24 October 2003 Internal T.I. 2003-0183447 - DEMUTUALIZATION EXPENSES

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:

Deductibility of expenses incurred in the course of demutualization.

Position:

Some expenses deductible as share issue expenses - paragraph 20(1)(e) of the Act; some as eligible capital expenditures - paragraph 20(1)(b) of the Act. Expenses incurred to "convert" financial statements to US GAAP may be deductible under paragraph 20(1)(g) if other requirements of that paragraph are met. Expenses are deductible only to extent they were incurred with respect to business carried on in Canada - subsections 20(1) and 138(2).20(1)(e)

Reasons:

Expenses incurred for purpose of obtaining authority to issue shares not deductible under paragraph 20(1)(e). US GAAP conversion expenses were incurred for purposes of seeking new capital following demutualization and hence not share issue expenses related to demutualization. Demutualization is reorganization of worldwide capital; hence some expenses must reasonably be attributed to insurance businesses carried on outside of Canada i.e. are not deductible.

		October 24, 2003

	XXXXXXXXXX  TSO	HEADQUARTERS
		Income Tax Rulings
	Attention:  XXXXXXXXXX 	Directorate
R. Maley
(613) 957-9226

		2003-018344

XXXXXXXXXX Deductibility of "Costs of Demutualization"

This is in response to your memorandum dated January 17, 2003 in which you request our views on the deductibility of certain expenses incurred by XXXXXXXXXX ("the insurer"). You advise that the expenses at issue were all related, to some degree, to the insurer's demutualization in XXXXXXXXXX . You have asked us to provide our views on the application of paragraph 20(1)(e) of the Act (share issue expenses) and paragraph 20(1)(b) of the Act (cumulative eligible capital) to the expenses described. In particular, you have asked whether the insurer may claim all of the expenses it incurred with respect to its demutualization in computing its income in Canada, or whether those expenses should be allocated between its insurance business in Canada and those it carries on outside Canada.

We have reviewed the general description of expenses you have provided and have the following comments. First, many of the expenses claimed by the insurer appear to have been incurred at a time when the insurer did not have authority to issue shares and in fact, appear to have been incurred for the purpose of obtaining that authority. As such, they would not be deductible under paragraph 20(1)(e) as share issue expenses. These expenses may prove, in whole or in part, to be eligible capital expenditures. To the extent that they so qualify, a deduction in respect of the insurer's cumulative eligible capital may be available pursuant to paragraph 20(1)(b).

Second, we believe that the expenses described that were incurred by the insurer after it received Letters Patent of Conversion would generally be deductible under paragraph 20(1)(e) as share issue expenses provided the particular expenses otherwise satisfy the requirements of that paragraph. The expenses you described as "US GAAP Conversion" expenses would not be a "share issue" expense, in our view, as these expenses do not appear to have been incurred in respect of the issuance of the demutualization shares. Rather, the US GAAP Conversion expenses appear to have been incurred for the purpose of expanding the market for the insurer's stock subsequent to the demutualization.

Third, the insurer's demutualization was, essentially, a capital reorganization of its worldwide business. As such, the expenses incurred in respect of the demutualization would appropriately be allocated between its insurance business in Canada and those carried on outside of Canada. In this respect, we disagree with the insurer that all expenses would be borne by the Canadian business because the insurer is resident in Canada.

Fourth, the basis for allocating expenses between the insurer's Canadian and non-Canadian businesses will be dictated by the nature of the expenses incurred. We agree with you that some expenses will be more easily allocated to a particular insurance business of the insurer than others. Certainly, expenses that can reasonably be viewed as related to particular insurance policies should be allocated to the applicable business on that basis (in your referral, such expenses are referred to as "direct expenses"). In our view, the share issue expenses discussed above would be expenses of this nature. Certain expenses incurred with respect to the insurer's worldwide capital may not be related to specific insurance policies (in your referral, such expenses are referred to as "indirect expenses"). The US GAAP Conversion expenses and the expenses incurred to obtain Letters of Conversion would be expenses of this nature. In our view, reserve liabilities may be the most reasonable basis for allocating these expenses, given that the insurer's investment income and its taxable capital employed in Canada are allocated on this basis for various purposes of the Act.

