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 fees incurred with respect to a proposed conversion to an income trust are deductible under subsection 9(1).
Reasons: Expenses are on account of capital and precluded under paragraph 18(1)(b)
June 20, 2007
David Kompare HEADQUARTERS
Audit Division Income Tax Rulings
Hamilton Tax Services Office Directorate
We are writing in response to your memorandum of April 24, 2007 wherein you requested our interpretation as to whether professional fees incurred by XXXXXXXXXX. (the "Corporation") for the purpose of converting its corporate structure to an income trust would be deductible in computing its income for its XXXXXXXXXX taxation year. Unless otherwise stated, each reference herein to a part, section, subsection, paragraph, subparagraph or clause is a reference to the relevant provision of the Income Tax Act (the "Act").
The Corporation is a Canadian-controlled private corporation within the meaning of subsection 125(7). XXXXXXXXXX.
The Corporation, along with several other XXXXXXXXXX, developed a plan to reorganize their business structures such that the businesses would be operated under an income trust structure, rather than in corporate form. The plan involved a proposed public offering of trust units; however, the shareholders of the Corporation and the other XXXXXXXXXX would hold a majority of the trust units.
During its XXXXXXXXXX taxation year the Corporation incurred professional fees in the amount of $XXXXXXXXXX relating to the proposed conversion to an income trust structure. These fees were all incurred during XXXXXXXXXX and included fees relating to audit services undertaken to verify the Corporation's financial statements for its XXXXXXXXXX fiscal periods, interim reviews for the periods ending XXXXXXXXXX, as well as certain other issues including EBITDA analysis at various periods.
The Corporation incurred additional fees with respect to the proposed conversion during its XXXXXXXXXX taxation year; however, as this return is not currently under audit you do not have details of these costs.
The planned conversion to an income trust structure was subsequently abandoned for various reasons, including the announcement by the Minister of Finance on October 31, 2006 that any income trust that began trading after that date would be subject to a distribution tax on distributions made to its public unit holders commencing with its 2007 taxation year.
As a result of its failure to complete the conversion to an income trust structure, the Corporation had by the end of XXXXXXXXXX sold all of its XXXXXXXXXX.
The Corporation's representative, XXXXXXXXXX, has submitted in his letter of March 7, 2007 that these fees are deductible in computing the Corporation's income for the purposes of section 9 as they were incurred for the purpose of earning income and the deduction would not be denied by paragraph 18(1)(b). In this regard, he has relied on several decisions of the Supreme Court of Canada (such as, Symes, 94 DTC 6003 and Canderel 98 DTC 6100) that found that profit is to be computed based on "well accepted business practices". He has also relied on the decisions in Boulangerie St.-Augustin Inc., 97 DTC 5012 (FCA), International Colin Energy Corporation, 2002 DTC 2185 (TCC), BJ Services Company, 2004 DTC 2032 (TCC), Truckbase Corporation et al 2006 DTC 2930 (TCC).
He further submits that paragraph 18(1)(b) would not be applicable to deny a deduction for the professional fees as the directors of the Corporation made the decision to incur these fees in order for an existing business to be carried on in a different form. No enduring benefit would have been obtained if the conversion had been undertaken.
He also submits that the professional fees should be deductible under the following provisions of the Act:
(a) The professional fees were incurred in the course of issuing a financial report to shareholders and would thus be deductible under paragraph 20(1)(g);
(b) As the professional fees were incurred with the intent to issue units to the public,
(i) they would have been necessary expenses to comply with the requirements of the provincial securities commission and would be deductible under paragraph 20(1)(cc), or
(ii) would be deductible pursuant to paragraph 20(1)(e) as costs incurred in the course of an issuance or sale of shares of the taxpayer.
It is your view that the professional fees incurred by the Corporation represent capital expenditures that fall within paragraph 18(1)(b).
While we do not disagree with the representative's submission that the Courts have indicated that profit, for the purposes of subsection 9(1), is to be computed based on "well accepted business practices", it is necessary to determine whether any specific provisions of the Act may apply in the determination of the Corporation's income. In our view, as discussed in more detail below, the professional fees incurred by the Corporation in XXXXXXXXXX would represent expenditures on account of capital and would, therefore, not be deductible by virtue of paragraph 18(1)(b) unless a deduction is provided under some other provision of the Act. Consequently, we have not considered whether the professional fees would be deducted in computing the Corporation's profit on the basis of "well accepted business practices".
While we acknowledge that annual audit fees would normally represent a current expense and, therefore, be deductible in computing a taxpayer's profit under subsection 9(1), the audit fees in question were incurred in respect of prior years and were related to the proposed conversion of the Corporation to an income trust structure. In these circumstances, we believe that the audit fees were not incurred as part of the income-earning process of the Corporation, but were incurred once and for all with a view to bringing into existence an advantage of an enduring nature for the business of the Corporation, being the reorganization of the capital structure of the business. The Courts have generally found that costs incurred for the creation of a business entity, structure or organization, or for the modification of such entity, structure or organization are capital in nature. For example, in Canada Starch Co. Ltd. v. M.N.R., 68 D.T.C. 5320 (Ex. t.), Jackett P. stated:
"In other words, as I understand it, generally speaking,
(a) on the one hand, an expenditure for the acquisition or creation of a business entity, structure or organization, for the earning of profit, or for an addition to such an entity, structure or organization, is an expenditure on account of capital, and
(b) on the other hand, an expenditure in the process of operation of a profit-making entity, structure or organization is an expenditure on revenue account."
These comments were cited with approval by Archambault, T.C.C.J. in Rona Inc. v. The Queen, 2003 DTC 979 (TCC).
Furthermore, the fact that the proposed income trust conversion was aborted would not, in our view, affect this treatment, as it would not change the Corporation's purpose for incurring the expenses. Support for this position may be found in the decisions in Rona, Firestone v. Canada,  3 F.C. 200 and Brooke Bond Foods Ltd. v. The Queen 84 DTC 6144.
In this regard, Archambault, T.C.C.J. stated the following in paragraphs 45 to 49 of his Reasons for Judgment in Rona:
 ...The nature of the fees depends on the purpose of the services that were rendered. If the professional fees involve current transactions, they are income expenditures. If the fees involve the expansion of the business structure, they are capital outlays. For example, if fees are paid for negotiations with respect to a marketing campaign, they are income expenses. However, if fees are paid in order to acquire a competitor, they are capital outlays. What needed to be determined first is the nature of the transactions conducted by Rona in order to characterize the nature of the professional services required for these.... The purpose of these services was to confer on Rona an advantage [TRANSLATION] "for the lasting benefit of [its] business". Therefore, the fees for those services are capital outlays, and the parties agree that those fees must be included in the costs of the assets acquired by Rona.
 However, some of the projects considered were abandoned. There is no asset the cost of which the related expenses incurred can be included. In these circumstances, must we conclude that the expenses incurred for these transactions should be considered income expenses? The answer to this question is provided by the Federal Court of Appeal in Firestone v. R.,  3 F.C. 200, 87 D.T.C. 5237 (Fed. C.A.). MacGuigan J.A. states these issues as follows, at page 210 (DTC, at page 5241):
Counsel for the appellant acknowledged in the course of argument that the costs of the investigation of opportunities in relation to the four operating companies actually acquired were capital expenditures, and made it clear that they had in fact been capitalized here.... However, he submitted that the investigation costs of the other fifty-odd opportunities that did not lead to acquisitions must be regarded rather as expenditures of an operating nature. [Emphasis added.]
 At the same page, MacGuigan J.A. concludes as follows:
I find it impossible to accept this contention. It seems to me that all of the expenditures relating to the investigation of opportunities must be considered on the same footing. They were the same kinds of expenses, and they were made for the same purpose. They were, in effect, all part of the same venture-capital business which, the appellant strenuously urged, existed from 1969 on. It makes no sense to separate off the few which led to acquisitions from the many that did not. All were equally part of the appellant's plan of assembly of business assets. It was only to be expected, and indeed was the premise of the appellant's investigative method, that some possibilities would on examination turn out to be good risks, others too poor to be proceeded with. In my view, the very common-sense approach for which the appellant contended vitiates his attempted distinction. [Emphasis added.]'
 In Brooke Bond Foods Ltd. v. The Queen,  1 F.C. 601, Décary, J. adopted the same approach. At page 604, he writes:
The fact the project was abandoned does not alter the nature of the expense, which remains an outlay on account of capital. As Thorson P. of the Exchequer Court wrote in Siscoe Gold Mines Ltd. v. Minister of National Revenue,  Ex.C.R. 257; at page [266 Ex.C.R.]:
The fact that it was decided to abandon the option and not to acquire the [mining] claims cannot change the character of the disbursements. They were losses incurred in connection with a capital venture. ... I think it is clear that an expenditure incurred for the purpose of enabling a taxpayer to decide whether a capital asset should be acquired is an outlay or payment on account of capital. ...
 Consequently, the abandonment of the 1994 project to open a store in co-operation with Groupe Lespérance and the 1998 projects to open stores in co-operation with Revy and perhaps with Loyola does not change the nature of the amounts that would otherwise have been capital outlays....
The Corporation's representative has also referred to the findings in Boulangerie St-Augustin Inc., International Colin Energy Corporation, BJ Services Company Canada and Truckbase Corporation et al in support of his contention that these audit fees represent currently deductible expenses to the Corporation. However, in our opinion, each of these decisions should be distinguished from the Corporation's situation. Each of the first three decisions involves a corporation that was the object of one or more takeover bids and the issue to be decided was whether certain expenses incurred by the target corporations in response to takeover bids were deductible. In each case, the expenses and obligations of the corporation arose under the relevant securities regulations from a takeover bid, made by a third party, to acquire shares of the corporation's capital stock. Each corporation was then compelled to inform its shareholders about this offer and to make recommendations with respect to its fairness. In each case, the Courts found that the corporation did not acquire any capital property and there was no enduring benefit to the corporation associated with the expenditures. This can be distinguished from the Corporation's situation where the decision to convert its corporate structure was made by the directors of the Corporation itself. In our view, the purpose of the proposed conversion was to obtain an advantage of an enduring nature, including the elimination of the corporate level of tax and increasing the ability of the business to raise investment capital.
