29 November 2005 External T.I. 2005-0121941E5 - Thin capitalization

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 retained earnings of predecessor corporations can be included in those of an amalgamated corporation

Position: yes

Reasons: any other interpretation would not be consistent with the scheme of the Act

2005-012194
XXXXXXXXXX T. Harris
(613) 957-2114
November 29, 2005

Dear Sir:

Re: Thin Capitalization Rules

This is in reply to your facsimile letter of March 18, 2005 wherein you requested our interpretation of subsection 18(4) of the Income Tax Act (the "Act") as it applies for the purposes of determining the opening retained earnings of an amalgamated company.

You have described the following hypothetical situation for our consideration:

1. Each of Opco1 and Opco2 is a taxable Canadian corporation and a wholly-owned subsidiary of a non-resident corporation ("NRco").

2. At the beginning of its taxation year ended December 31, 2004, Opco1 had no retained earnings and had a deficit of $1 million as at December 31, 2004. Throughout its 2004 taxation year Opco1 had an interest-bearing debt of $2 million owing to NRco such that subsection 18(4) of the Act applied to deny a deduction for interest payable by Opco1 on this debt for its 2004 taxation year.

3. As at December 31, 2004, Opco2 had retained earnings of $2 million.

4. On January 1, 2005, Opco1 and Opco2 were amalgamated to form Amalco. The opening balance sheet of Amalco as at January 1, 2005, which was prepared in accordance with Canadian generally accepted accounting principles ("GAAP"), reports retained earnings of $1 million, being the net of Opco1's deficit and Opco2's retained earnings as determined immediately before the amalgamation.

5. The paid-up capital of the issued shares and contributed surplus of each of Opco1, Opco2 and Amalco is nominal.

In the situation described, you have asked for our interpretation as to what amount, if any, of retained earnings that Amalco would have at the beginning of its taxation year commencing on January 1, 2005. In particular, you are concerned whether the phrase "...except to the extent that those earnings include retained earnings of any other corporation" as used in clause 18(4)(a)(ii)(A) of the Act would result in Amalco's retained earnings at the beginning of its 2005 taxation year being nil.

Our Comments

Written confirmation of the income tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request as described in Information Circular 70-6R5 dated May 17, 2002 issued by the Canada Revenue Agency (the "CRA"). Where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office. Although we cannot provide any comments with respect to your particular fact situation or to any specific asset, the following general comments may be of assistance.

Your concern appears to be related to paragraph 87(2)(a) of the Act which deems the amalgamated corporation to be a new corporation for all purposes related to the computation of its income (The Queen v. Pan Ocean Oil Ltd. 94 DTC 6412). Since Amalco is considered to be a new corporation and its retained earnings are determined under GAAP by aggregating the retained earnings of its predecessor corporations, which are considered to be separate entities by virtue of paragraph 87(2)(a) of the Act, you are concerned that Amalco's retained earnings may be considered to include the retained earnings of another corporation.

As the term "retained earnings" is not defined in the Act, the CRA will generally rely on the ordinary meaning of that term as used in commercial practice, which is generally the meaning adopted under GAAP. However, in certain circumstances, retained earnings of a corporation as determined under GAAP may be computed on the equity basis and include the corporation's share of the retained earnings of another corporation over which it exercises "significant influence". We understand that the purpose for the words "...except to the extent that those earnings include retained earnings of any other corporation" in clause 18(4)(a)(ii)(A) was to ensure that the retained earnings of a corporation would not be determined on the equity basis for purposes of subsection 18(4) of the Act. The concern was that the computation of retained earnings on the equity basis would result in a duplication of retained earnings, once in the corporation that earned the income and again in the corporation that exercises significant influence over it. It was not intended to preclude an amalgamated corporation from including the retained earnings of its predecessor corporations in its retained earnings as this would not result in any duplication of such amounts.

For these reasons, it is our opinion that the exception in clause 18(4)(a)(ii)(A) of the Act will not preclude the retained earnings of an amalgamated corporation from including the retained earnings of its predecessor corporations for the purposes of subsection 18(4) of the Act.

Our comments, which we trust will be of assistance, are provided in accordance with the practice outlined in paragraph 22 of IC 70-6R5.

Yours truly,

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