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: Whether contingent liabilities and accounting reserves need to be taken into account in determining safe income on hand.
Reasons: Previous positions.
FEDERAL TAX ROUNDTABLE, OCTOBER 7, 2022
APFF CONFERENCE 2022
1. Contingencies and book reserves: impact on protected income
In Technical Interpretation 2016-0672321C6 [footnote 1], the CRA indicated that it was of the view that safe income on hand should be reduced by accounting contingencies, reserves and allowances because of the effect of those items on the value of a share. The calculation is done in two steps, the first to calculate safe income and the second to determine safe income on hand (i.e., the portion of safe income contributing to the gain on the share).
In general, the value of a share of a corporation is made up of three elements. The first is the amount of money invested by the shareholders and the profits earned, i.e., the shareholders' equity. To this element must be added the unrealized gains on the corporation's assets (both tangible and intangible). Finally, unrealized losses (both on assets held by the corporation and on possible future expenditures) must be subtracted from this value.
Parliament has adopted an implicit assumption that a dollar of earned income retained by a corporation produces an equivalent increase in value of the shares. As quoted in paragraph 45 of the Federal Court of Appeal's decision in Canada v. Kruco, [footnote 2] “There is an implicit assumption that one can determine the portion of any gain arising on the sale of the shares that is attributable to the retention of post-1971 income and the portion that is attributable to something else.”
Consider the following example:
The fair market value ("FMV") of the shares of Opco's capital stock consists of the following components
Shareholders' equity: $800,000
Unrealized appreciation: $500,000
Contingencies, book reserves: ($300,000)
Value of shares: $1,000,000
Assume that the shareholders' equity consists solely of profits earned in past years and that there is no difference between those profits and the safe income attributable to the shares of Opco's capital stock held by Holdco.
Question to the CRA
In determining safe income on hand, should safe income be reduced by accounting contingencies and reserves?
Indeed, we believe that book contingencies and reserves should reduce the portion attributable to unrealized capital gains and not the safe income on hand. Depending on the case, it can be shown that each dollar of safe income contributed to the value of Opco's equity shares. If there had been no unrealized appreciation and the value of the shares had been $500,000 (i.e., shareholders' equity minus accounting contingencies and provisions), it seems to us that in this situation safe income on hand should be reduced by $300,000.
The CRA is maintaining its longstanding position that to the extent that contingencies and accounting reserves have the effect of reducing the inherent gain on a corporation's share, such amounts should reduce the corporation's safe income on hand.
Consequently, safe income on hand of a corporation must generally be reduced by actual or potential cash outflows, such as non-deductible expenses, contingencies and accounting reserves, in determining the amount of safe income that can be considered to contribute to the gain on a share.
The CRA would, however, be prepared to consider more specific situations in the context of a request for advance rulings so as to make a safe income determination based on all the facts of a case.
October 7, 2022
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 CANADA REVENUE AGENCY, Technical Interpretation 2016-0672321C6, November 15, 2016.
2 2003 FCA 284.
All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5
© Her Majesty the Queen in Right of Canada, 2022
Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistributer de l'information, sous quelque forme ou par quelque moyen que ce soit, de facon électronique, méchanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.
© Sa Majesté la Reine du Chef du Canada, 2022