14 September 1992 Income Tax Severed Letter 2M01980 - Income Earned or Realized

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.

September 14, 1992 Income Earned or Realized: Some Reflections

M.A. Hiltz

A paper presented at the 1991 Annual
Conference of the Canadian Tax Foundation

Introduction

Subsection 55(2) of the Income Tax Act1 applies to a dividend received by a corporation that is deductible under subsection 112(1) if the dividend reduces that portion of a gain on a share that could reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971. Under certain conditions, subsection 55(2) will deem the dividend paid to be proceeds of disposition of the share that was disposed of or, if the share was not disposed of, a gain of the corporation from the disposition of a capital property.2

In general terms, subsection 55(2) permits the part of the gain on a share of a corporation that is referable to earnings that have been taxed in the corporation under Part I of the Act to be received as a tax-free dividend by a shareholder that is a corporation. The earnings may be received free of tax because they have been taxed at the corporate level. They are not required to be taxed again until they are distributed by a corporation to shareholders who are not corporations. On the other hand, subsection 55(2) does not permit the part of the gain on a share that is referable to the fair market value of property in the corporation that has not been taxed to be received by a corporate shareholder as a tax-free dividend.

As stated above, such dividend would reduce the portion of the gain that is referable to something other than income earned and the shareholder would be required to account for that dividend as proceeds of disposition of the share that has been disposed of, or as a deemed capital gain on a disposition of capital property if the share has not been disposed of.

The term "income earned or realized" by a corporation is deemed to be the amount determined pursuant to paragraph 55(5)(b), (c) or (d), as the case may be. In order to contribute to a gain on shares, income earned or realized must be on hand. Income that has been distributed as a dividend or laid out to pay taxes is not on hand and cannot contribute to the fair market value of, or the gain inherent in, a share. The portion of gain that is attributable to anything other than income earned or realized is that part of the gain on the shares that is attributable to unrealized, untaxed appraisal and accounting surpluses of a corporation (herein referred to as "unrealized gains"). It includes, for example, appreciation in the value of property and the value of goodwill that has not been purchased.

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To determine whether a dividend reduces a portion of a capital gain that could reasonably be considered to be attributable to anything other than income earned or realized, it is necessary to analyze the elements that make up the gain on the share. In determining the portion of the gain on a share that is attributable to unrealized gains on property the portion of a gain that is so attributable should be reduced by the amount of unrealized losses on property. Also, the amount of losses incurred by the corporation must be included in the computation of income earned or realized that is on hand at the time in determining the portion of the gain attributable to income earned or realized by a corporation. If a gain on a share is attributable to income earned or realized (less losses incurred), and to unrealized gains on property (less unrealized losses), a dividend paid by the corporation is considered to reduce, first, the gain on the shares attributable to income earned or realized and, second, the gain attributable to something else.

Reduction of Accrued Gains by Accrued Losses

The following example illustrates the effects of this analysis on a corporation that owns a property in respect of which there is an accrued gain and another property in respect of which there is an accrued loss. The income earned or realized is assumed to be represented by property; it is on hand.

X Co
| FMV - $2,200
| ACB - 600
|-------------------------|-------------------------|
| Property A: FMV - $1,500 |
| ACB - 100 |
| |
| B: FMV - 0 |
| ACB - 500 |
| |
| C: FMV - 700 Share capital - $600 |
| ACB - 700 IE or R - 700 |
|---------------------------------------------------|
A Co
X Co has incorporated A Co and subscribed for $600 of shares. A Co now owns three properties, A, B, and C.
Property A has a cost amount (ACB) of $100 and a fair market value (FMV) of $1,500; property B has an ACB of
$500 and an FMV of nil; property C has an ACB of $700 and an FMV of $700. An analysis of the gain on the shares
of A Co indicates that the gain that is attributable to income earned or realized (IE or R), $700, and the
unrealized gain on property A, $1,400, is reduced by the unrealized loss in respect of property B, $500. In
determining what portion of the gain on the shares of A Co is reduced by a dividend, the gain that is
attributable to something other than income earned or realized is reduced by the loss that is attributable to
something other than income earned or realized. Therefore, $700 of the gain on the shares of A Co can
reasonably be considered to be attributable to income earned or realized and $900 is attributable to something
else.

Reduction of Income Earned by Losses

The following example illustrates the effect of reducing a corporation's income earned or realized by losses incurred by that corporation.

X Co
| FMV - $1,500
| ACB - 600
|-----------------------|----------------------------|
| Property: FMV - $1,500 |
| ACB - 100 |
| |
| Share capital - $600 |
| IE or R - (500) |
|----------------------------------------------------|
A Co

X Co has incorporated A Co and subscribed for $600 of shares. A Co's property now consists of property with an ACB of $100, which was purchased using $100 of the share subscription. The property has an FMV of $1,500.

A Co has lost the remaining $500 of the proceeds of the share subscription. This loss reduces the amount of the gain that otherwise would be inherent in the A Co shares that is attributable to something other than income earned or realized, namely, the unrealized gain in the property of A Co. The gain on the A Co shares is reduced because $500 of the amount (of cash) that was included in the ACB of the A Co shares has been lost by the corporation and therefore is not on hand and cannot contribute to the FMV of the shares of the corporation.

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The fortunes of A Co improve to the following extent.
X Co
| FMV - $2,200
| ACB - 600
|----------------------|--------------------------|
| Property: FMV - $2,200 |
| ACB - 800 |
| |
| Share capital - $600 |
| IE or R - 200 |
|-------------------------------------------------|
A Co

After incurring the $500 loss, A Co has income earned or realized of $700. The income earned or realized is on hand. An analysis of the gain inherent in the A Co shares shows that only $200 of the $700 of income earned or realized is on hand and contributes to the gain. The balance of $500 of the income earned offsets the amount reflected in the ACB of the shares that was lost in previous years. The result is that $1,400 of the gain on the A Co shares is attributable to something other than income earned or realized and $200 is attributable to income earned or realized.

It is important to appreciate that the failure to deduct the prior loss will yield a result that is inconsistent with the purpose of subsection 55(2). If the prior loss is not deducted in computing income earned or realized of A Co and it is contended that $700 of the gain on the A Co shares is attributable to income earned or realized, the balance of the gain on the A Co shares that is said to be attributable to something other than income earned or realized, $900, will be less than the unrealized gain on the property of A Co.

As explained above, subsection 55(2) is intended to prevent receipt of a tax-free dividend by a corporate shareholder where that dividend reduces the portion of the gain on the share that is attributable to unrealized gains on property. An understatement of the amount of the gain on the share that is referable to unrealized gains would allow the shareholder to receive a tax-free dividend equal to part of the gain that is referable to unrealized gains in respect of property and thereby avoid the intended application of subsection 55(2).

Consolidation of Income Earned or Realized
or Losses in a Corporate Group

In many cases, a corporation that pays a dividend to which subsection 55(2) may apply will be a member of a corporate group. Revenue Canada stated in 1981 and again in 1988 that, when determining the income earned or realized of the parent corporation in a corporate group, income earned or realized and losses within the corporate group, consisting of the corporate parent and its direct and indirect subsidiaries, must be consolidated.3 This means that the income earned or realized of the parent will be determined by including the parent's interest in the income earned or realized, or the losses, as the case may be, of its direct and indirect subsidiaries.

In a situation in which a corporation owns less than 50 percent of the shares of another corporation, the appropriate portion of income earned or realized or loss of any corporation over which the shareholder corporation may exercise significant influence with respect to operating and financial decisions should be consolidated.

The reference in subsection 55(2) to "income earned or realized by any corporation" contemplates that a gain in respect of the shares of the parent may be attributable to income earned or realized of a corporation other than the parent. The reference to "any corporation" permits the income earned or realized or loss incurred by a direct or indirect subsidiary corporation to be taken into account in determining the part of the gain on the shares owned by the parent corporation that could reasonably be considered to be attributable to income earned or realized and the part that could reasonably be considered to be attributable to something else.

The computation of the income earned or realized of a parent in this manner is a recognition of the fact that a shareholder that has de jure control of, or exercises significant influence over, the operations of a subsidiary corporation has the ability to obtain economic benefits from the subsidiary corporation in the form of, for example, dividends, interest, and management fees. Conversely, the shareholder that has de jure control of, or exercises significant influence over, the subsidiary corporation will be exposed to the risks of the subsidiary's operations. Where income earned or realized by a subsidiary corporation contributes to the fair market value of the shares of the subsidiary owned by the parent and, therefore, the fair market value and gain inherent in the shares of the parent, it is reasonable that the income earned or realized or losses realized by the subsidiary be taken into account in determining the amount of the gain on the shares of the parent that is attributable to income earned or realized by any corporation for the purposes of section 55.

