This translation was prepared by Tax Interpretations Inc. The CRA did not issue this document in the language in which it now appears, and is not responsible for any errors in its translation that might impact a reader’s understanding of it or the position(s) taken therein. See also the general Disclaimer below.
Principal Issues: Corporation A is a CCPC and carries on a residential and commercial construction business. Corporation A issues progress billings as work on a project proceeds for the purposes of reporting contract revenues as described in IT-92R2. Corporation A's only issued and outstanding shares consist of 100 common shares. Corporation A has only one construction project outstanding, for which construction costs and profits are estimated to be respectively $20,000,000 and $2,000,000. In Corporation A's first taxation year, say year 1, work in progress (hereinafter "WIP") and construction expenses amount to respectively $11,000,000 and $10,000,000. In the computation of its year 1 net income for income tax purposes, Corporation A deducted the WIP and, consequently, incurred a non-capital loss of $10,000,000. At the beginning of year 2, transactions are implemented and the application of subsection 55(2) is triggered. How, in the particular situation, will the safe income on hand (hereinafter "SIOH") be computed for the stub period starting on the first day of year 2 and ending on the safe income determination time?
Position: General comments provided. The key factors are that the computation of SIOH for the stub period must be reasonable in the circumstances and that generally the SIOH for the stub period is determined by allocating a proportion of the income of the corporation for the taxation year to the stub period.
Reasons: Question of fact and previous positions.
December 12, 2011
Subject: Request for Technical Interpretation - Subsection 55(2)
This is in response to your letter of August 10, 2011, in which you asked us for clarification regarding the application of subsection 55(2) of the Income Tax Act (the "Act"). in the context of a particular situation.
Unless otherwise stated, all statutory references are to provisions of the Act.
It appears to us that the situation described in your letter and summarized below could constitute an actual situation involving taxpayers. As explained in Information Circular 70-6R5, it is not the practice of this Directorate to provide comments on proposed transactions involving specific taxpayers other than in the form of an advance income tax ruling. However, we are able to offer the following general comments that may be helpful to you. It should be noted that the application of one or more provisions of the Act generally requires the analysis of all facts relating to a particular situation. Accordingly, and in light of the fact that your letter only briefly describes a hypothetical particular situation, the comments that we make below may not be fully applicable in a particular situation.
The Particular Situation
You have presented the situation described below (the "Particular Situation") as part of your request for a technical interpretation:
1. A corporation ("Corporation A") is a Canadian-controlled private corporation as that term is defined in subsection 125(7).
2. The only issued and outstanding shares of the capital stock of Corporation A since its incorporation have been 100 common shares.
3. The principal activity of Corporation A is the carrying on of a residential and commercial construction business.
4. Income from the carrying on of Corporation A's business is recorded by it in accordance with the percentage of completion method. Under that method, operating revenues and profits are recorded in proportion to the percentage of completion of the work based on billings made after the client, architect or engineer has approved the portion of the work covered by the progress billing.
5. Corporation A had only one construction project underway. Estimated profits on the entire construction contract are 10% of construction costs. The estimated construction costs for the construction contract are $20,000,000.
6. Corporation A incurred expenses totaling $10,000,000 for year 1.
7. Year 1 was the first taxation year of Corporation A.
8. In year 1, Corporation A did not bill for work performed.
9. At the end of year 1, Corporation A completed 50% of the work to be done on the construction project, given that 50% of the estimated expenses were incurred.
10. In the preparation of its financial statements, Corporation A recorded work in progress ("WIP") of $11,000,000 since 50% of the work was completed at the end of year 1.
11. For accounting purposes, the income statement of Corporation A for year 1 indicated a profit of $1,000,000 and the balance sheet showed WIP of $11,000,000 and accounts payable of $10,000,000.
