21 November 2011 External T.I. 2010-0384001E5 - Guarantee/Collateral/ASPE effect on Thin Cap

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:
1. A Canadian corporation ("Canco") is controlled by a non-resident individual ("NRI"). Canco has a loan outstanding from an arm's length foreign bank. Is Canco's debt-to-equity ratio calculated for the thin-capitalization rules in subsections 18(4) - (6) of the ITA affected:
a) If the NRI pledges, as additional collateral for the loan, a pool of assets that is owned by various related foreign entities?
b) If the NRI offers a personal guarantee to support the loan?
2. In the process of converting to the new Accounting Standards for Private Enterprises ("ASPE") on January 1, 2011, the retained earnings of a private corporation could change. Would the adjusted retained earnings be used in calculating the equity portion of the debt-to-equity ratio?

Position:
1. a) & b) Maybe - A question of fact
2. Yes

Reasons:
1. a) & 1. b) Generally, we would not consider the hypothecation of assets, or a guarantee, as security for the loan to constitute a loan from a specified non-resident shareholder for purposes of subsection 18(6) of the ITA. Accordingly, subsection 18(4) of the Act would likely not have application to this arrangement.

2. In ITTN 42, released in May 2010, we outlined our position in this matter. If a company is using a particular accounting standard, in this case the new ASPE, then that standard should be used on a consistent basis to all calculations in order to determine income tax.

XXXXXXXXXX 						2010-038400
							Phil Thompson
November 21, 2011

ATTN: XXXXXXXXXX

Dear XXXXXXXXXX :

Re: Debt-to-Equity questions relating to Thin Capitalization rules

This is in reply to your letter of October 7, 2010 addressed to the Income Tax Rulings Directorate. We apologize for our delay in responding to your letter.

In your letter you requested our view on the following questions:

1. A Canadian corporation ("Canco") that is controlled by a non-resident individual ("NRI") has received a loan from an arm's length foreign bank. The loan is secured by a mortgage on Canadian real estate owned by Canco. Is Canco's debt-to-equity ratio calculated for the thin-capitalization rules affected:

a) If the NRI pledges, as additional collateral for the loan, a pool of assets that is owned by various related foreign entities; or
b) If the NRI offers a personal guarantee to support the loan?

2. Private enterprises in Canada will have to use either International Financial Reporting Standards ("IFRS") or Accounting Standards for Private Enterprises ("ASPE") to prepare their annual financial statements for fiscal years beginning on or after January 1, 2011. As a result of this transition, certain assets, liabilities, revenues or expenses which were recognized under former Canadian Generally Accepted Accounting Principles ("GAAP") may no longer be so recognized and, conversely, certain items which were not previously recognized under GAAP may now be recognized under IFRS or ASPE. In addition, ASPE more frequently provide for the optional or the mandatory use of fair market value to measure assets and liabilities than do the Canadian standards formerly in effect.

Private enterprises that apply ASPE on January 1, 2011 are obligated to present the comparative amounts for the previous period. This will require the retrospective application of ASPE to the financial statements of 2010. The cumulative effect of these adjustments will be presented, net of taxes, as an adjustment to the balance of retained earnings as of January 1, 2010. Would the adjusted retained earnings value be used in calculating the equity portion of the debt-to-equity ratio in the thin capitalization calculation?

Our Comments

Question 1- Collateral/Guarantee

Whether the two scenarios you provided in 1. a) and b) above would have any effect on the debt-to-equity ratio that would be used for the thin capitalization limits calculated under subsections 18(4) through 18(6) of the Income Tax Act ("ITA") is a question of fact. Although an amendment to subsection 18(6) of the ITA was proposed in the Federal Budget of 2000 that would have targeted such transactions, the amendment was never implemented.

Generally, we would not consider the mere hypothecation of additional assets or a personal guarantee, as security for the bank to make a loan to Canco, to constitute a loan for purposes of subsection 18(6) of the ITA. Accordingly, subsection 18(4) of the Act would likely not have application to this arrangement as the bank is not a "specified non-resident shareholder". However, in a particular transaction, we would reserve the right to review all of the facts in order to ensure that the granting of such security by a specified non-resident shareholder could not be considered the making of a loan to the bank.

Question 2 - Retained Earnings

We have recently provided our view on a conversion to IFRS from GAAP in Income Tax Technical News #42 ("ITTN"). ITTN #42 is available on our website at http://www.cra-arc.gc.ca/E/pub/tp/itnews-42/README.html. Our policy would apply to a conversion to the new ASPE as well.

In ITTN #42 we explained that it is our view that although the provisions provided in subsections 18(4) through 18(6) of the ITA do not refer to Canadian GAAP, the term "retained earnings" is an accounting term, and the CRA has maintained that retained earnings is to be computed under GAAP. When a taxpayer files under IFRS, we would expect retained earnings to be computed using IFRS. Similarly, when a taxpayer files under ASPE, we would expect retained earnings to be computed under ASPE.

As you indicated in your letter, paragraph 8 of IT-59R3, entitled Interest on Debts Owing to Specified Non-Residents (Thin Capitalization), states that "generally accepted accounting principles govern in determining retained earnings" and yet also informs the reader that retained earnings cannot include unrealized appraisal surpluses. A transition to ASPE may lead to a new retained earnings value, which could potentially include unrealized appraisal surpluses due to the manner in which retained earnings is calculated under ASPE.

It is our view that where a term used in the ITA derives its meaning primarily from accounting (e.g., retained earnings), the accounting meaning (e.g., retained earnings as calculated under ASPE) will prevail. Furthermore, it is also our view that in circumstances where a change in accounting policy is warranted (e.g., to a new ASPE standard), the adjusted unconsolidated retained earnings should be used in the thin capitalization calculation in the first year in which the taxpayer uses the new standard. Please note, however, that retained earnings reported in financial statements presented for comparative purposes only should not be used in the thin capitalization calculation for the year prior to the adoption of the new ASPE.

We trust that our comments are of some assistance.

Yours truly,

for Director
International and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch