10 June 2008 Internal T.I. 2008-0278261I7 - Royalty Income - Cash v. Accrual

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: Does the Federal Court of Appeal Decision of Banner Pharmacaps NRO v The Queen impact the comments contained in Document 2001-0072367?

Position: The Banner decision does not impact the views expressed in Document 2001-0072367.

Reasons: The Banner decision did not specifically address the inter-relationship between subsections 9(1) and 12(1) of the Act.

June 10, 2008

Jane Stalker
Coordinator, Resources Industry
Industry Specialist Services
Audit Professional Services Directorate

Attention: Peter Lee

					Bob Naufal
								Income Tax Rulings Directorate
								Resource Industries Section
(613) 957-2097

								2008-027826

Paragraph 12(1)(g) - Cash method vs. Accrual method

We are writing in response to your email dated May 8, 2008 wherein you requested our views as to whether the comments contained in Document Number 2001-0072367 (May 11, 2001) continue to apply in light of jurisprudence that arose after the issuance of the Document. More specifically, you have asked whether the comments from the Federal Court of Appeal ("FCA") decision of Banner Pharmacaps NRO v The Queen, 2003 DTC 5642, impacts the opinion contained in that Document.

You have also forwarded to us a copy of a submission by a taxpayer's representative dated May 5, 2008, in which the representative argues, based on the Banner Pharmacaps decision, that the use of the word "received" in paragraph 12(1)(g) of the Act mandates the use of the cash basis for reporting royalty income.

Our Comments

Document 2001-0072367

Briefly, the Document addressed whether royalties accrued for accounting purposes should be included in income for tax purposes under subsection 9(1) or paragraph 12(1)(g) of the Income Tax Act (the "Act"). In this regard, that Document opined that in the situation described therein, earned, but unpaid royalties could be accurately measured and matched to a specific period and as such, should be included in profits under subsection 9(1) of the Act to provide an accurate picture of income. The Document also opined that, based on the wording of the Act, as well as the case law referred to therein, subsection 12(1) of the Act does not provide specific exceptions to the computation of income under subsection 9(1) of the Act, but expands on the range of amounts that can be included in income. The case law referred to in the Document included inter alia Maritime Telegraph and Telephone Company Ltd. v. The Queen, 92 DTC 6191, FCA and The Queen v. La Capitale, 98 DTC 6428, FCA.

Banner Pharmacaps NRO v The Queen, 2003 DTC 5642, FCA

In this case, the Appellant, an NRO, acquired the shares of a Canadian corporation, Banner Canada. Following the acquisition, Banner Canada declared a dividend of approximately $5.6 million payable to the Appellant by way of an interest bearing promissory note. In filing its tax return for 1996 tax year, the Appellant (i) filed as an ordinary corporation and (ii) deducted, under section 112 of the Act, the dividend amount. The Minister reassessed the Appellant, adopting the position that the Appellant was an NRO for the 1996 tax year, which resulted in the application of subsection 133(2) of the Act, which denies the Appellant the deduction under section 112 of the Act in respect of the dividend income.

The Tax Court of Canada (2003 DTC 245) dismissed the appeal stating that the Appellant was "an NRO at all relevant times in 1996." Moreover, the Court concluded that the Appellant was required to include the dividend in income on the accrual basis.

In the judgement issued October 2, 2003, the FCA opined that the TCC reached the correct conclusion that the dividend was to be included in income but for the wrong reasons. In this regard, the FCA provided the following comments in its decision:

[6] First, we respectfully disagree with the Tax Court Judge's interpretation of the provisions of the Income Tax Act dealing with the tax treatment of dividends from a corporation resident in Canada. We note that the Crown has conceded this point. The clear result of the combined operation of paragraph 12(1)(j) and clause 82(1)(a)(ii)(A) of the Income Tax Act is that such dividends are taxable only when received, not when they are merely receivable. Therefore, Banner was required to include the dividend in its 1996 income only if it received the dividend in that year.