12. In determining its net income for the purposes of the Act, Corporation A deducted the WIP on its balance sheet, as permitted in paragraph 6 of Interpretation Bulletin IT-92R2 – Income of Contractors, December 29, 1983 (the "Bulletin"). Thus, Corporation A realized a non-capital loss ("NCL") of $10,000,000 for year 1.
13. During year 2, transactions were carried out at the Corporation 2 shareholder level, such that subsection 55(2) applied. The "safe income determination time" ("SIDT") was determined in accordance with the definition of that term in subsection 55(1).
14. On the first day of year 2, Corporation A reclassified its year-1 WIP as expenses so that that amount was not deducted twice in computing its net tax income.
Your questions respecting the Particular Situation
1. In the event that the SIDT falls on the first day of year 2 and there is no transaction in the normal course of Corporation A's operations, that is, there is neither billing made nor change in WIP, what would be the amount of safe income attributable to the common shares in the capital stock of Corporation A for purposes of subsection 55(2)?
2. In the event that the SIDT falls on the 30th day of year 2 and the only transaction made by Corporation A was to charge all of its WIP, that is to say, $11,000,000 and that such billing was approved by the purchaser or the purchaser's architect or engineer, what would be the amount of safe income attributable to the common shares of the capital stock of Corporation A for the purposes of subsection 55(2)? Also, should the taxes attributable to the WIP included in income in year 1 in the determination of safe income be considered?
3. Would the answer to question 2 be the same if the amount invoiced has not been approved by the purchaser, the purchaser’s architect or engineer given the possibility of not including in income for tax purposes the invoiced but unapproved amounts?
4. In the event that the SIDT falls on the 180th day of Year 2 and Corporation A has invoiced all of its WIP in Year 1 (i.e., $11,000,000) and at that date, 75% of the work is completed, what would be the amount of safe income attributable to the common shares of the capital stock of Corporation A for the purposes of subsection 55(2)?
Your comments respecting the Particular Situation
You stated that your position is based on the assumption (the "Assumption") that, for purposes of computing safe income on the SIDT, it is necessary to consider the accounting entries to be made in respect of the WIPs as if financial statements were prepared at that time. Thus, an assessment of the WIP on the SIDT should be done on the basis of billing and progress, which are two variables that affect WIP.
For the purposes of your interpretation, you designated, as the “stub” period, the period beginning on the first day of year 2 and ending at the SIDT.
Thus, with respect to the 1st question, the safe income is, in your view, nil because in year 1, Corporation A incurred a NCL of $10,000,000 and, for the “stub” period, the taxable income was nil.
You suggested that in respect of the second issue, Corporation A's safe income is $1,000,000, less related taxes. In fact, on your taking into account the NCL of $10,000,000 for year 1 and for the "stub" period, the net taxable income of Corporation A amounted to $11,000,000.
As for the 3rd question, you submitted that the safe income would be nil because the taxable income is also nil since the WIP is billed but not approved by the purchaser or the purchaser's architect or engineer.
Finally, you stated that with respect to the fourth issue, the safe income would be nil. In fact, still taking into account the NCL of $10,000,000 for year 1 and, regarding the "stub" period, the taxable income of $6,000,000, there is cumulative safe income of negative $4,000,000.
In conclusion, you stated that as long as the WIP is not invoiced and that the billing has not been approved by the purchaser or the purchaser's architect or engineer, there would be no addition in the calculation of safe income.
Our comments on the Particular Situation
At the outset, it is important to note that the interpretation and application of subsection 55(2) requires the consideration of all facts and circumstances pertaining to a particular situation.
Subsection 55(2) applies where a corporation resident in Canada has received a taxable dividend in respect of which it is entitled to a deduction under subsection 112(1) as part of a transaction or event or a series of transactions or events, one of the purposes of which (or, in the case of a dividend under subsection 84(3), one of the results of which) was to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on a disposition at fair market value (”FMV”) of any share of capital stock immediately before the dividend and that could reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971 and before the relevant SIDT.
