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: Following a non-arm's length transfer of assets, a corporation's books reflected the transferred assets at fair market value. The share capital reported on the consolidated balance sheet presented to the shareholders reflected the transferred assets at fair market value. The share capital reported on the unconsolidated balance sheet prepared for Part I.3 tax purposes reported a lesser amount in share capital as if the transferred assets were carried at the rollover transfer amount rather than fair market value. Can the unconsolidated balance sheet prepared using different accounting principles than those used in preparing the consolidated financial statements presented to the shareholders be used for purposes of Part I.3?
Position: It depends upon whether the accounting presentation for that transaction as reflected in the consolidated statements was in accordance with GAAP. If it was, the same accounting principles must be employed in establishing the unconsolidated balances for Part I.3 purposes. If it was not, a presentation for the transaction that is in accordance with GAAP must be employed in preparing the unconsolidated financial statements.
Reasons: Subsection 181(3) of the Act requires that amounts reflected in the unconsolidated balance sheet prepared in accordance with GAAP and presented to the shareholders shall be used for Part I.3 purposes. Where no such balance sheet exists, the balances that would have been reflected in such a balance sheet shall be used. Where only a consolidated balance sheet has been prepared and presented to the shareholders, the unconsolidated balance sheet prepared for tax purposes shall incorporate only those changes necessary to satisfy the criteria of subsection 181(3). Hence, if the consolidated statements were prepared in accordance with GAAP, the only acceptable changes would be to remove the effects of consolidation.
May 16, 2005
XXXXXXXXXX TSO HEADQUARTERS
XXXXXXXXXX Income Tax Rulings
Manager Directorate
R. Maley
Attention: XXXXXXXXXX (613) 946-3558
2004-010430
XXXXXXXXXX - Subsection 181(3) - Amounts Reflected in Balance Sheet
This is in response to your memorandum of November 18, 2004 requesting our comments on the appropriate application of subsection 181(3) of the Income Tax Act ("the Act") in circumstances where a taxpayer has prepared consolidated financial statements for corporate purposes and unconsolidated financial statements for Part I.3 tax purposes using different accounting presentations.
Facts and Issue
We understand the relevant facts and issues to be as follows. The taxpayer, XXXXXXXXXX, acquired a business from a related company in XXXXXXXXXX by means of an asset sale. For tax purposes, the assets were transferred at an Agreed Amount that was less than the fair market value of the assets pursuant to section 85 of the Act. The difference between the fair market value of the transferred assets at the time of the sale and the Agreed Amount was $XXXXXXXXXX ("the excess amount").
At issue is XXXXXXXXXX Part I.3 tax liability for the XXXXXXXXXX taxation year. Subsection 181(3) of the Act provides that the amounts and carrying values of the various components of a corporation's capital are those reflected in the corporation's unconsolidated balance sheet prepared in accordance with generally accepted accounting principles ("GAAP") and presented to the corporation's shareholders. Where no such balance sheet has been prepared, the balances that would have been reflected if such a balance sheet had been prepared in accordance with GAAP shall be used.
For the XXXXXXXXXX taxation year, XXXXXXXXXX prepared consolidated financial statements for presentation to its shareholders and for other corporate purposes. It also prepared and filed, with its T2 returns, unaudited unconsolidated financial statements, which is required by the Canada Revenue Agency ("CRA") in circumstances where the only balance sheet prepared for presentation to the shareholders is on a consolidated basis (e.g., see paragraph 14 of IT-532 "Tax on Large Corporations"). The unconsolidated financial statements reflect the transferred assets at the Agreed Amount. As such, the share capital of XXXXXXXXXX does not reflect the excess amount. XXXXXXXXXX view is that its capital, for Part I.3 purposes, does not include the excess amount because its share capital reflected in its unconsolidated financial statements does not include the excess amount.
XXXXXXXXXX audited consolidated financial statements for the XXXXXXXXXX taxation year reflect the transferred assets at their fair market value and not at the Agreed Amount. As such, XXXXXXXXXX share capital reflected in its consolidated balance sheet includes the excess amount. You have concluded that XXXXXXXXXX capital for Part I.3 purposes does include the excess amount because the CRA generally requires that the unconsolidated balance sheet prepared for Part I.3 purposes be prepared using the same accounting principles (other than consolidation) as were used in preparing the consolidated balance sheet presented to the shareholders.