Additional Comments

Subparagraph 20(1)(e)(i) of the Act provides as follows:

20 (1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(e) such part of an amount (other than an excluded amount) that is not otherwise deductible in computing the income of the taxpayer and that is an expense incurred in the year or a preceding taxation year

(i) in the course of an issuance or sale of units of the taxpayer where the taxpayer is a unit trust, of interests in a partnership or syndicate by the partnership or syndicate, as the case may be, or of shares of the capital stock of the taxpayer,

...(including a commission, fee, or other amount paid or payable for or on account of services rendered by a person as a salesperson, agent or dealer in securities in the course of the issuance, sale or borrowing) that is the lesser of

(iii) that proportion of 20% of the expense that the number of days in the year is of 365 and

(iv) the amount, if any, by which the expense exceeds the total of all amounts deductible by the taxpayer in respect of the expense in computing the taxpayer's income for a preceding taxation year,

The Tax Appeal Board has confirmed, on two occasions, that share capital must be authorized for related issuance expenses to be deductible under paragraph 20(1)(e). Thus, expenses incurred for the purposes of obtaining supplementary letters patent authorizing the shares that are to be issued are not deductible under that paragraph. For example, see Enterprise Foundry Co. Ltd. 22 Tax A.B.C. 137 and Atlas Steels Ltd. 27 Tax A.B.C. 331. These views are reflected in paragraph 21 of IT 341R3, "Expenses of Issuing or Selling Shares, Units in a Trust, Interests in a Partnership or Syndicate, and Expenses of Borrowing Money":

21. Expenses of incorporation, including legal and accounting fees, and expenses of obtaining the original or supplementary letters patent or expenses of amending the original charter (e.g. for the purpose of increasing the company's authorized capital as a preliminary to the issuance of shares" do not qualify for a deduction under paragraph 20(1)(e). Such expenses may, however, be eligible capital expenditures and hence form part of a taxpayer's cumulative eligible capital as defined under subsection 14(5). As such they are deductible to the extent provided by paragraph 20(1)(b). (See the current version of IT-143).

The insurer became a stock life insurance company on XXXXXXXXXX pursuant to Letters Patent of Conversion. The expenses incurred with respect to affecting these conversions thus would not be expenses incurred with respect to issuing shares. Rather, they would be expenses incurred to obtain authority to issue the shares, in the same manner as those addressed in Enterprise Foundry and Atlas Steels.

In order to demutualize, a mutual insurer is required to satisfy a number of steps that are overseen by the Office of the Superintendent of Financial Institutions (OSFI). These steps are very broadly described in the Department of Finance (DFIN) news release #98-113 dated November 30, 1998 as follows:

1. Board Authorization

First, the company's board of directors must authorize management to develop a conversion proposal (Canada's four large mutual life companies have already taken this step).

2. Preparation of the Documentation

The second step is to develop the conversion proposal. This is a comprehensive package that must first be approved by the company's board of directors, then sent to OSFI. Among other things, the proposal contains the estimated market value of the company and a description of how the value would be allocated to eligible policyholders (for example, in the form of shares, cash or policy enhancements).

Under the proposed regime, the entire value of the company must be allocated to eligible policyholders - that is, policyholders entitled to vote at annual meetings of the company. These policyholders would receive benefits upon demutualization in exchange for their current ownership rights and interests in the company.

A number of expert opinions are required in the conversion proposal, such as opinions on whether the methods used to estimate the company value are appropriate, whether the distribution among policyholders is fair and equitable, and on the security of policyholders' policy benefits.

3. Review of Documentation and Authorization by OSFI

In addition to the conversion proposal, the company must submit to OSFI for review all information destined for eligible policyholders.

Once OSFI authorizes its release, the company would send an information package to policyholders. This package must, among other things, include: the conversion proposal and a summary of the expert opinions; a description of the advantages and disadvantages of demutualization to the company and its policyholders; a description of the alternatives to demutualization considered and the reasons why the directors of the company believe demutualization is in the best interests of the company and its policyholders; and a discussion of the tax treatment of demutualization benefits. OSFI would also review and approve the notice of meeting and proxy form that would be sent to eligible policyholders with the information package.