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The requirement to consolidate all income earned or losses within a corporate group when determining the income earned or realized of the parent corporation does not ignore the separate existence of a parent corporation and its subsidiary corporations. It is recognized that a parent corporation does not own the property of a subsidiary corporation and, if it is not a guarantor of the subsidiary's debts, is not responsible for the payment of those debts. The parent corporation merely owns shares in the subsidiary corporation.

A shareholder that has de jure control of, or exercises significant influence over, a subsidiary corporation will include a dividend that it receives in its income earned or realized to the extent that the dividend is paid out of the income earned or realized of the subsidiary corporation with respect to the shareholder's shares of the subsidiary.

In the case of shares that are portfolio investments to their owner, there will be no consolidation of underlying income earned or realized. Dividends received on shares that are portfolio investments are included in the income earned or realized of the recipient when received.

The terms "subsidiary", "significant influence", and "portfolio investments" have the meaning ascribed by section 3050 in the "Accounting Recommendations on Long Term Investments" section of the CICA Handbook.4

Following are examples that illustrate the manner in which income earned or realized is calculated on a consolidated basis. Example 1

X Co
| FMV - $2,100
| ACB - 600
|-------------|------------|
| B Co: FMV - $1,500 |
| ACB - 100 |
| |
| C Co: FMV - 600 |
| ACB - 500 |
| |
| Share capital - 600 |
| IE or R - nil |
|----|--------------|------|
| A Co |
| |
FMV - $1,500 | | FMV - $600
ACB - 100 | | ACB 500
|---------------------|--| |----|-----------------|
| Property: FMV - $1,500| | Property: FMV - $600|
| ACB - 600| | ACB - 600|
| | | |
| IE or R - 500| | IE or R - 100|
| Share capital - 100| | Share capital - 500|
|------------------------| |----------------------|

X Co has incorporated A Co and subscribed for $600 of shares. A Co has incorporated B Co and C Co and subscribed for shares in these companies for $100 and $500, respectively. A Co owns all the issued shares of B Co and C Co. A Co, B Co, and C Co are taxable Canadian corporations.

A Co's property consists solely of shares of B Co and C Co. B Co's property has an ACB of $600, the source of which is the share subscription of $100 and income earned or realized of $500. The FMV of B Co's property is $1,500.

C Co's property has an ACB of $600, the source of which is the share subscription of $500 and income earned or realized of $100. There is no unrealized gain with respect to the property of C Co. The income earned or realized of B Co and C Co is on hand.

X Co proposes to sell A Co. Before the sale, X Co will cause A Co to pay a dividend of $600, which will reduce the FMV of the A Co shares to $1,500. X Co will sell the shares for $1,500 and will report a capital gain of $900. Does subsection 55(2) apply to increase the proceeds of disposition of the A Co shares?

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An analysis of the gain inherent in the shares of A Co before the payment of the dividend shows that the gain is attributable to gains of $1,400 and $100 in respect of the shares of B Co and C Co, respectively, owned by A Co. The $1,400 gain on the shares of B Co is attributable to the unrealized gain of $900 in respect of the property of B Co and to income earned or realized of $500 in B Co. The $100 gain on the shares of C Co is attributable to income earned or realized of $100 in C Co.

If B Co paid a dividend of $500 to A Co, the dividend would reduce the gain inherent in the shares of B Co that, on the assumptions mentioned above, would be reasonably attributable to income earned or realized of B Co. Similarly, if C Co paid a dividend of $100 to A Co, the dividend would reduce the gain on the shares of C Co that would be reasonably attributable to income earned or realized of C Co. The dividends that would be received by A Co that would have been referable to the income earned or realized by B Co and C Co would form part of the income earned or realized of A Co with respect to X Co. If, following receipt of the dividends from B Co and C Co, A Co paid a dividend of $600 to X Co, that dividend would reduce the portion of the gain on the shares of A Co that could reasonably be considered to be attributable to income earned or realized by A Co.

