6 November 2001 Internal T.I. 2001-0081267 - APPROPRIATIONS

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 purpose of this memorandum is to reconsider the comments provided in document # 982474 with regard to whether amounts that have been appropriated in the notes to the financial statements prepared for OSFI constitute reserves or continue to be part of retained earnings.

Position: It is our opinion that such appropriations not required by OSFI will have the dual character of reserves and retained earnings. The taxpayer may choose which characterization they prefer for purposes of calculating capital for Part I.3 purposes. Where the appropriation is required by OSFI it is our view that such amounts will constitute reserves.

Reasons: After reconsideration which included taking into account further representations.

									November 6, 2001

	John Luck							Financial Institutions
Coordinator Financial Institutions 				  Section
Industry Specialist Services					M. Trotier
957-3494

									2001-008126

"Appropriations"

The purpose of the memorandum is to summarize our current views with respect to the treatment for capital tax purposes of amounts which have been "appropriated" from a life insurer's surplus (retained earnings in the case of stock insurance companies). We would appreciate if you forward our comments to Duncan McKay and Marg McCreery of your Services.

All references to statute are to the Income Tax Act unless otherwise specified. We will be referring only to Part I.3 tax in this memorandum. However, the same views should apply with respect to Part VI tax.

An "appropriation" of surplus is usually made by a life insurer for certain purposes such as, for example, cash surrender value deficiencies. Previously the Office of the Superintendent of Financial Institutions ("OSFI") required such appropriations to be reported on one of the schedules included in the reporting package. While the OSFI still requires this information for purposes of the Minimum Continuing Capital and Surplus Requirements ("MCCSR") such amounts are no longer considered appropriations by the OSFI. Nevertheless certain insurers are continuing to report these amounts as "appropriations" in the notes to the financial statements prepared for the OSFI.

As previously noted it is our view that the definition of "reserves" in subsection 181(1) would include an "appropriation" of surplus made at the discretion of the life insurer in a note to its financial statements prepared for the OSFI even if not required by the OSFI. It also continues to be our view that such an "appropriation" nevertheless remains as part of the retained earnings of the life insurer where the full amount of the retained earnings is reflected as such on the balance sheet. Consequently, for purposes of Part I.3 tax the amount of an "appropriation" of surplus would be included in the capital of the life insurer both as a reserve and as "retained earnings" absent subsection 181(4).

Multinational Life Insurers (stock companies)

To the extent that the amount, as noted above, would be included in capital twice a multinational life insurer can choose between the two characterizations (i.e. either as a reserve or as retained earnings). However, where the "appropriations" relate to the insurance business of the insurer carried on outside of Canada these "appropriations", even though they may be characterized by the life insurer as reserves, would not be included in the capital of the life insurer as a reserve since only the reserves which have been established in respect of an insurance business carried on in Canada are to be included in the capital of the life insurer and this pursuant to clause 181.3(1)(c)(ii)(B). The reserves which do not relate to the insurance business in Canada would be included in capital as retained earnings pursuant to subparagraph 181.3(3)(b)(ii) since they have not previously been included as "reserves" for capital tax purposes. There is, therefore, no double inclusion.

It has been suggested that if litigated the Courts would not look favourably on the inclusion as retained earnings of "appropriations" that relate to the out of Canada insurance business since the purpose of Part I.3 is to tax capital employed in Canada. However, the scheme of the Part I.3 is to include the full amount of the retained earnings and then prorate it on the basis of the "Canadian reserve liabilities" and the "Total reserve liabilities" pursuant to clause 181.3(1)(c)(ii)(A) such that only the "Canadian" portion is included in capital. In our opinion the portion of the retained earnings to be included in capital is legislatively intended to be calculated using the reserves required by the OSFI. Non-mandated "appropriations", particularly since they are being made primarily in respect of out of Canada business, would distort this calculation resulting in a lesser amount included in capital as retained earnings than would otherwise be the case if no discretionary "appropriations" are made. Accordingly we would argue that to include "appropriations" related to the foreign business in capital as retained earnings does not result in the inclusion in capital of reserves relating to out of Canada business but rather is necessary to include in capital the appropriate portion of retained earnings that relates to the Canadian business. This is illustrated in the attached example from which can be seen that even with the inclusion of the "appropriations" related to foreign business in retained earnings the result will be that a lesser amount will be included in capital as retained earnings than would have been the case had such discretionary "appropriations" not been made. XXXXXXXXXX.

Quebec Life Insurers

Life insurers which are regulated by the Quebec regulator, the Inspector General of Financial Institutions Quebec, have been required by the regulator in the past and continue to be required to "appropriate" their surplus accounts for amounts such as the cash surrender value deficiencies. It is our understanding that these amounts are considered by the Quebec regulator as "appropriations" of surplus and that they would be identified as such on the balance sheet or in a note to the financial statements of the life insurer. These "appropriations" of surplus come within the definition of "reserves" for purposes of Part I.3 tax as noted above.

It is our understanding that the Quebec life insurers are primarily carrying on their insurance business in Canada. The Quebec life insurers are of the view that such "appropriations" are included as "reserves" for capital tax purposes pursuant to subclause 181.3(1)(c)(ii)(B)(I) for purposes of Part I.3 tax with a corresponding deduction pursuant to clause 181.3(1)(c)(ii)(B) as the Part I deduction for the year. They are therefore of the view that there would be no other amount which could be included in respect of these "appropriations" as retained earnings since they have been included as reserves for purposes of Part I.3 tax even though there is a corresponding deduction for purposes of the Part I deduction as described above. We agree with this view and in fact given that the Inspector General of Financial Institutions Quebec requires the amounts to be appropriated we would suggest particularly in view of the Manulife decision that such amounts should be viewed as reserves and not retained earnings for purposes of Part I.3.

Non-resident life insurers

Where a non-resident life insurer reports certain amounts to OSFI in the Supplementary Consolidated Actuarial Exhibit for solvency information purposes only and does not report those amounts either on the balance sheet or in a note to the financial statements prepared for OSFI then we are of the view that these amounts do not constitute an "appropriation" of surplus by the non-resident life insurer. On the understanding that such amounts are not reported as "appropriations" there would be no basis to include these amounts as "reserves" in the capital of the non-resident life insurer for capital tax purposes.

We trust that the above comments will be of assistance. If you require further discussion please do not hesitate to contact F. Lee Workman at 957-3497 or Michele Trotier at 957-3494.

F. Lee Workman
Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch

Appendix
Example - Multinational Life Insurer

Assume the following:

Retained Earnings of 10,000
"Appropriation" from Retained Earnings of 1,000
"Appropriation" is with respect to out of Canada insurance business

Canadian Reserve Liabilities are 50,000
Total Reserve Liabilities are 100,000
Taxable Capital is comprised only of the Retained Earnings

Pursuant to subsection 181.3(1), the taxable capital employed in Canada will be equal to:

A. Where no "appropriation"

Retained Earnings X Canadian Reserve Liabilities/Total Reserve Liabilities=
10,000 X 50,000/100,000 = 5,000

B. Where there is an "appropriation"

Where "Appropriation" of 1,000 included as "reserves", then the Retained Earnings are reduced by the amount of the "appropriation" pursuant to subsection 181(4). The Total Reserve Liabilities would be increased by the amount of the "appropriation"

Retained Earnings X Canadian Reserve Liabilities/Total Reserve Liabilities=
9,000 X 50,000/101,000 = 4,455

C. Where there is an "appropriation"

Where "Appropriation" of 1,000 but it is included as retained earnings (dual character)
10,000 X 50,000/101,000 =4,950
3