2020-0869172E5 Reserve for impaired loans

Principal Issues: Whether the loan loss allowance computed under IFRS 9 can be considered as a taxpayer’s reserve or allowance for impairment in accordance with generally accepted accounting principles for the calculation of the deduction in subparagraph 20(1)(l)(ii) of the Act?

Position: Question of fact.

Reasons: Each loan must be specifically identified as being impaired and that impairment must be measurable on a loan by loan basis.

Author: Johnstone, Alexander
Section: 20(1)(l)

                                                                                                    July 19, 2021                                 
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                                                                                                    Income Tax Rulings
                                                                                                    Directorate
                                                                                                    Alex Johnstone
                                                                                                    (613) 410-9134  

                                                                                                    2020-086917

      Re: Paragraph 20(1)(l) - Doubtful or Impaired Debt Reserves

This is in reply to your email of November 2, 2020, wherein you have asked for our comments regarding the deduction under paragraph 20(1)(l) of the Income Tax Act (Act) following the adoption of IFRS 9 Financial Instruments (IFRS 9) as the accounting guidance for the impairment of loans for publicly accountable enterprises in Canada. We apologize for the delay in responding.

Briefly, you describe that IFRS 9 which applies to financial instruments including loans issued by financial institutions, introduced an “expected credit loss” (ECL) framework for recognizing credit losses that replaced the prior “incurred loss” framework. You further describe that at any given time, a financial institution is at risk of a given loan being uncollectible after the funds have been advanced and that IFRS 9 seeks to monetize this risk by weighting the probability of an “impairment” by categorizing expected credit losses on loans into the following three stages:

*     Stage 1: An allowance is recorded to recognize ECLs resulting from default events that are possible within 12 months from when a loan is originated or purchased as well as existing loans with no significant increase in credit risk since initial recognition.

*     Stage 2: An allowance is recorded to recognize ECLs relating to loans for which there have been significant increases in credit risk since initial recognition and the credit risk is not considered low.

*     Stage 3: An allowance for credit-impaired loans is recorded where one or more events have taken place to cause the loan to become impaired.

The sum of these three stages then forms the basis for the allowance for expected credit losses as reflected in the financial statements.

You ask whether the CRA would consider the sum of these three stages as the taxpayer’s reserve or allowance for impairment in accordance with generally accepted accounting principles for the calculation of the deduction in subparagraph 20(1)(l)(ii) of the Act.

Our Comments

This technical interpretation provides general comments about the provisions of the Act and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R11, Advance Income Tax Rulings and Technical Interpretations.

The stages described above appear to distinguish between loans that may be at risk for collection, with no indication that the loans are impaired (Stages 1 & 2), and loans identified as impaired (Stage 3).

Subparagraph 20(1)(l)(ii) of the Act permits a taxpayer who is a financial institution (as defined in subsection 142.2(1)) or whose ordinary business includes the lending of money to claim a reserve in respect of impaired loans and lending assets. In this regard, subparagraph 20(1)(l)(ii) of the Act is an exception to the general prohibition under paragraph 18(1)(e) of the Act against the deduction of reserves. A reserve claimed by a taxpayer under paragraph 20(1)(l) of the Act for one taxation year must be included in income in the following taxation year pursuant to paragraph 12(1)(d) of the Act. Thus the reserve claimed for a taxation year is always a new reserve and the whole of the reserve is subject to the conditions specified in paragraph 20(1)(l) of the Act, and not merely any increase in the reserve as it may appear in the taxpayer's accounts.

The maximum reserve deduction is equal to the total of the amounts in clauses 20(1)(l)(ii)(C) and (D) of the Act. The amount under clause 20(1)(l)(ii)(C) of the Act is the percentage that the taxpayer claims of the prescribed reserve amount (calculated in section 8000 of the Income Tax Regulations). The amount under clause 20(1)(l)(ii)(D) of the Act is the taxpayer’s specified percentage (defined under subsection 20(2.4) of the Act) of the lesser of the following amounts

*     a reasonable reserve in respect of impaired loans (other than any portion of which is in respect of a sectoral reserve) for the amortized cost of loans at the end of the year [sub-clause 20(1)(l)(ii)(D)(I)]; and,

*     an amount computed under a formula by reference to the amount that is the taxpayer's reserve or allowance for impairment (other than any portion of the amount that is in respect of a sectoral reserve) for all loans that is determined for the year in accordance with generally accepted accounting principles reduced by a specified reserve adjustment, calculated on a loan-by-loan basis. [sub-clause 20(1)(l)(ii)(D)(II)].

A "sectoral reserve" is defined in subsection 20(2.3) of the Act for the purpose of clause 20(1)(l)(ii)(D) as a reserve or allowance for impairment for a loan that is determined on a sector-by-sector basis (including a geographic sector, industrial sector or a sector of any other nature) and not on a property-by-property basis.

It is a question of fact as to whether a particular financial institution's reserve for impaired loans determined in accordance with generally accepted accounting principles will give rise to a deductible amount under subparagraph 20(1)(l)(ii) of the Act. In order determine the amount of an impaired loan reserve that may be deductible by a financial institution the Act requires that each loan must be specifically identified as being impaired and that impairment must be measurable on a loan by loan basis. A reserve set up to provide for possible loan losses with no evidence of impairment would be a reserve for a contingency, and subject to the prohibition in paragraph 18(1)(e) of the Act.

We trust that our comments will be of assistance.

Yours truly,

Bob Naufal
Manager
Financial Institutions Section
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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