As noted, subsection 181(3) of the Act requires that the amounts reflected in an unconsolidated balance sheet prepared in accordance with GAAP be used for Part I.3 purposes. XXXXXXXXXX consolidated financial statements for the XXXXXXXXXX year are qualified by the auditors responsible as not having been prepared in accordance with GAAP. XXXXXXXXXX maintains that the unaudited unconsolidated financial statements it submitted with its T2 return reflect the appropriate balances for Part I.3 purposes because the consolidated balance sheet was not prepared in accordance with GAAP. Your view is that the accounting presentation for the transferred assets in the consolidated balance sheet was in accordance with GAAP.
You advise that, in preparing its unaudited unconsolidated financial statement for its XXXXXXXXXX taxation year, XXXXXXXXXX has adopted a significant change in accounting principles. For its XXXXXXXXXX through XXXXXXXXXX taxation years, XXXXXXXXXX filed unaudited unconsolidated financial statements that reflected the excess amount in XXXXXXXXXX share capital. XXXXXXXXXX view, for those taxation years, was that the unaudited unconsolidated financials statements were not prepared in accordance with GAAP. For this reason, XXXXXXXXXX filed a GAAP Adjustment Schedule with its T2 return for each of those years, and excluded the excess amount in computing its capital for Part I.3 purposes. The CRA reassessed XXXXXXXXXX for each of its XXXXXXXXXX through XXXXXXXXXX taxation years to add the excess amount back to XXXXXXXXXX capital for Part I.3 purposes.
For the XXXXXXXXXX taxation year, the unaudited unconsolidated financial statements do not reflect the excess amount in XXXXXXXXXX share capital. This change was due to a journal entry at year-end to reduce share capital by the excess amount, with offsetting adjustments to goodwill and retained earnings. You conclude based on a review of XXXXXXXXXX journal entries that this adjustment was made for the sole purpose of preparing the T2 return, with the shares continuing to be carried in XXXXXXXXXX books at the fair market value transfer amount.
We understand that you have arranged to obtain an expert opinion on the whether the consolidated and unconsolidated financial statements were prepared in accordance with GAAP. In our view, if both the consolidated audited financial statements and the unconsolidated unaudited financial statements were prepared in accordance with GAAP, the accounting principles reflected in the consolidated financial statements should be used in establishing the relevant unconsolidated amounts. Provided that the increased carrying value of assets in the consolidated statements would not be viewed as a consolidation entry under GAAP, the excess amount would be reflected in XXXXXXXXXX share capital.
If the consolidated financial statement were not prepared in accordance with GAAP and the unconsolidated financial statements were prepared in accordance with GAAP, the amounts reflected in the unconsolidated financial statements should be used for Part I.3 purposes i.e., the excess amount would not be reflected in XXXXXXXXXX share capital.
Discussion
For a corporation that is neither a bank nor an insurance corporation that is required to report to the Superintendent of Financial Institutions (or similar provincial authority of a province under whose laws the insurer is incorporated), subsection 181(3) provides as follows:
(3) For the purposes of determining the carrying value of a corporation's assets or any other amount under this Part in respect of a corporation's capital, investment allowance, taxable capital or taxable capital employed in Canada for a taxation year or in respect of a partnership in which a corporation has an interest,
(a) the equity and consolidation methods of accounting shall not be used; and
(b) subject to paragraph (a) and except as otherwise provided in this Part, the amounts reflected in the balance sheet
(i) presented to the shareholders of the corporation ...or, where such a balance sheet was not prepared in accordance with generally accepted accounting principles or no such balance sheet was prepared, the amounts that would be reflected if such a balance sheet had been prepared in accordance with generally accepted accounting principles, or...
shall be used.
CRA's Interpretation Bulletin It-532 "Tax on Large Corporations" ("the bulletin") discusses the CRA"s views of the appropriate application of various provisions in Part I.3 of the Act including subsection 181(3). The preamble to the bulletin notes that the application of Part I.3 requires the use of a balance sheet that is prepared in accordance with GAAP.