Subsection 55(2), however, does not require that a subsidiary that has income earned or realized in respect of the shareholder of the parent pay that amount as a dividend to the parent in order that a dividend paid by the parent not contravene the subsection. As discussed above, subsection 55(2) contemplates that the income earned or realized by any corporation, not only the corporation that pays the dividend, may be taken into account in determining to what the gain on the shares of the parent corporation may be attributed. If the gain on the shares of the parent is attributable to the fair market value of the shares of the subsidiary and the fair market value of the shares of the subsidiary is attributable to the income earned or realized of the subsidiary, it is reasonable to consider that part of the gain on the shares of the parent is attributable to income earned or realized of the subsidiary.

In example 1, the gain on the shares of A Co is attributable to the FMV of the shares of B Co and C Co, and the FMV of the shares of B Co and C Co is attributable to the income earned or realized by B Co and C Co. It is reasonable, therefore, to consider that part of the gain on the shares of A Co is attributable to income earned or realized by B Co and C Co. As a consequence, the dividend of $600 paid by A Co will be considered to reduce that portion of the gain on the shares of A Co that is attributable to income earned or realized.

Example 1 deals with the consolidation of income of a parent and two wholly owned subsidiaries. In a situation in which one corporation in a corporate group has losses, the income earned or realized of other members of the corporate group must be reduced by the amount of those losses.

Example 2
X Co
| FMV - $1,500
| ACB - 600
|------------|-----------|
| B Co: FMV - $1,500 |
| ACB - 100 |
| |
| C Co: FMV - 0 |
| ACB - 500 |
| |
| Share capital - 600 |
| IE or R - nil |
|------|----------|------|
| A Co |
| |
FMV - $1,500 | | FMV - 0
ACB - 100 | | ACB - $500
|----------------------|---| |---|------------------|
| Property: FMV - $1,500 | |Property: nil |
| ACB - 600 | | |
| | | IE or R - ($500)|
| IE or R - 500 | |Share capital - 500 |
| Share capital - 100 | | |
|--------------------------| |----------------------|

X Co has incorporated A Co and subscribed for $600 of shares. A Co has incorporated B Co and C Co and subscribed for shares in those companies for $100 and $500, respectively. A Co owns all the issued shares of B Co and C Co. A Co, B Co, and C Co are taxable Canadian corporations.

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A Co's property consists solely of shares of B Co and C Co. B Co's property has an ACB of $600, the source of which is the share subscription of $100 and income earned or realized of $500. The income earned or realized of B Co is on hand. The FMV of B Co's property is $1,500.

C Co has no property. The amount invested in share capital was dissipated and is represented by operating losses of $500.

X Co proposes to sell A Co. Before the sale, X Co will cause A Co to pay a dividend of $500, which will reduce the FMV of the A Co shares to $1,000. X Co will sell the shares of A Co for $1,000 and will report a capital gain of $400. In computing income earned or realized of A Co with respect to X Co, A Co includes the income earned or realized of B Co of $500 but does not include the loss of C Co of $500.

An analysis of the gain inherent in the shares of A Co before the payment of the dividend reveals that the gain of $900 on the shares of A Co is the difference between the gain of $1,400 in respect of the shares of B Co and the loss of $500 in respect of the shares of C Co. The gain on the shares of A Co is only $900 because $500 of the amount (of cash) that was included in the ACB of the A Co shares and in the ACB of the C Co shares was lost by C Co and, therefore, is not on hand and cannot contribute to the FMV of the A Co shares. The gain on the shares of B Co is attributable to an unrealized gain of $900 in respect of property of B Co and to $500 of income earned or realized in B Co. The loss of $500 in respect of the shares of C Co is attributable to the operating loss suffered by that company. The loss incurred by C Co must be deducted in computing the income earned or realized on hand of A Co with respect to X Co in order that X Co not receive an unduly large tax-free dividend. As mentioned previously, subsection 55(2) is intended to ensure that the part of the gain on a share that is referable to untaxed gains in respect of property of a corporation cannot be received by a corporate shareholder of that corporation as a tax-free dividend. If the amount of income earned of A Co with respect to X Co is not reduced by losses of C Co, the gain on the shares of A Co that is said to be attributable to income earned or realized by any corporation will be overstated to the extent of the amount of the losses. As a consequence, $500 of the gain that is attributable to unrealized gains in respect of the property of B Co could be received tax-free - a result, as pointed out above, that is contrary to the purpose of subsection 55(2).