Paragraph 55(5)(a) provides that where a dividend referred to in subsection 55(2) was received by a corporation as part of a transaction or event or a series of transactions or events, the portion of a capital gain attributable to any income expected to be earned or realized by a corporation after the SIDT for the transaction, event or series is deemed to be a portion of a capital gain attributable to anything other than income.
The income earned or realized by any corporation after 1971 referred to in subsection 55(2), commonly referred to as "safe income", is net income computed for the purposes of the Act taking into account the adjustments referred to in paragraphs 55(5)(b) to (d). However, the "safe income" must be "on hand" ("SIOH") in order to contribute to the unrealized capital gain on a share (footnote 1).
For example, if income has been used or earmarked to pay non-deductible expenses for the purposes of the Act, to pay dividends or to pay taxes, it can no longer be considered "on hand" to fund the payment of the dividend. (footnote 2)
In paragraphs 35 to 38 of the Kruco decision (footnote 3), the Federal Court of Appeal set out the general principles that must govern the determination of the SIOH attributable to shares of the capital stock of a corporation. The Federal Court of Appeal first clearly recognized that the calculation of a corporation's safe income (that is, the net taxable income of that corporation, with the adjustments referred to in paragraphs 55(5)(b) to (d)) is only the first step in the process and that a determination of the SIOH is required by the Act.
In that regard, the Court of Appeal stated at paragraph 38 of its decision:
There can be no doubt that this exercise calls for an inquiry as to whether "the income earned or realized" was kept on hand or remained disposable to fund the payment of the dividend. It follows, for instance, that taxes or dividends paid out of this income must be extracted from safe income (see Deuce Holdings Ltd., supra and Gestion Jean-Paul Champagne Inc., supra).
In addition, Noël J stated at paragraph 41 of the decision:
Reducing this income by reference to cash outflows, which take place after it has been computed in conformity with paragraph 55(5)(c), but before the dividend is paid, does no violence to the deeming provision since the deemed amount is accepted as the starting point and modified only by reference to subsequent events which are relevant to the subsection 55(2) computation, i.e. cash outflows which take place after the income has been determined - in conformity with the deeming provision - and which reduce the income to which the capital gain can be "reasonably ... attributable".
The long-standing position of the Canada Revenue Agency ("CRA") is that the SIOH attributable to a share of the capital stock of a corporation is based on the holding period of that share and may include two periods called "stub periods" (in French périodes "tampons" or périodes "souches"), namely: 1) a period starting on the date of acquisition of the share of the capital stock of the corporation and ending at the end of the corporation's first taxation year following the acquisition of the share, and 2) a period beginning at the end of the particular corporation's last taxation year ending after the acquisition of the share and continuing to the SIDT.
Note that in Nassau Walnut (footnote 4) and Brelco Drilling (footnote 5), the Federal Court of Appeal recognized that there are two reasonable methods that can be used to evaluate and attribute SIOH to a share; the courts will generally accept the method employed by the CRA.
Thus, the Federal Court of Appeal confirmed in HIV Logging Ltd. (footnote 6) that the calculation of the SIOH attributable to the shares of the capital stock of a corporation during the holding period of such shares includes the SIOH generated in the "stub" periods. The Federal Court of Appeal held that such an interpretation was not only consistent with the terms of subsection 55(2), but also with the purpose underlying that statutory provision. It should be noted that the decision in HIV Logging Ltd. was made subsequent to that in the Kruco case.