It is not clear what support the Corporation's representative finds in the Truckbase decision, other than perhaps the statement of McArthur J. from paragraph 16 to the effect that, in his opinion, "the decisions in BJ Services and the other decisions cited in that case" should not be limited to "situations involving hostile takeover bids or economically difficult circumstances." From the court's analysis in the part of that decision that related to the deduction of the fees by Truckbase, it appears that the legal fees in question involved only those incurred with respect to the review and modification of the existing shareholder agreements, which the court found to be akin to the maintenance of a corporate asset. Truckbase treated its share of the remaining legal fees as an eligible capital expenditure. We would, however, note that in paragraph 22 of the decision, McArthur J. stated, in the context of determining whether an expenditure is on income or capital account, that "[t]he focus is on the purpose of the expenditure and not the result" [emphasis added]. This statement would add further support to those cited previously that the fact that a proposal is aborted will not affect the status of the related costs as being on current or capital account.
As we believe that the audit fees that were incurred to satisfy the requirements of the securities regulations to enable the proposed income trust to issue units to the public represent capital expenditures for the purposes of paragraph 18(1)(b), we will now comment on the other provisions that the Corporation's representative has submitted in support of his argument that these fees are deductible in XXXXXXXXXX.
Subparagraph 20(1)(g)(iii) provides that a corporation may deduct "an expense incurred in the year in the course of printing and issuing a financial report to shareholders of the taxpayer or to any other person entitled by law to receive the report". In the Boulangerie St-Augustin decision, Archambault, T.C.C.J. made the following comments concerning the meaning of a financial report:
Having regard to the historical context of the addition of paragraph 20(1)(g) to the Act and to the definitions stated above, I believe that the definition of "annual report" given by Black's Law Dictionary corresponds most closely to the notion of "financial report" contemplated by this paragraph. This is a report addressing a corporation's financial situation, generally including financial statements and often officers' comments on the corporation's activities.
The definition from Black's Law Dictionary, cited in the decision is:
Annual report. A report to stockholders and other interested parties prepared by a corporation once a year; includes a balance sheet, an income statement, a statement of changes in financial position, a reconciliation of changes in owners' equity accounts, a summary of significant accounting principles, other explanatory notes, the auditor's report, and often comments from management about the year's business and prospects for the next year. By law, any public corporation that holds an annual stockholders meeting is required to issue an annual report.
Although the annual financial statements and the auditor's report thereon may be a component of a corporation's annual report, we do not believe that the audit fees in question were "incurred in the year in the course of printing and issuing a financial report..." for the purposes of subparagraph 20(1)(g)(iii). The financial statements that were being audited had been prepared and presumably provided to the shareholders in prior years. Furthermore, as a result of the audit fees there does not appear to be any evidence to the effect that any report was printed and issued to the shareholders of the Corporation or any other person who had a legal entitlement to receive one.
For an amount to be deductible under paragraph 20(1)(cc), it is our view that the taxpayer must actually make representations to the government or public body. A mere intention to submit documents to a provincial securities commission would not be sufficient. Consequently, we have not considered whether the type of expenditures incurred by the Corporation would otherwise satisfy the requirements of paragraph 20(1)(cc). Similarly, with respect to the possible application of paragraph 20(1)(e), we would note that paragraph 12 of IT-341R4 indicates that a taxpayer seeking a deduction under this provision must actually undertake the issuance or sale of shares or units of its capital.
In our view, the audit fees would, in these particular circumstances, represent eligible capital expenditures within the meaning of subsection 14(5) to the Corporation and it would be entitled to an allowance pursuant to paragraph 20(1)(b) in respect thereof. As described in paragraph 2 of Interpretation Bulletin IT-143R3 Meaning of Eligible Capital Expenditure, dated August 29, 2002, it is the Agency's position that an expenditure will constitute an eligible capital expenditure if it was 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).
Furthermore, these fees would not fall into any of the exceptions described in paragraph 3 of IT-143R3. We would also note that paragraph 18 of IT-143R3 indicates that an expense incurred in issuing shares or borrowing money was an eligible capital expenditure prior to paragraph 20(1)(e) coming into effect. Consequently, it seems reasonable that such expenditures that are not deductible because the financing was never completed should continue to qualify as an eligible capital expenditure.
In summary, for the reasons given above, we agree with your view that the audit fees are not deductible in computing the Corporation's income for its XXXXXXXXXX taxation year; however, the Corporation would be entitled to an allowance under paragraph 20(1)(b) in respect these expenditures.
We trust that these comments will be of assistance.
Reorganizations and Resources Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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