7 May 2003 External T.I. 2003-0183345 - ACCUMULATED PROFITS CONSOLIDATED

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 CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues:

Whether, in determining interest deductibility in a situation that is within the exceptional circumstances category, CCRA's position on computing the "accumulated profits" could be expanded such that it would allow the retained earnings of a parent corporation and its subsidiaries to be computed on a consolidated basis.

Position TAKEN:

No.

Reasons FOR POSITION TAKEN:

The determination of the accumulated profits component of the aggregate amount of capital used for a direct eligible purpose of earning income prior to the replacement of that capital with borrowed money (under the exceptional circumstances category) must respect the legal relationships that exist and this would include the legal structure that a taxpayer has selected.

XXXXXXXXXX 								2003-018334
P. Diguer
May 7, 2003 

Dear XXXXXXXXXX:

Re: Subparagraph 20(1)(c)(i) of the Income Tax Act (Canada) (the "Act")

This is in reply to your letter dated January 16, 2003, in which you provide us with your comments on the CCRA's discussion paper on interest deductibility, released October 1, 2002 at the Canadian Tax Foundation Annual Conference (the "Discussion Paper").

Your comments on the Discussion Paper:

(a) are restricted to one issue in particular; the deductibility of interest paid on money borrowed to redeem shares or otherwise make distributions to shareholders; and

(b) were prompted, in part, by the recent reassessment of one of your clients. A notice of objection is being filed in relation to this reassessment.

Your concerns

Briefly, you are concerned about CCRA's position on the computation of the cost of capital and the "accumulated profits" component thereof as described in paragraphs J and K of the Discussion Paper. The Discussion Paper mentions that CCRA generally accepts that capital includes the contributed capital and accumulated profits [retained earnings] of a corporation computed on an unconsolidated basis. In particular, you are concerned that a non-consolidated assessment of retained earnings does not test whether untaxed appreciation or earnings are being distributed.

To illustrate your concern you describe the situation where a subsidiary corporation has ample retained earnings to offset a borrowing undertaken by a parent corporation [with insufficient retained earnings] in order to fund a share repurchase or other distribution to shareholders and suggest that such a borrowing would, in substance, constitute a distribution of tax-paid earnings [on a consolidated basis] and, therefore, in your view, would meet the specific policy concern of the CCRA. In such circumstances, it is your view that there should be recognition of retained earnings in subsidiary corporations in computing the accumulated profits of the parent corporation.

Our comments

We appreciate your comments concerning the Discussion Paper. However, the situation that is described in your letter involves a series of actual completed transactions involving specific taxpayers for which the tax consequences are presently in dispute. Written confirmation of the tax implications inherent in particular transactions are given by this Directorate only where the transactions are proposed and are the subject matter of an advance ruling request submitted in the manner set out in Information Circular IC-70-6R5 dated May 17, 2002. Where the particular transaction is completed, the inquiry should be addressed to the relevant Tax Services Office. Although we are unable to provide any opinion in respect of the specific transactions described in your letter, we have set out some general comments which we hope are of assistance to you.

As stated in the Discussion Paper,

I. Borrowing to redeem shares or return capital

The Supreme Court has outlined that direct use is the primary test to determine interest deductibility, and that indirect uses will not be acceptable, other than in exceptional circumstances. Trans-Prairie Pipelines Ltd. is the leading case with regard to exceptional circumstances and remains valid today. This case addressed the exceptional circumstances of borrowing to redeem shares. The concept of using borrowed money to "fill the hole" of capital withdrawn from the corporation's business is a key element of this concept. We accept these exceptional circumstances for interest deductibility provided that the capital replaced by the borrowing was previously used for an eligible purpose of earning income from a business or property. We further accept that borrowing to return capital could also apply in a partnership context.

J. How is capital calculated

Based on the preceding analysis, the amount of capital used for an eligible purpose of earning income prior to the replacement of that capital with borrowed money must be determined. We generally accept that capital includes the contributed capital and accumulated profits of a corporation or partnership.

Contributed capital is considered to be the funds provided by the owners of a corporation or partnership to commence or to further the carrying on of the corporate or partnership business. We accept that in most corporate situations the legal or stated capital for corporate law purposes would be the best measurement of capital for this purpose, although other measurements may be more appropriate depending upon the circumstances.

Generally, accumulated profits means retained earnings computed on an unconsolidated basis with investments accounted for on a cost basis. However, profits or gains resulting from the disposition of property to persons with whom the taxpayer does not deal at arm's length will generally be excluded.

The underlying concept remains that of "filling the hole" of capital withdrawn from the business.

In situations where some proportion of shares is being replaced with borrowed money, only the capital of those shares, computed on a pro-rata basis, would be considered to be replaced with the borrowed money. The accumulated profits of a corporation, however, do not track any particular shareholdings.

K. Borrowing to pay dividends

Borrowing to pay dividends is an ineligible direct use, but interest deductibility in such situations may be provided under the exceptional circumstances category, consistent with the concept of borrowing to replace capital to "fill the hole" described above. We generally accept this category of exceptional circumstances and generally accepts accumulated profits (as described in J above) as the appropriate measurement of the hole that may be filled with the borrowed money used to pay a dividend.

Thus, the CCRA has, in its Discussion Paper, adopted an interpretive policy that seeks to capture the intent of the Court's interpretation of the relevant legislation as it relates to exceptional circumstances and the related key concept of "filling the hole" of capital withdrawn from the business.

However, the Supreme Court has held, in The Queen v. Shell Canada Limited 98 DTC 6177 (SCC), The Queen v. John R. Singleton 2001 DTC 5533 (SCC), and other decisions, that the economic realities of a situation cannot be used to recharacterize a taxpayer's bona fide legal relationships. It has held that, absent a specific provision of the Act to the contrary or a finding that there is a sham, the taxpayer's legal relationships must be respected in tax cases. Thus, generally and subject to GAAR, recharacterization is permissible only if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect.

As such, it is our view that the determination of the accumulated profits component of the aggregate amount of capital used for an eligible purpose of earning income prior to the replacement of that capital with borrowed money must respect the legal structure that a taxpayer has selected without regard to the economic substance of the transaction.

On February 18, 2003, as part of the presentation of the Federal budget, the Department of Finance published the following statement concerning the deductibility of interest:

Recent court decisions have raised uncertainties as to how taxpayers are to treat expenses, in particular interest, in computing income from a business or property for purposes of the Income Tax Act. Most notably, these decisions could lead to inappropriate tax results where a taxpayer derives a tax loss by deducting interest expenses, even if under any objective standard there is no reasonable expectation that the taxpayer would earn any income (as opposed to capital gains), or where the presence or the prospect of revenue (as opposed to income net of expenses) is enough to conclude that an expenditure was incurred "for the purpose of earning income".

Neither of these results is consistent with appropriate tax policy, nor would they have been generally expected under prior law and practice. Therefore legislative amendments to the Income Tax Act will be considered in order to provide continuity in this important area of the law. Before finalizing any proposals, however, the Department of Finance will release them for public consultation, with a general goal of ensuring that they restore continuity with the expected consequences before these recent court decisions."

We trust our comments will be of assistance to you.

Yours truly,

Steve Tevlin
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch