29 November 2001 Internal T.I. 2001-0106227 - PREPAID LEASE OBLIGATIONS

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:

The taxpayer engaged in a number of sale-sale-leaseback transactions in which its lease receivables were prepaid. There is no amount on the face of the balance sheet in respect of the prepaid lease amounts. Are the prepaid lease amounts "advances" within the meaning of paragraph 181.2(3)(c)? Can CCRA look to the notes to the corporation's balance sheet and if necessary, to extrinsic evidence, to include an amount in respect of those advances in the corporation's capital?

Position:

The amounts are advances within the meaning of 181.2(3)(c). However, there appears to be no amount reflected in the corporation's balance sheet in respect of those amounts and hence, no amount may be included in the corporation's capital.

Reasons:

Subsection 181(3) provides that, in computing a corporation's capital, the amounts reflected in its balance sheet shall be used. Our view is that subsection 181(3) permits the CCRA to look to the notes of a corporation's financial statements in determining what items of capital are held by the corporation, and what value is attributable to those items of capital. In this case, there appears to be no amount in respect of the prepaid amounts reflected on the face of the balance sheet or in the notes. To date, the only use of extrinsic evidence that has been approved by the courts in applying subsection 181(3) is the identification of the components of an aggregate account. We doubt that such evidence could be used for the purposes of identifying items of capital that are not otherwise reflected in the financial statements.

									November 29, 2001

HAMILTON TAX SERVICES OFFICE			HEADQUARTERS
R. Maley
Attention:  Tony Marcogliese					(613-957-9226)

2001-010622
XXXXXXXXXX

This is in reply to the memorandum dated October 15, 2000 from Christine Frolick, requesting our views as to the appropriate application of Part I.3 to certain prepaid lease amounts XXXXXXXXXX has received from a special purposes vehicle ("SPV").

As we understand it, the amounts at issue were received in the course of a financing arrangement favoured by XXXXXXXXXX known as a "sale-sale-leaseback". In this arrangement, XXXXXXXXXX transfers a portfolio of office equipment and related leases to a special purpose vehicle ("SPV"). The SPV issues commercial paper and short-term debt and uses the proceeds to pay XXXXXXXXXX then repurchases the equipment from the SPV, using the securitization proceeds as payment. Finally, the SPV leases the equipment from XXXXXXXXXX pursuant to a Master Lease agreement. The SPV prepays its lease obligations with its proceeds received when it sold the assets to XXXXXXXXXX uses the amounts prepaid to reduce its outstanding indebtedness.

You ask whether amounts XXXXXXXXXX receives from the SPV in prepayment of its obligations under the Master Lease constitute "advances" within the meaning of paragraph 181.2(3)(c). If so, is any amount "reflected" in the balance sheet in respect of the advances within the meaning of subsection 181(3). In this regard, you have provided us with a copy of XXXXXXXXXX audited Financial Statements.

It is our view that prepaid lease obligations generally do constitute "advances" within the meaning of paragraph 181.2(3)(c). However, it is not clear to us from the information provided that there is any amount reflected in XXXXXXXXXX balance sheet in respect of the prepaid lease amounts it has received. Unless the prepaid lease amounts can be clearly identified as a component of the amounts reflected in the notes to the financial statements (i.e., part of an aggregate amount), we are of the view that no amount is included in XXXXXXXXXX capital in respect of prepaid lease amounts for the XXXXXXXXXX taxation year (or for any other taxation year in which sale-sale-leaseback transactions and their concomitant prepaid lease amounts are presented in the same manner for accounting purposes.)

Paragraph 181.2(3)(c) includes in a corporation's capital the amount of advances to a corporation at year-end. The concept of an "advance" for Part I.3 purposes was defined in Oerlikon Aerospatiale (Endnote ¹) as having two distinct meanings. First, it includes loans. Second, it includes amounts paid before they are due. In our view, prepaid lease obligations generally fall within this second meaning and hence are advances for the purposes of paragraph 181.2(3)(c).

Subsection 181(3) of the Act provides that, in determining values and amounts for the purposes of Part I.3, the amounts reflected in the balance sheet shall be used. In our view, this provision applies to quantify amounts for the purposes of Part I.3. However, there may be circumstances in which GAAP will characterize an amount in a manner inconsistent with its legal nature, such as a leasing agreement that is treated for GAAP purposes as a sale of assets. In general, our view is that the legal nature of an amount governs it treatment for the purposes of Part I.3 (e.g. E9826313, E9828577). The Tax Court of Canada echoed this view in Autobus Thomas Inc (Endnote ²).

The question, of course, is how to properly determine the amount that reflects the legal nature of an item of capital, given the constraints of subsection 181(3). We have expressed the view, on a number of occasions, that subsection 181(3) permits us to look to the notes of a taxpayer's financial statements in determining what items of capital are held by a taxpayer, and what value is attributable to those items of capital (e.g. E9918917, E961771).

In some circumstances, it may be appropriate to look further, to supporting documentation, to determine what particular amounts reported in the balance sheet relate to and to thereby determine whether any capital is reflected in the particular amount. For example, paragraph 10 of IT-532, "Part I.3 - Tax on Large Corporations", notes that there may be circumstances where different amounts are aggregated for financial reporting purposes. Where the relevant amount of capital is included in the aggregate balance, resort may be had to supporting documentation to determine the appropriate amount or carrying value for the amount at issue.

This position is supported by the recent decision in PCL Construction Management Inc. et. al. (Endnote ³) where the Tax Court of Canada noted that

The use of the words "reflected in the balance sheet" indicates a clear intention on the part of the drafter to leave it open to consider the components of the balance sheet item where some, but not all, of those components fall within the statutory definition of capital. This is such a case. The intention that GAAP should prevail in fixing quantum would be frustrated if the item "Unearned Revenues and Contract Advances" could only be excluded or included in its entirety. If that were the legislative intent then parliament would have used the expression "appearing on the balance sheet". The unearned amounts that are advances do not appear on the Appellants' balance sheets, but they are reflected in them as an identifiable component of the amounts that do appear there.

However, we would note that, to date, the only use of such extrinsic evidence that has been approved by the courts for capital tax purposes is the identification of the components of an aggregate account. We doubt that such evidence could be used for the purposes of identifying items of capital that are not otherwise reflected in the financial statements.

It is not clear to us whether the sample financial statements you have provided reflect any amount that could be viewed as representing, or including, the prepaid lease amounts. Note 3 to the statements disclose that the lease agreements at issue were recorded as sales for accounting purposes and indicate the proceeds received therefore. We wonder if the reference to "proceeds" in the first paragraph of Note 3 is a reference to the prepaid amounts? Was a gain or loss reflected in the corporation's retained earnings as a result of the sale transactions?

Note 3 also discloses the company's potential credit exposure with reference to the financial contracts it owns and manages. While you have noted that the reference to contracts managed but not owned would likely include the contracts subject to the sale-sale-leaseback arrangement, it is not apparent to us that disaggregating the amounts disclosed with reference to ancillary documentation would leave us with individual balances that represent the prepaid amounts.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Canada Customs and Revenue Agency's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version, or they may request a copy severed using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (613) 994-2898. A copy will be sent to you for delivery to the client.

F. Lee Workman
Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings Directorate

ENDNOTES:

^1. 99 DTC 5318 (FCA)

^2. 99 DTC 259 (TCC) affd on appeal 2000 DTC 6299 (FCA). The taxpayer's appeal to the SCC was dismissed, October 11, 2001.

^3. 2000 DTC 2624 (TCC).