The CRA's position with respect to the calculation of the SIOH attributable to a share of the capital stock of a corporation, particularly with respect to a "stub" period, is that there must not be artificial creation of safe income, for example, by not claiming capital cost allowance. Likewise:
The computation should be reasonable in the circumstances and should be made on a basis consistent with computation methods used in other periods within the holding period. If it is reasonable to expect that any of the income earned or realized in a stub period will be offset by losses in the remainder of the year, then the calculation of the safe income on hand for the stub period should reflect the anticipated losses, since that income could not reasonably be considered to be reflected in the inherent gain in the shares. It may be appropriate to take business cycles into account. Proration of income on a daily basis for the stub period is often, but not always, a reasonable approach to the calculation (footnote 7). [our emphasis]
It should be noted that the Federal Court of Appeal, in HIV Logging (footnote 8), recognized the relevance of that last comment, particularly where there is an unrealized loss before the SIDT. (footnote 9)
Based on the foregoing, we are of the view that in the Particular Situation, your calculation of the SIOH attributable to the shares of the capital stock of Corporation A in the context of questions 1, 2 and 4 described above would likely be correct, to the extent that the SIDT, as set out in each of those questions, would be the end of the taxation year (whether or not deemed) of Corporation A.
However, if it turns out, for example, that the SIDT is January 1, day 30 or day 180 of a 365-day taxation year of Corporation A, we are of the view that your Assumption would have the effect of distorting the amount of the SIOH attributable to the shares of the capital stock of Corporation A in respect of the "stub" period since your calculations would then fail to take into account the full results of Corporation A's taxation year 2. In the Particular Situation, the calculation of the SIOH in respect of the "stub" period should generally not be calculated as if an end of a taxation year has occurred at the SIDT but, rather, in proportion to the number of days of the "stub" period in relation to the total number of days in the particular taxation year of Corporation A.
In addition, we agree with your position that the calculation of the SIOH attributable to the shares of the capital stock of Corporation A in respect of a "stub" period must generally take into account the income taxes payable by the corporation and attributable to the "stub" period.
Regarding your third question, in the event that billing has not been approved by the purchaser or the purchaser's architect or engineer in accordance with the contract and that the SIDT would correspond to the end of the taxation year (deemed or not) of Corporation A, we are of the view that the SIOH attributable to common shares of the capital stock of the Corporation for such period would be nil.
Please note that this opinion is not an advance ruling and does not bind the CRA with respect to a particular factual situation.
We hope that these comments will be of assistance.
Maurice Bisson, CGA
Reorganizations Section IV
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 John R. Robertson " Capital Gains Strips : A Revenue Canada Perspective on the Provisions of Section 55" in Conference 1981 (Toronto : Canadian Tax Foundation, 1982), pages 81-109, to page 84. The concept of SIOH has been accepted by the Federal Court of Appeal, notably in The Queen v. Brelco Drilling Ltd., 99 DTC 5253.
2 See in that regard Income Tax Technical News No. 37.
3 The Queen. v. Kruco Inc., 2003 DTC 5506 (F.C.A.).
4 The Queen v. Nassau Walnut Investments Inc., 97 DTC 5051 (C.A.F.).
5 The Queen v. Brelco Drilling Ltd., supra footnote 1.
6 VIH Logging Ltd. V. The Queen, 2004 DTC 2090 (T.C.C.); The Queen v. VIH Logging Ltd., 2005 DTC 5095 (F.C.A.).
7 Robert J. L. Read " Section 55 : A Review of Current Issues in Conference 1988 (Toronto: Canadian Tax Foundation, 1989), 18:1-28, on pages 18:5 and 18:6.
8 Supra footnote 7, at aux paragraphs 40 and 41 reasons of judge Sharlow JA.
9 It should be remembered that the calculation of the SIOH ended before the transaction or event or the beginning of the series of transactions or events, as subsection 55(2) read at the time the relevant facts of HIV Logging Ltd occurred. Since then, the definition of SIDT has been added to subsection 55(1) and means, in respect of a transaction or event or a series of transactions or events, the time that is the earlier of the time that is immediately after the earliest disposition or increase in interest described in any of subparagraphs 55(3)(a)(i) to 55(3)(a)(v) that resulted from the transaction, event or series, and the time that is immediately before the earliest time that a dividend is paid as part of the transaction, event or series.
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