When the loss in C Co is taken into account in computing A Co's income earned or realized on hand with respect to X Co on a consolidated basis, the consolidated income earned or realized will be nil and the payment of a $500 dividend by A Co will reduce part of the gain that is attributable to the unrealized gain on the property of B Co.

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This example illustrates why losses of corporations in a corporate group must be included in the computation of consolidated income earned or realized.5 The same result would obtain if, sometime before the relevant time, A Co had sold the shares of C Co to B Co for nominal consideration.

Example 3

X Co
| FMV - $1,500
| ACB - 600
|----------|-----------|
|B Co: FMV - $1,500 |
| ACB - 600 |
A Co | |
|Share capital- 600 |
| IE or R - nil |
|----------|-----------|
| FMV - $1,500
| ACB - 600
|------------|------------|
|Property: FMV - $1,500 |
| ACB - 600 |
| |
| C Co: FMV - 0 |
B Co | ACB - 0 |
| |
| IE or R - 500 |
|Share capital - 100 |
|------------|------------|
|
| FMV - 0
| ACB - 0
|------------|------------|
|Property: Nil |
C Co | |
| IE or R - ($500) |
|Share capital - 500 |
|-------------------------|

On the disposition by A Co of its shares of C Co to B Co, the $500 capital loss that A Co would otherwise realize will be deemed by paragraph 85(4)(a) of the Act to be nil and the amount of the denied loss will be added to the ACB of the shares of B Co.

An analysis of the gain inherent in the shares of A Co before the payment of the dividend reveals that the gain of $900 is attributable to the unrealized gain in respect of the B Co shares. This latter gain is the difference between the income earned or realized of B Co and the untaxed gain on the property of B Co and the $500 loss in C Co. The gain on the A Co shares is $900 because, as in example 2, $500 of the amount (of cash) that was included in the ACB of the A Co shares and then in the ACB of the C Co shares owned by A Co (which amount is now included in the ACB of the B Co shares owned by A Co by reason of paragraph 85(4)(b)) was lost by C Co and, therefore, is not on hand and cannot contribute to the FMV of the A Co shares.

The payment by A Co of a dividend of $500 to X Co will reduce the potential gain on the shares of A Co from $900 to $400. This gain is, of course, less than the accrued gain on the property of B Co, which, as described above, is intended to be proceeds of disposition of a share and subject to tax as a capital gain in the hands of X Co. Therefore, in order to avoid an overstatement of the income earned or realized of A Co with respect to X Co, the loss in C Co must be deducted from the income earned or realized of B Co in computing the consolidated income earned or realized on hand of A Co with respect to X Co. When this is done, the dividend of $500 will reduce that part of the gain on the shares of A Co that is attributable to something other than income earned or realized, namely, the unrealized gain of $900 in respect of the property of B Co.

These three examples illustrate the effects of the consolidation of income earned or realized within a corporate group. Example 3 illustrates that the losses in one corporation cannot be excluded from the computation by transferring the loss corporation to another corporation in the corporate group.

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Consolidation of Income and Losses of Foreign
Affiliates

Paragraph 55(5)(d) defines the income earned or realized by a foreign affiliate of another corporation. The income earned or realized is deemed to be the amount that the corporation would have been able to deduct under paragraphs 113(1)(a) and (b), or either of them, if the corporation owned all the shares of the foreign affiliate, had disposed of those shares for proceeds equal to their fair market value, and had made an election under subsection 93(1) in respect of the full amount of such proceeds of disposition.

The deemed income earned or realized is those amounts that the corporation would be able to deduct under both or either of paragraphs 113(1)(a) and (b) if the foreign affiliate paid a dividend equal to its net surplus. An amount that is prescribed by the Income Tax Regulations (the "Regulations") to be paid out of exempt surplus will be deductible under paragraph 113(1)(a). Similarly, an amount that is prescribed to be paid out of taxable surplus will be exempt to the extent that there is underlying foreign tax prescribed to be applicable to the dividend prescribed to be paid out of taxable surplus. If there is insufficient underlying foreign tax prescribed to be applicable to the dividend prescribed to be paid out of taxable surplus, a part of the dividend prescribed to be paid out of taxable surplus will not be deductible under paragraph 113(1)(b).

Example 4 illustrates the application of paragraph 55(5)(d) to a Canadian corporation that owns 100 percent of the shares of two foreign corporations.

