director, not at the time a payment is made by the director pursuant to section 227.1 of the Act.

As regards paragraph 39(1)(c) of the Act, you argue that it is only necessary that a corporation be a small business corporation within 12 months of the time that the corporation becomes bankrupt and not within 12 months of a payment being made by an individual.

Our Comments

An employer and any person charged under subsection 153(1) of the Act with withholding or deducting tax at source is considered, for purposes of this provision, to be the agent of the Minister.⁽¹⁾ In addition, pursuant to subsection 227(4) of the Act, any such employer or person must act as a trustee of those funds. Therefore, the debt owed is that of the employee and by deducting at source the amount of tax fixed by the regulations, the agent/employer is paying the tax that the employee would have had to pay if the full amount of salary had been received.⁽²⁾

In order to enforce the provisions of subsection 153(1) of the Act and ensure recovery if the trust funds are diverted to another creditor or converted to personal use, the government introduced section 227.1 of the Act, making the directors of a corporation personally liable for the agent/employer's breach of trust. Since it is usually the directors of a corporation who manage the affairs of the corporation, it is not unusual that the liability for not remitting the trust funds should be imposed on them. They are best able to ensure that these trust funds will be collected and remitted and, to the extent that they are an active party to an improper disposition of trust property, it is acceptable that they also be liable for breach of trust.

Therefore, in our view, the debt that arises is that of the employee for which the employer, which is mandated to collect and remit the debt, is liable in its capacity as a statutory agent. The directors' liability under section 227.1 of the Act simply flows from the employer/agent's liability and is intended to ensure that the provisions of subsection 153(1) of the Act can be enforced, such that the loss occasioned by unremitted source deductions is not passed on to other taxpayers.

As stated in paragraph 2 of Interpretation Bulletin IT-159R3, under paragraph 40(2)(g)(ii) of the Act, a taxpayer's loss arising from the disposition of a debt is nil unless the debt was acquired by the taxpayer for the purpose of gaining or producing income from a business or property. In our view, section 227.1 of the Act is essentially a means of collecting tax. While it could be argued that the payment of an amount by a director pursuant to section 227.1 of the Act creates a debt owing by the corporation to the director, since the payment of this amount relates to a failure by the corporation to remit tax owed by its employees and thus, to a breach of trust, in our view, the debt would not be acquired by the director for the purpose of gaining or producing income from a business or property.⁽³⁾ As indicated in the Jackman v. M.N.R., 91 D.T.C. 1275 (T.C.C.) case, "the payment of the corporate liability (does) not present in any way the prospect that either (the director) or the Corporation (can) gain or produce any income therefrom". Our opinion would be the same whether the income earning test was applied when the individual first became a director or when he was held liable under section 227.1 and required to pay the corporation's unremitted source deductions.

As regards capital losses from guaranteeing corporate loans for inadequate consideration, the Department's position, as stated in paragraph 4 of Interpretation Bulletin IT-239R2, is that a capital loss arising where a taxpayer is required to honour a guarantee given for inadequate consideration or for no consideration is nil by virtue of subparagraph 40(2)(g)(ii) of the Act. Nevertheless, the Department has adopted a position with respect to Canadian corporations of which the taxpayer is a shareholder that allows the taxpayer a loss where certain conditions are met, as stated in paragraph 6 of IT-239R2. Although there is nothing in the Act which supports this liberal position, it has been justified on the basis that small businesses are often unable to obtain bank financing unless their debt is guaranteed by a shareholder. In addition, the guarantee is considered to have been given for the purpose of enabling the corporation to earn income that may result in dividends to the guarantor. The Department is not, however, prepared to extend this administrative position to situations other than those described in paragraph 6 of IT-239R2.

With respect to question 48 of the Revenue Canada Round Table of the 1992 conference of the Association de planification fiscale et financière, in our view, the question asked can be distinguished from the present situation, as unpaid wages are clearly a debt of the corporation, whereas unremitted source deductions represent debts of the employees which the corporation is mandated to collect on behalf of the Crown. In our view, the response provided does not assimilate payments made by a director as a result of a corporation's breach of trust to payments made by a shareholder to honour a guarantee provided in respect of a corporation's debts.

Accordingly, since the debt, if any, that arises pursuant to section 227.1 of the Act would not be considered to be acquired for the purpose of gaining or producing income from a business or property and as the Department is not prepared to grant administrative leniency in the case of a breach of trust, subparagraph 40(2)(g)(ii) of the Act would apply to deny the loss on the disposition of the debt created when a director is held liable under section 227.1 of the Act. As the loss on the disposition of the debt would be nil, the director would not be entitled to claim an allowable business investment loss in respect thereof.

We trust that these comments will be of assistance.

Yours truly,

R. Albert
for Director
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch

cc. R.M. Beith

Assistant Deputy Minister
Appeals

ENDNOTES

^1. See Lalonde v. M.N.R., 82 D.T.C. 1772 (T.R.B.) at 1774, The National Indian Brotherhood v. M.N.R., 75 D.T.C. 110 at 111 and Realty Projects (1957) Inc. v. M.N.R., 79 D.T.C. 511 at 515.

^2. See Morin v. The Queen, 75 D.T.C. 5061 (F.C.T.D.) at 5064-5065.

^3. It is for that reason that paragraph 18(1)(t) of the Act denies a deduction in respect of "any amount paid or payable under this Act". Such amounts are not considered to be disbursements incurred for the purpose of producing income.