Paragraph 14 of the bulletin discusses the appropriate application of subsection 181(3) in circumstances where the only financial statements presented to the shareholders were prepared on a consolidated basis:
14. The equity and consolidation methods of accounting are not permitted by virtue of paragraph 181(3)(a). In circumstances where the only balance sheet prepared for presentation to the shareholders is on a consolidated basis, an unconsolidated balance sheet will have to be prepared for each of the parent and its subsidiary corporations for purposes of Part I.3. In such circumstances, it is the CCRA's position that the unconsolidated balance sheets must be prepared using the same accounting principles (other than consolidation) used in preparing the consolidated balance sheet presented to the shareholders.
The bulletin also recognizes that there are many instances where GAAP would recognize more than one accounting presentation for a particular type of transaction. In such circumstances, there is no requirement that the corporation select the accounting presentation which would result in the greatest amount of capital for tax purposes. The corporation is entitled to select the presentation that meets its corporate purposes. See paragraph 16 of the bulletin.
However, the words of subsection 181(3) indicate that a corporation's Part I.3 liability is computed based on the capital of the corporation that is reported to the shareholders. As such, where the financial statements presented to the shareholders do not otherwise satisfy the criteria of subsection 181(3), only those changes required to satisfy those criteria may be made in computing capital for Part I.3 purposes. Therefore, a corporation may not use one GAAP presentation in preparing consolidated statements for general corporate purposes and a different GAAP presentation in preparing its unconsolidated statements for filing with its T2 return for Part I.3 purposes.
We understand that it has been submitted that the sole shareholder of a closely-held corporation should be viewed as "presented" with both the consolidated financial statements prepared for general corporate purposes and the unconsolidated financial statements prepared for tax purposes. In our view, the words "presented to the shareholders" in subparagraph 181(3)(b)(i) clarify which balance sheet is to be used for Part I.3 purposes in circumstances where more than one balance sheet has been prepared. In our view, it would be the audited balance sheet that was "presented to the shareholders" within the meaning of subparagraph 181(3)(b)(i) in such circumstances.
In short, XXXXXXXXXX liability for Part I.3 tax may depend upon whether the consolidated financial statements presented to its shareholders for the XXXXXXXXXX taxation year were prepared in accordance with GAAP. We understand that you have arranged to obtain an expert opinion in this regard, and that XXXXXXXXXX auditors have provided their reasons as to why the consolidated financial statements were qualified as not having been prepared in accordance with GAAP.
If it is determined that the consolidated financial statements were not prepared in accordance with GAAP, then the new accounting presentation employed in preparing the unconsolidated balance sheet should be accepted for Part I.3 purposes if it is in accordance with GAAP.
XXXXXXXXXX liability for Part I.3 tax may also be affected by XXXXXXXXXX change in accounting presentation for the transferred assets. As we understand it, XXXXXXXXXX made a journal entry at year-end to reduce its share capital by the excess amount, and offsetting adjustments to goodwill and retained earnings. It is not clear to us whether the journal entries made in XXXXXXXXXX to remove the excess amount from XXXXXXXXXX books were in fact made to the general ledger of the company or are notional entries made only for the purposes of preparing the unconsolidated financial statements for tax purposes.
If the excess amount was, in fact, removed from XXXXXXXXXX books, our question is whether the adjustment to increase the carrying value of assets in the consolidated financial statements would properly be viewed as a consolidation entry that would have to be eliminated in adjusting the consolidated statements (if they are in accordance with GAAP) to unconsolidated financial statements for XXXXXXXXXX. If so, the excess amount would not be included in XXXXXXXXXX share capital for purposes of Part I.3. We suggest that you pursue this point with your accounting expert.
If the consolidated financial statements were prepared in accordance with GAAP and the increased carrying value of assets reflected in those statements did not result from a consolidation entry in accordance with GAAP, our view is that the excess amount would be included in XXXXXXXXXX share capital for Part I.3 purposes.
For your information a copy this memorandum will be severed using the Access to Information Act criteria and placed in the Canada 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 (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
Policy and Planning Branch
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