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 taxpayer's retained earnings reflect proper GAAP treatment of a related party transaction.
Position: We are not experts on application of GAAP but it would seem that in this case the recording of the transaction at the carrying amounts would be in accordance with GAAP.
Reasons: Facts of particular case and CICA Handbook section 3840.
January 12, 2001
LONDON TSO HEADQUARTERS
Terry Dickey Alison Campbell
2000-004913
XXXXXXXXXX
This is in reply to the inquiry we received from your office on September 25, 2000, wherein our views were requested with respect to the application of subsection 181 to a specific set of facts.
The facts of your particular situation can be summarized as follows:
1. XXXXXXXXXX ("Company A") had an option to purchase assets, that at the time were being leased by Company A (the "Option") from the XXXXXXXXXX ("Trust"). Company A had paid nothing for the Option and the exercise price was $XXXXXXXXXX. The value of the leased assets in XXXXXXXXXX was approximately $XXXXXXXXXX, giving an estimated fair market value of the Option at that time of $XXXXXXXXXX.
2. The Trust was formed by a Declaration of Trust dated XXXXXXXXXX. The sole trustee of the Trust since the date of settlement has been XXXXXXXXXX are not related to the trustee of the Trust or to any beneficiaries of the Trust.
3. Company A incorporated Newco and then transferred the Option to Newco in exchange for preferred shares redeemable at $XXXXXXXXXX and the companies agreed to elect under subsection 85(1), for the transfer to take place at the cost of the Option (i.e. nil).
4. Newco then redeemed the preferred shares by issuing a non-interest bearing note (the "Note"), to Company A for $XXXXXXXXXX.
5. Company A then sold its common shares in Newco to XXXXXXXXXX ("Company B") for the fair market value of $XXXXXXXXXX.
6. Company A and Company B are both controlled by the same non-resident corporation.
7. Company B wound-up Newco under subsection 88(1), and thereby became the owner of the Option and the debtor under the Note payable to Company A.
8. Company B then transferred the Option to Company A in full payment of the Note.
9. Finally, Company A exercised the Option and acquired, for the $XXXXXXXXXX exercise price, the assets which it had previously been leasing.
10. Company B realized a taxable capital gain on the disposition of the Option to Company A in satisfaction of the Note. Company B had sufficient non-capital loss carryforwards to off-set the amount of the taxable capital gain.
11. The companies involved had obtained an advance income tax ruling (Document #9628173) as to the application of specific provisions under Part I of the Act and the non-application of section 245 to the series of transactions.
12. Company A did not report a gain on the transfer of the Option to Newco for book purposes, but rather reported the transfer of the Option to Newco at its carrying amount of nil.
The issue on which you are seeking our views relates to whether Company A's financial statements prepared in accordance with Generally Accepted Accounting Principles ("GAAP") should reflect an estimated $XXXXXXXXXX gain on the Option in retained earnings. You are of the view that Company A has understated its capital for the purposes of Part I.3 tax by not reporting the book gain on the disposition of the Option to Newco. Company A's representatives are of the view that pursuant to the CICA Handbook Recommendations in respect of related party transactions, the transfer of the Option to Newco must be recorded as a disposition at the carrying amount of the Option which is nil, and that to record the gain on the transfer of the Option to Newco, would not be in accordance with GAAP.
While we do not purport to be experts on GAAP, based on our review of the information provided to us, we have the following comments:
1) As is stated in paragraph 5 of Interpretation Bulletin IT-532 "Part I.3 - Tax on Large Corporations", "[t]he amounts and carrying values of the various components of a corporation's capital tax base are generally based upon amounts reflected in the corporation's unconsolidated balance sheet as prepared in accordance with generally accepted accounting principles (GAAP) and presented to the corporation's shareholders. GAAP, for this purpose, generally refers to those accounting principles specific to the accounting requirements of the Canadian Institute of Chartered Accountants (CICA), the generally accepted authority for the application of GAAP in Canada." We therefore, refer to the Recommendations in the CICA Handbook ("the Handbook") to assess whether any particular balance on the balance sheet is in accordance with GAAP.
2) Since your concern relates to the amount of retained earnings reflected on the balance sheet of Company A, section 3250 of the Handbook, which deals with accounting for "Surplus", should be reviewed. Section 3250.06 provides that "retained earnings represents the accumulated balance of income less losses arising from the operation of the business, after taking into account dividends, refundable taxes and other amounts that may properly be charged or credited thereto." Given this definition it would seem necessary, in assessing whether the amount of retained earnings reflected in the statements is an amount that reflects the application of GAAP, to consider whether the income and loss transactions of the company were reflected in the financial statements in accordance with GAAP. Therefore, it is necessary to consider the Handbook sections that relate to the transfer of the Option from Company A to its wholly-owned subsidiary Newco.
