Proposed section 143.4 of the Income Tax Act (Canada) (the “Act”) will limit the recognition of a "contingent amount" for tax purposes. This new rule is in response to the Federal Court of Appeal's decision in Collins v. The Queen (2010 FCA 12) where the taxpayers were permitted to deduct the full amount of accrued, but unpaid, interest, even though they had the right under the loan agreement to subsequently elect to pay a substantially lower amount.
As often happens with remedial legislation, though, the proposed amendment is not limited to reversing the unfavourable decision in Collins. Indeed, as we suggest here, it has a much broader reach, and may have some unintended harmful consequences.
The Collins Decision
In Collins, the taxpayers borrowed funds in 1981 under an Alberta government financing program designed to encourage the construction of apartment buildings. In 1993 the loan agreement was amended so that the taxpayers were required to pay only $20,000 on account of interest in each of the following 15 years, instead of the full 10% per annum stipulated as the interest payable elsewhere in the loan agreement. The balance of the interest owing, calculated at the full 10% per annum rate, was payable at the end of the 16th year. However, the amended loan agreement gave the taxpayers an option to "payout" their obligations under the agreement by paying a lump sum of $100,000 plus $20,000 for each year remaining in the initial 15 year term.
In calculating their income, the taxpayers used the accrual method to deduct interest at the full 10% per annum rate, rather than deducting only the $20,000 which they had actually paid. The Crown in Collins argued that this was inappropriate since there was no legal obligation to pay any interest above the $20,000 per year and the obligation to pay interest at the full 10% rate was contingent.
The Federal Court of Appeal decided against the Crown's position. The Federal Court of Appeal reasoned that it was the right to pay less than 10% that was contingent, and not the obligation to pay interest at 10%. Since the taxpayers were accrual basis taxpayers, they were permitted to deduct the interest on the loan as it accrued, even if it could be subsequently reduced.
Treatment of contingent liabilities
The term "contingent" and related concepts appear throughout the Act. For example, paragraph 18(1)(e) prohibits a taxpayer from deducting a contingent liability except as expressly permitted.
While it may appear straight forward, there are a number of legal subtleties. For example, some liabilities may be subject to a condition precedent, in which case there is no liability until the condition is satisfied. This is a classic contingent liability, the deduction of which is prohibited by paragraph 18(1)(e). Other liabilities may be subject to a condition subsequent, in which case the liability exists initially, but may cease to exist in the future if the condition arises.
As illustrated by Collins, the treatment of a liability with a condition subsequent can be quite different from the treatment of a liability that is subject to a condition precedent. Nevertheless, the rules are well known. All this will change with proposed section 143.4.
New Section 143.4
Proposed section 143.4, in effect, expands the scope of contingent liabilities to include liabilities which are subject to a condition subsequent. In particular, proposed section 143.4 addresses situations where a taxpayer has the right, exercisable in the future, to reduce an expenditure or cost. The new section will operate, simply, by requiring all “expenditures” to be reduced for tax purposes by any “contingent amount.”
“Contingent amount,” is defined for this purpose as follows:
“contingent amount”, of a taxpayer at any time … includes an amount to the extent that the taxpayer, or another taxpayer that does not deal at arm's length with the taxpayer, has a right to reduce the amount at that time.
The term "right to reduce" is defined as follows:
“right to reduce,” an amount in respect of an expenditure at any time, means a right to reduce or eliminate the amount including, for greater certainty, a right to reduce that is contingent upon the occurrence of an event, or in any other way, if it is reasonable to conclude, having regard to all the circumstances, that the right will become exercisable.
Proposed subsection 143.4(2) generally limits "expenditures" which are recognized for tax purposes by excluding contingent amounts. In effect, an "expenditure" for tax purposes will be reduced to the lowest amount that the taxpayer is required to pay after exercising applicable rights to reduce the expenditure. In determining the amount of the expenditure, the new rules take into account the fact that a taxpayer may have to pay to acquire the right to reduce the contingent amount.
Where a contingent amount is not recognized for tax purposes in a year, but is in fact paid in a later year, it will be deemed to have been incurred and to have become payable in the year it is paid, and it will be deemed to retain the same character as the original expenditure. Unfortunately, it is not clear how this relieving provision will operate for an expenditure that would otherwise form part of the cost of property. That is, will the subsequent amount be added to the cost or capital cost of the property when paid? It would seem so, but the proposed language is not completely clear.
Proposed subsection 143.4(4) addresses a less typical situation, where the expenditure is not contingent in the year it is deducted, but later becomes contingent. Where a taxpayer's right to reduce an expenditure arises in a subsequent taxation year, the earlier deduction is addressed by deeming the "subsequent contingent amount" to be income pursuant to paragraph 12(1)(x) of the Act. In these circumstances, subsection 12(2.2) of the Act may provide some relief if an election can be made to reduce an outlay or expense (other than the cost of property) and consideration could be given to whether paragraph 20(1)(hh) would allow a deduction if the full amount is ultimately paid.
In case these extensive deeming rules are not sufficient, there is a new anti-avoidance rule in proposed subsection 143.4(6) that will apply if one of the purposes of a taxpayer acquiring a right to reduce an expenditure after the end of the year was to avoid a reduction in the year under subsection 143.4(2).
Implications of the new rule
These new provisions raise a number of questions. Conditions and contingencies abound in commercial agreements. Funds are held in escrow pending conditions being met. Earnouts and reverse-earnouts are dependent on conditions. Under previous law, confirmed by the Federal Court of Appeal in Collins, obligations subject to a condition precedent were readily identifiable as contingent obligations and would not generally be recognized for tax purposes until the happening of the future event. The option provision at issue in Collins, like an obligation with a condition subsequent, is logically distinct. Under the drafting strategy of the proposed legislation, the distinction between these two concepts is essentially collapsed. It remains to be seen whether the expanded meaning of the concept "contingent" will create unforeseen challenges and confusion.
It is also not clear whether the treatment of subsequent contingent amounts, to the extent they are deemed to be 12(1)(x) amounts, will result in the re-characterization of capital receipts as income.
Finally, for every party who is subject to a contingent liability there is another party who is entitled to receive the contingent payment, but it is not clear how the reductions and inclusions required by these new provisions will affect the recipient in respect of the timing and nature of their corresponding inclusions or receipts.
At first glance, therefore, given the very fundamental nature of the concept "contingent", it appears to us that the legislative reversal of the decision in Collins may require more thought.
These new provisions apply for taxation years ending on or after the announcement date of March 16, 2011 and there is no limitation period for assessments, determinations and redeterminations under proposed section 143.4.