13 December 2005 Internal Memo 2005-0161221A11 - interest charged on carry back of loss

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.

Principal Issues: Whether the comments expressed in our internal memorandum dated May 26, 1998 (our file #9733167) are applicable to the particular fact situation described?

Position: No.

Reasons: The position in the memo indicating that there will be no interest charged where there is a substitution of losses and tax credits on an amended return does not apply to the particular fact situation because, in that situation, there is a change to the corporation's taxable income reported for 1995. The fact situation is identical to that considered in the Connaught case in which the Court held that interest was payable under subsections 161(1) and (7) on a previously unreported capital gain where the taxpayer choose to carry back a net capital loss from a subsequent year, even though there were discretionary deductions available in the reassessed year that could have been used to bring the taxable income to nil.

December 13, 2005

Michael Brescacin, Manager HEADQUARTERS
Income Tax, Southern Ontario Region Resources Industry Section Appeals and Referrals Division Income Tax Rulings Directorate
Tax & Charities Appeals Directorate Catherine Bowen
(613) 957-8284
Attention: John Kingston
2005-016122

Interest payable under subsections 161(1) and (7)

We are writing in reply to your electronic transmission dated November 28, 2005 in which you requested our comments on whether the opinion expressed in our memorandum dated May 26, 1998 (our file #E9733167) (the "Opinion Letter") is applicable to a particular fact situation that you are currently dealing with. You have an appeal filed by a corporation that is in the process of being settled and the corporation wants to ensure that there will be no interest charged pursuant to subsections 161(1) and (7) of the Income Tax Act (the "Act") where its net capital loss from 1997 is carried back to offset a taxable capital gain that was not previously reported in 1995.

Taxpayer's Situation

The taxpayer's situation is as follows:

? The original notice of assessment issued for the corporation's (the "Corporation") 1995 taxation year was a nil assessment.

? In the reassessment issued as a result of an audit performed on the 1995 taxation year, the Corporation had a sufficient amount of discretionary deductions (i.e., Canadian exploration expense and non-capital losses) available for that year to reduce its taxable income to nil. However, in order to enable the Corporation to file a valid Notice of Objection/Appeal, it chose to report income of $125 that resulted in $60 of income tax being assessed.

? The settlement now being discussed with the Corporation will include reporting a capital gain in 1995 that was previously not reported. This gain could be completely offset with more discretionary deductions available to the taxpayer such that no additional income tax would be payable for that year and no interest charged. However, it is more advantageous for the Corporation to carry back the net capital loss that it has available from 1997 to offset the 1995 taxable capital gain.

Normally, where a net capital loss is carried back to offset a previously unreported taxable capital gain that arose in a prior year, there would be interest charged on the tax payable for the prior year pursuant to subsections 161(1) and (7) of the Act. However, the taxpayer is of the view that the comments in the Opinion Letter support the position that no interest should be charged in the taxpayer's circumstances. This view is contrary to that indicated to you by individuals in the T2 Returns Adjustments section of the Sudbury Taxation Centre.

Your Questions

You have asked for our comments on the following:

(1) whether the position in the Opinion Letter apply to the above situation, and

(2) the basis of the position in the Opinion Letter that no interest would be charged in the circumstances described therein.

Opinion Letter

The Opinion Letter describes two situations in which the taxable income reported on a corporation's original T2 Corporation Income Tax Return for a taxation year is reduced, either entirely or in part, by a prior year loss. The corporation then files an amended return and substitutes the loss previously claimed with a carry back of investment tax credit ("ITCs") to offset taxes payable as a result of not using the prior year loss. The tax payable on the amended return remains the same as that on the original return. Two additional situations are described in which the Part I tax payable reported on a corporation's original return for a taxation year is reduced, either entirely or in part, by ITCs carried forward from a prior year. The corporation subsequently files an amended return and substitutes the ITCs previously claimed with a foreign tax credit carried back from a subsequent year. Again, the tax payable on the amended return remains the same as that on the original return. The question posed was whether there was a requirement to charge interest under subsections 161(1) and (2) of the Act in these situations since they were similar to one outlined in our technical interpretation letter dated June 10, 1991 (our file #E910949A). That letter stated that it was the practice of the Department not to charge interest under subsection 161(1) of the Act where there is a substitution of losses (e.g., net capital loss for a non-capital loss or a subsequent year loss for a prior year loss) and there was no tax payable on either the original or amended return.