3) Section 3840.26 of the Handbook recommends that a non-monetary related party transaction that represents the culmination of the earnings process, that is not in the normal course of operations, should be measured at the carrying amount unless two criteria are met. First, there must have been a change in the ownership interests in the item transferred that is substantive and secondly, the exchange amount must be supported by independent evidence. You have indicated that the valuation of the Option is supported by independent evidence and therefore the second criteria is met. The issue is then, whether there was a change in the ownership interest for accounting purposes on the transfer of the Option from Company A to Newco. If there was no change in the ownership interest for accounting purposes, then the Handbook recommendations would require this transaction between Company A and Newco to be recorded by the two parties at the carrying amounts of the items transferred. This would result in Company A reflecting the journal entry below in its books at the time of the transfer:
DR. Investment in Pref. Shares of Newco $XXXXXXXXXX
CR. Option $XXXXXXXXXX
CR. Contributed Surplus $XXXXXXXXXX
Section 3840.30 of the Handbook suggests that when an item is transferred between two wholly-owned subsidiaries of a parent corporation, while legal title to the item may have changed, there has been no change in the ownership interests in the item transferred and, accordingly, the transfer is accounted for at the carrying amount of the item transferred. In our view it would seem reasonable to conclude that the same treatment would apply in a transfer from a parent corporation to its wholly-owned subsidiary, as is the case for the transfer of the Option from Company A to Newco and the issuance of the preferred shares from Newco to Company A. Accordingly, it would be our view that the taxpayer's position that the transaction should be reported by Company A at its carrying amount, such that no gain is reported for tax purposes, has merit.
The credit to the contributed surplus account of Company A, would be removed by the following entry on the return of the Option to Company A by Company B to repay the Note owing from Company B to Company A:
DR. Option $ XXXXXXXXXX
DR. Contributed Surplus $XXXXXXXXXX
CR. Note Receivable $XXXXXXXXXX
Given that all of the transactions were completed within the same taxation year, we would not expect to see any amounts reflected in the retained earnings or contributed surplus accounts of any of the three companies with respect to the series of transactions undertaken by them.
4) Based on a review of the Handbook recommendations in respect of capital assets in section 3060, and in particular section 3060.18 which states that "a capital asset should be recorded at cost", it is our view that the assets acquired on the exercise of the Option, while they may be valued at $XXXXXXXXXX , would only be recorded in Company A's books at a carrying amount of $XXXXXXXXXX (i.e. the cost of acquiring the assets was the Option exercise price). Consequently, the estimated $XXXXXXXXXX difference between the value of the assets and the price at which they were acquired, will never be amortized into retained earnings for book purposes, reducing the capital tax base over time. Furthermore, if the assets were to be sold outside the related group, it is our view that the application of Handbook section 3060.56 would result in the $XXXXXXXXXX inherent book gain being realized for accounting purposes at such time. This would result in an increase in retained earnings and corresponding increase in the Part 1.3 capital of Company A. It should be noted that the above comments are based upon Company A and the Trust not being related parties for Handbook purposes. If Company A and the Trust are related parties for Handbook purposes, the recommendations in section 3840 should be considered with respect to the appropriate reporting of the option exercise for accounting purposes.
5) We note that the unconsolidated financial statements which were provided to you by Company A did not include notes. In our view, subsection 181(4) requires that the carrying amounts be determined with reference to the balance sheet of the corporation that was prepared in accordance with GAAP, except that the equity and/or consolidation methods of accounting should not be used. When the financial statements have been prepared on a non-consolidated basis, in our view they must include notes to be considered to be in accordance with GAAP. We would also note however, that in this particular instance, it is not likely that the note disclosure of the related party transactions involving the transfer of the Option, would alter what would be considered to be the GAAP reporting of the gain on the transfer of the Option from Company A to Newco, from the nil amount reflected in the retained earnings reported on the face of the balance sheet.
6) After all of the series of transactions, prior to the actual exercise of the Option by Company A, have been completed, there has been no change in the financial position of Company A. It begins and ends the series, prior to exercise, with the same option and has gained nothing but for an increased adjusted cost base of the option for tax purposes. It therefore, does not seem unreasonable that the capital of the corporation for Part I.3 purposes should remain unchanged.
XXXXXXXXXX
F. Lee Workman
Manager
Financial Industries Division
Income Tax Rulings Directorate
Policy & Legislation Branch
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