The notice of meeting must be sent between 45 and 75 days before the special meeting to consider demutualization, to allow policyholders sufficient time to review the information package. If the Superintendent is of the view that policyholders require additional information prior to the vote on demutualization, he may direct the company to undertake such measures as sending additional information to policyholders or holding information sessions.

4. Special Meeting to Consider Demutualization

A special meeting must be held at which eligible policyholders vote on the conversion proposal. The proposal must receive the support of at least two-thirds of eligible policyholders who cast votes, either in person or by proxy.

5. Application for Ministerial Approval

If the conversion proposal is approved by eligible policyholders, an application for demutualization must be forwarded within three months to the Minister of Finance for his approval.

6. Allocation of Benefits

Upon demutualization, contractual obligations between the company and its customers would not be changed.

What would change are the policyholders' ownership rights in the company. In exchange for these rights, the company would distribute benefits to policyholders, as described in the conversion proposal. Nevertheless, policyholders would still have the right to elect at least one-third of the board of directors of the converted company.

Demutualization benefits would generally take the form of shares which could be kept or sold for cash. Each share would entitle the shareholder to one vote (shareholders elect up to two-thirds of the board of directors). Benefits could also be in the form of cash, policy enhancements or premium reductions. When benefits other than shares are distributed, an independent actuary or a valuation expert must provide an opinion that these benefits are appropriate substitutes for shares.

7. Post-Demutualization

Converted companies will face a public market environment, and should be allowed time to adjust to their new corporate structure before being approached by possible acquisitors or merger partners.

Therefore, after demutualizing, companies must remain widely held (i.e. no one person can own more than 10 per cent of any class of shares of the company). This restriction will be reviewed two years after the demutualization regulations come into force. In addition, the government will not approve merger proposals between large demutualized companies during this adjustment period.

A shareholder structure will allow converted companies more flexibility to raise capital to offer innovative new products to meet their customers' evolving needs and invest in new technologies. Increased access to capital will also enhance companies' ability to make acquisitions, which will enable converted companies to take advantage of growth opportunities and compete for a market share in a rapidly changing marketplace.

In our view most, if not all of the expenses incurred in respect of steps 1 through 5 would be expenses with respect to obtaining the authority to issue share capital. Expenses incurred at these steps of the process may qualify as eligible capital expenditures, which are broadly defined in section 2 of IT-143R3, "Meaning of eligible capital expenditure":. An "eligible capital expenditure", which is defined in subsection 14(5) of the Act, may be broadly described as an outlay or expense made or incurred by a taxpayer:

(a) in respect of a business;

(b) as a result of a transaction occurring after 1971;

(c) on account of capital; and

(d) for the purpose of gaining or producing income from the business (whether or not income from the business was actually produced by such outlay or expense).

Where a taxpayer carries on more than one business, the eligible capital expenditure arising from an outlay or expense will form part of the "cumulative eligible capital", as defined in subsection 14(5), only of that business to which it relates.

The bulletin also provides in paragraphs 13 and 14 that many expenses of incorporation, reorganization or amalgamation are eligible capital expenses. In our view, many of these expenses are analogous to expenses that would be incurred in the course of obtaining authority to demutualize. For e.g.,

13. Incorporation expenses include all the expenses necessarily incurred by the incorporators to bring a corporation into existence, including:

(a) fees required by the appropriate government agency (federal or provincial);

(b) cost of affidavits;

(c) advertising expenses in those jurisdictions where applicants are required to give notice of their intention to apply for a charter;

(d) legal fees;

(e) costs of preparation of articles of incorporation and of bylaws;

(f) expenses incurred by applicants in attending preliminary meetings; and

(g) accountant's fees associated with the incorporation.

