10 August 2012 External T.I. 2012-0436411E5 - Accumulated Profits

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: Where a corporation’s retained earnings are increased by an amount that relates to an appraisal surplus, would a later decrease in the corporation’s retained earnings resulting from depreciation claimed in respect of that appraisal surplus be considered (i.e., reversed) when determining the accumulated profits of the corporation that were being used for purposes that would have qualified for interest deductibility had the capital been borrowed money. I.E., for the purpose of determining the amount that the corporation could borrow and deduct interest paid or payable thereon?

Position: Yes; when determining the accumulated profits of a corporation that were being used for purposes that would have qualified for interest deductibility had the capital been borrowed money (i.e., for the purpose of determining the amount that the corporation could borrow and deduct interest paid or payable thereon), we would consider (i.e., reverse) both increases and decreases to the corporation’s retained earnings resulting from an appraisal surplus included in the corporation’s retained earnings prior to that time.

Reasons: It is a corporation’s accumulated profits that were being used for purposes that would have qualified for interest deductibility had the capital been borrowed money immediately before shares are redeemed, capital is returned or dividends are paid that are relevant for the purpose of determining the amount that the corporation could borrow and deduct interest paid or payable thereon, and when determining a corporation’s accumulated profits at a point in time, it is the retained earnings of the corporation at that time that are relevant.

XXXXXXXXXX
2012-043641
L.M. Carruthers, CA
August 10, 2012

Dear XXXXXXXXXX,

Re: Accumulated Profits

This is in reply to your letter of February 9, 2012, in which you asked for our assistance in clarifying the proper technical interpretation of paragraph 20(1)(c) of the Income Tax Act (the “Act”) with respect to the determination of a corporation’s accumulated profits that were being used for purposes that would have qualified for interest deductibility had the capital been borrowed money (i.e., for the purpose of determining the amount that the corporation could borrow and deduct interest paid or payable thereon). In your letter, you described the following scenario:

• a corporation holds, as part of its real estate, depreciable property such as buildings;
• when determining the cost of its real estate, for International Financial Reporting Standards “IFRS” purposes, the corporation decides to fair value its real estate which results in an increase to the corporation’s retained earnings for financial statement purposes;
• you acknowledged our view that the above described increase in value of the corporation’s real estate would be an appraisal surplus which would not constitute accumulated profits of the corporation; and
• in the future, the corporation claims depreciation in respect of the depreciable property resulting in a decrease to the corporation’s retained earnings for financial statement purposes, such that the corporation would claim depreciation on a part of the increase arising from the fair valuing of the real estate.

It is your view that where a corporation’s retained earnings were increased by an amount that relates to an appraisal surplus, a later decrease in the corporation’s retained earnings resulting from depreciation claimed in respect of that appraisal surplus should be considered (i.e., reversed) when determining the accumulated profits of the corporation that were being used for purposes that would have qualified for interest deductibility had the capital been borrowed money (i.e., for the purpose of determining the amount that the corporation could borrow and deduct interest paid or payable thereon).

Our comments

As described in paragraphs 12 and 13 of Interpretation Bulletin IT-533, entitled “Interest Deductibility and Related Issues”, subparagraph 20(1)(c)(i) of the Act requires that the interest sought to be deducted be on "borrowed money used for the purpose of earning income from a business or property." The interpretation of the term "used" means directly used, however, in certain circumstances the courts have stated that the indirect use will be accepted as an exception to the direct use test.

The exception to the direct use test for borrowed money used by a corporation to redeem shares, return capital or pay dividends is described in paragraph 23 of IT-533 as follows:

¶ 23. Interest expense on borrowed money used to redeem shares or return capital can be an exception to the direct use test. In connection with this use, the purpose test will be met if the borrowed money replaces capital (contributed capital or accumulated profits) that was being used for purposes that would have qualified for interest deductibility had the capital been borrowed money (eligible purposes). Consistent with the concept of filling the hole, contributed capital generally means the funds provided by the shareholders to commence, or otherwise further, the carrying on of the business. While in most situations the legal or stated capital for corporate law purposes would be the best measurement of contributed capital for this purpose, other measurements may be more appropriate depending on the circumstances. In situations where some proportion of shares is being replaced with borrowed money, only the capital of those shares, computed on a pro-rata basis, would be considered to be replaced with the borrowed money. A corporation's deficit does not reduce contributed capital for purposes of this exception.

Similarly, with regard to the payment of dividends (including deemed dividends), borrowed money used to replace the accumulated profits of a corporation that have been retained and used for eligible purposes can be an exception to the direct use test. Accumulated profits would generally be the retained earnings of the corporation computed on an unconsolidated basis with investments accounted for on a cost basis. The accumulated profits of a corporation do not track any particular shareholdings.

Generally, accumulated profits can reflect transactions arising in the ordinary course of business between non-arm's length parties. The impact on accumulated profits of other non-arm's length transactions must be examined on the basis of the particular facts involved.

The key concept in this context remains that of "filling the hole" of capital withdrawn from the business.

Based on the above, generally, the accumulated profits of a corporation would be equal to the unconsolidated retained earnings of the corporation only to the extent that the retained earnings of the corporation reflected income/losses from the corporation's business operations and income/losses from the corporation’s investments, including gains and losses from the sale of investments and assets; there were no amounts included in the corporation's retained earnings that related to an appraisal surplus or that arose as a consequence of any transaction undertaken to transform an appraisal surplus into retained earnings; and there were no amounts included in the corporation's retained earnings that resulted from profits or gains from transactions between the corporation and non-arm's length parties.

As can be seen from the scenario described above, the retained earnings of a corporation which are increased due to an IFRS fair value write up may later be decreased by the accounting depreciation taken against that increased value. The result would be that the amount included in the corporation's retained earnings that related to the appraisal surplus described in the scenario above would decrease over time.

It is a corporation’s accumulated profits that were being used for purposes that would have qualified for interest deductibility had the capital been borrowed money immediately before shares are redeemed, capital is returned or dividends are paid that, in our view, are relevant for the purpose of determining the amount that the corporation could borrow and deduct interest paid or payable thereon. It is our further view that when determining a corporation’s accumulated profits at a point in time, it is the retained earnings of the corporation at that time that are relevant.

Therefore, when determining the accumulated profits of a corporation that were being used for purposes that would have qualified for interest deductibility had the capital been borrowed money (i.e., for the purpose of determining the amount that the corporation could borrow and deduct interest paid or payable thereon), we would consider (i.e., reverse) both increases and decreases to the corporation’s retained earnings resulting from an appraisal surplus included in the corporation’s retained earnings prior to that time.

We trust our comments will be of assistance to you.

Yours truly,

Doug Watson
For Director
Financial Industries Division
Income Tax Rulings Directorate