The response provided in the Opinion Letter referred to the case Connaught Laboratories Limited v. The Queen, 94 DTC 6697 (FC-TD) ("Connaught"). In that case, the corporate taxpayer filed an income tax return for its 1981 taxation year showing nil tax payable. In 1985, the Minister reassessed the taxpayer's 1981 return, adding to its reported income a net capital gain, but (at the taxpayer's request) carrying back a substantial net capital loss from 1982. This resulted in nil taxes payable for 1981. With respect to its 1981 taxation year, the taxpayer also had available undeclared scientific research expenditures ("SREs") and unused ITCs but, as a result of its tax planning, it still chose to apply the 1982 net capital loss against its 1981 capital gain. The Minister took the position that the taxpayer owed interest with respect to its 1981 taxation year on the amount that was not paid in that year, even though, as a result of the capital loss incurred in 1982, the tax payable for 1981 was reduced to zero. The taxpayer alleged that, even if there had been no capital loss in 1982, it would still have had no tax payable for 1981, because it would have used either its ITCs or its SREs. The Court dismissed the taxpayer's appeal and held that in this situation, regardless of the taxpayer's unused 1981 SREs and ITCs, there were still taxes payable at the end of its 1981 taxation year as a result of the undeclared taxable capital gain for that year. The reference in subsection 161(7) of the Act to "tax payable" is a reference to tax payable on the basis of the particular way in which a taxpayer has chosen to compute its taxable income and not to the tax which might have been payable had another option been chosen [emphasis added]. The unambiguous wording of subsection 161(7) of the Act, therefore, required the payment of interest as assessed by the Minister.

In the Connaught case, the taxpayer brought the court's attention to the position outlined in our letter dated June 10, 1991 (referred to above). The response of the Court, part of which is included in the Opinion Letter, is as follows:

That fact situation is different from the present one. In year 1, on the facts described by the letter, the capital gain was declared and no tax was payable because of non-capital losses incurred by the taxpayer. Thus when the amended return was filed it was merely a matter of substituting one type of loss for another - the taxable income remained nil. In the present case there were taxes payable at the end of year 1, as a result of the undeclared taxable capital gain of that year. [emphasis added] In the present situation, had the taxpayer declared the taxable capital gain in 1981 and offset against it the scientific research expenditures and unused investment tax credits, it may be that the department would have allowed the substitution of the subsequent capital loss in 1982 for those expenditures and credits. But that is not what occurred. This is not a situation where there were no taxes payable at year end - taxes were payable as a result of the undeclared capital gain. I do not think the two fact situations are comparable. [emphasis added]

As noted in the Opinion Letter and the Appeals Income Tax Decisions Number 95-11 dated 1995-03-24 issued for this case, the decision in Connaught does not contradict the Department's policy of not charging interest where a corporation has substituted a subsequent year loss for a prior year loss previously deducted for a taxation year if the Part I tax payable showing on the original return remains unchanged by the amended return. The Opinion Letter extended that position to other types of substitutions to be used to offset the amount of the tax owing on the net income reported on the original return.

Our Comments

For the purpose of computing interest on the tax payable by the Corporation as a result of the reassessment of its 1995 taxation year to include a previously unreported taxable capital gain, subparagraph 161(7)(a)(iv) of the Act requires a determination of what the tax payable would have been for its 1995 taxation year if there were no deduction for the carry back of the 1997 net capital loss. As noted in the Connaught case, the fact that the previously unreported taxable capital gain could be completely offset with discretionary deductions available to the Corporation but that the Corporation chooses not to use is not relevant for the purposes of the interest calculation. By choosing to carry back a loss from its 1997 taxation year to offset the gain, the tax payable for the Corporation's 1995 return for purposes of subsection 161(1) of the Act must be calculated as if no loss were carried back until the date determined under paragraph 161(7)(b) of the Act. Consequently, there will be interest payable as a result of the inclusion of the taxable capital gain in the 1995 return.

This position is consistent with that taken in the response to Question 49 of the Revenue Canada Round Table published in the 1993 Conference Report of the Canadian Tax Foundation that involves a somewhat similar situation of an individual who reports a taxable capital gain that is fully offset by the capital gains deduction. Three years later, it is determined that the capital gain should actually have been characterized as income. Consequently, the capital gains deduction is no longer applicable. The individual requests that a non-capital loss incurred in the year subsequent to the year in question be applied to reduce the income. The response indicates that interest would be payable because:

The individual could not have requested the application of this loss at the time of filing the prior year's return since the existence of the non-capital loss would not have been known until the following year. Since the loss being applied arose in a year subsequent to the year to which it is being applied, the loss is not available to reduce the taxable income as of the due date of the return. Rather, the tax reduction resulting from the application of the loss is considered to take place, for interest purposes, on the latest of the dates specified in paragraph 161(7)(b) of the Act.

In summary, the position outlined in the Opinion Letter indicating that there will be no interest charged where there is a substitution of losses and tax credits filed on an amended return and there is no change in taxes payable does not apply to the Corporation because there is an unreported taxable capital gain for 1995. This result is consistent with the decision in the Connaught case.

We trust that our comments will be of assistance.

for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Planning Branch