Once Ministerial approval for demutualization is given and Letters of Conversion have been issued, an insurer is authorized to issue shares. Where a corporation has authority to issue the shares contemplated, it would appear that subparagraph 20(1)(e)(i) will apply fairly broadly to allow deductibility for related expenses, provided that the expenses do not relate to an insurance business the corporation carries on in a country other than Canada. The threshold for deductibility has been discussed in several Rulings opinions e.g., in E9704727; E9615787 the relevant criteria for deductibility is discussed as follows:

... with respect to the issue of deductibility of the expenses pursuant to subparagraph 20(1)(e)(i) of the Act there are in effect two tests that have to be met. The first one is that the expenses must be "in the course of an issuance ...of shares of the capital stock of the taxpayer". The phrase "in the course of" was looked at by the courts in the Yonge-Eglinton Building Ltd. 74 D.T.C. 6180 (F.C.A.) case where the court stated

"What appears to me to be the test is whether the expense, in whatever taxation year it occurs, arose from the issuing or selling or borrowing. It may not always be easy to decide whether an expense has so arisen but it seems to me that the words "in the course of" in section 11(1)(cb) are not a reference to the time when the expenses are incurred but are used in the sense of "in connection with" or "incidental to" or "arising from" and refer to the process of carrying out or the things which must be undertaken to carry out the issuing or selling or borrowing for or in connection with which the expenses are incurred."

In addition to the above test, the expenses must meet the additional test imposed by the preamble to subsection 20(1) of the Act which is, "... there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto...". As such, the expenses incurred must be wholly applicable to the issuance of the shares and not be only consequential or resulting from the issuance of the shares. That is, there must be a clear connection between the amount sought to be deducted and the issuance of the shares.

Paragraph 16 of IT-341R3 where a corporation has expenses that are incurred in the course of an issuance or sale of shares in the capital stock of the corporation the following expenses would be deductible in the year in which they are incurred:

(a) legal fees in connection with the preparation and approval of a prospectus pertinent to the issuance or sale of shares, units, or interests;

(b) accounting or auditing fees in connection with the preparation of reports on financial statements and statistical data for inclusion in, or for presentation with, the prospectus;

(c) the cost of printing the prospectus, new share, unit, or interest certificates, etc;

(d) registrars' or transfer agents' fees; and

(e) filing fees charged by any public regulatory body which requires the filing of a prospectus for acceptance

The pre-amble to subsection 20(1) provides as follows:

20(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source of such part of the following amounts as may reasonably be regarded as applicable thereto: (emphasis added)

Subsection 138(2) of the Act provides that the income or loss of a multinational life insurer from carrying on an insurance business shall be computed with reference only to insurance businesses carried on in Canada:

(2) Notwithstanding any other provision of this Act, where a life insurer resident in Canada carries on an insurance business in Canada and in a country other than Canada in a taxation year

(a) its income or loss for the year from carrying on an insurance business is the amount of its income or loss for the year, computed in accordance with this Act, from the business in Canada; and

Section 4 of the Act provides, more generally, that income or loss from any source is to be computed as if the particular source were a taxpayer's only source of income. Where the particular source is a business or an office or employment, and the income or loss would be derived from that source in more than one place, the income or loss from the particular place is also to be computed as if the income or loss from that place was the only income or loss from that source.

Thus, having concluded that certain of the described expenses have the nature of share issue expenses, and certain of the expenses have the nature of eligible capital expenditures, deductibility under subsection 20(1) is dependent upon the expenses having the insurance business in Canada as their source.

The expenses at issue all appear to have been incurred with respect to the insurer's worldwide capital. Certain of the expenses - the share issue expenses - are clearly related to particular insurance policies issued by the insurer. It is our view that the proportion of share issue expenses the insurer has incurred that may reasonably be viewed as related to its insurance business carried on in Canada would be the proportion of the shares in respect of which the expenses were incurred (i.e., the demutualization shares) it issued to Canadian policyholders.

The other expenses at issue (the eligible capital expenditures and the US GAAP expenses) do not appear to be related to particular insurance polices issued by the insurer. However, these expenses were incurred with respect to the insurer's worldwide business, including its insurance businesses carried on outside of Canada. We believe that it would be reasonable to allocate such expenses in the same proportion that the insurer's reserve liabilities are allocated to its business carried on in Canada. In this respect, we note that the insurer's investment income and its taxable capital employed in Canada are allocated on this basis for purposes of the Act.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. 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 electronic library version, or they may request a severed copy 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 (819) 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