[underlines added]

Based on our understanding of the Banner case, the FCA decision therein was based on the factual evidence presented, namely the existence of the resolution and promissory note as noted in paragraphs [7] and [8] of the FCA's decision. As the Crown conceded in the case, such evidence, resulted in the correct application of the specific legislative references contained in subdivision h, and paragraph 12(1)(j) of the Act with respect to the dividend in question.

The taxpayer's representative submits that the relationship between subsections 9(1) and 12(1) of the Act described in the Document is wrong and that the author thereof incorrectly relied on the decisions in Maritime Telegraph and La Capitale, which should be read in context and limited to the interpretation of paragraphs 12(1)(a) and (b) of the Act.

We are unable to agree with the representative's submission in this regard. Although the provision in question in those decisions was paragraph 12(1)(b), we believe it is quite apparent from the following comments of Macguigan, J.A. in Maritime Telegraph that the comments were made in the context of subsection 12(1) in general and were not limited to paragraph 12(1)(b):

In my opinion, and as the respondent argued, such an interpretation could not be accepted without first locating par. 12(1)(b ), including the amendment to it, in the scheme of the Act.

The determinative provision for the definition of income is s. 9, which equates income for a year with profit for a year. It was common ground that the purpose of s. 12 of the Act was only to specify what should be included in income, but there was no agreement between the parties as to whether exclusions from income were created in the course of the delineating of inclusions in s. 12(1).

In my view, the statutory language and structure support the respondent's position. That is particularly true of s. 12(2), which explains that the purpose of s. 12(1) is only to provide greater certainty, obviously by specifying with more exactitude what is to be included in income, and which clearly forbids any construction that would have the effect of excluding income that would otherwise be included. This interpretation is also confirmed by s. 12(1) itself, which begins with the words "there shall be included in computing the income of a taxpayer for a taxation year... " [Emphasis added].

In my opinion, s. 12(1) operates so as to expand s. 9(1)'s ambit of inclusion. Obviously, at the boundary line of inclusion there may logically be some exclusions, but the joint thrust of s. 9 and s. 12(1) is to include, not exclude, and s. 12(2) has the effect of ensuring, at the very least, that nothing clearly included in s. 9 is henceforth excluded.

These comments were referred to favourably by both Letourneau, J.A. and Denault, J.A. in La Capitale.

The representative has suggested that two important rules relating to the interpretation of section 9 and paragraph 12(1)(g) flow from the Banner decision, namely that in absence of paragraph 12(1)(j) and clause 82(1)(a)(ii)(A) of the Act, income from dividends would be included in subsection 9(1) of the Act and that the FCA in that case gave effect to the specific rules and clear language in paragraph 12(1)(j) and clause 82(1)(a)(ii)(A) of the Act over the application of the general provision of subsection 9(1) of the Act.

However, in our opinion, this decision stands for nothing more than the determination that, due to the combined operation of paragraph 12(1)(j) and clause 82(1)(a)(ii)(A) of the Act, dividends are taxable when received. The Banner FCA decision did not specifically address the inter-relationship between subsection 9(1) and paragraph 12(1)(g) of the Act. Accordingly, it is our view that the Banner decision does not impact the views expressed in Document 2001-0072367. Therefore, the opinions expressed in that Document should continue to apply to situations that are similar to the one described therein.

It should be noted that proposed subsection 12(2.01), contained in the February 27, 2004 technical amendments and scheduled to apply on Royal Assent 1 , provides that paragraph 12(1)(g) does not defer the inclusion of such an amount that would be otherwise included under section 9 of the Act prior to the year of receipt. Accordingly, where an amount based on production or use would otherwise be included in computing a taxpayer's income from a business or property at a time when the amount is accrued but not yet received, proposed subsection 12(2.01) merely clarifies that paragraph 12(1)(g) of the Act does not apply to defer the inclusion of the amount in income until the time of receipt. Therefore, proposed subsection 12(2.01) reaffirms the CRA's view (as stated in Document 2001-0072367) that paragraph 12(1)(g) would apply to include amounts that were not otherwise included under subsection 9(1) of the Act.

We trust our comments will be of assistance to you.

for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
ENDNOTES

1 The proposed amendment is currently included in Bill C-10, which, has received 2nd reading in the Senate and is currently with a Senate Committee.