Example 4

X Co
| FMV - $2,100
| ACB - 600
|----------|-----------|
| B Co: FMV - $1,500|
| ACB - 100|
| |
| C Co: FMV - 600|
| ACB - 500|
| |
| Share capital- 600|
| IE or R - nil|
|--|------------|------|
| A Co |
| |
FMV - $1,500 | | FMV - $600
ACB - 100 | | ACB - 500
|---------------------|--| |----|------------------|
|Property: FMV - $1,500| |Property: FMV - $600|
| ACB - 600| | ACB - 600|
| | | |
|Exempt surplus - 500| |Taxable surplus - 100|
|Share capital - 100| |Share capital - 500|
|------------------------| |-----------------------|

X Co has incorporated A Co and subscribed for $600 of shares. A Co has incorporated B Co and C Co and subscribed for shares in these companies for $100 and $500, respectively. B Co and C Co are foreign affiliates of A Co. B Co's only activity consists of carrying on an active business through a permanent establishment in a country listed in subsection 5907(11) of the Regulations, where it is resident. C Co's only activity consists of carrying on an active business in a non-listed country (other than Canada). It has not paid any income or profits tax in respect of its net earnings from the active business.

A Co's property consists solely of shares of B Co and C Co. B Co's property has an ACB of $600, which is derived from the share subscription of $100 and exempt surplus of $500. The exempt surplus is on hand. There is an unrealized gain of $900 in respect of B Co's property.

C Co's property has an ACB of $600, the source of which is the share subscription of $500 and taxable surplus of $100. The taxable surplus is on hand. There is no unrealized gain with respect to C Co's property.

X Co proposes to sell A Co. Before the sale, X Co will cause A Co to pay a dividend of $600 (the sum of the exempt surplus of B Co and the taxable surplus of C Co), which will reduce the FMV of the A Co shares to $1,500. X Co will sell the shares of A Co for $1,500 and report a capital gain of $900.

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An analysis of the gain inherent in the shares of A Co reveals that the gain is attributable to gains of $1,400 and $100 in respect of the shares of B Co and C Co, respectively. The $1,400 gain on the shares of B Co is attributable to the unrealized gain of $900 in respect of the property of B Co and exempt surplus of $500. The $100 gain on the shares of C Co is attributable to taxable surplus of $100 in C Co.

The proposed dividend of $600 will reduce the gain on the shares of A Co by an amount that is equal to the surpluses of B Co and C Co. Are the amounts of the exempt and taxable surplus income earned or realized for the purposes of subsection 55(2)?

The $500 of exempt surplus in B Co would have been deductible by A Co under paragraph 113(1)(a) if A Co had disposed of the shares of B Co and made an election under subsection 93(1) in respect of the full proceeds of disposition. Paragraph 55(5)(d) provides that this amount is income earned or realized for the purposes of section 55.

However, the amount of taxable surplus in C Co would not constitute income earned or realized for the purposes of section 55. C Co paid no tax in respect of its taxable surplus of $100. Therefore, none of the dividend paid out of its taxable surplus would have been deductible by A Co under paragraph 113(1)(b) if A Co had disposed of the shares of C Co and made an election under subsection 93(1).

The result is that $100 of the dividend proposed to be paid by A Co will be considered to reduce the gain in the shares of A Co attributable to something other than income earned or realized.

Example 5 concerns the treatment of exempt losses of foreign affiliates in calculating consolidated income earned or realized.

Example 5

X Co
| FMV - $1,500
| ACB - 600
|------------|------------|
| B Co: FMV - $1,500 |
| ACB - 100 |
| |
| C Co: FMV - 0 |
| ACB - 500 |
| |
| Share capital - 600 |
| IE or R - nil |
|------|----------|-------|
| A Co |
| |
FMV - $1,500 | | FMV - 0
ACB - 100 | | ACB - $500
|----------------------|-| |--|-------------------|
|Property: FMV - $1,500| |Property: Nil|
| ACB - 600| | |
| | |Exempt surplus -($500)|
| IE or R - 500| |Share capital - 500 |
| Share capital - 100| | |
|------------------------| |----------------------|

X Co has incorporated A Co and subscribed for $600 of shares. A Co has incorporated B Co and C Co and subscribed for shares for $100 and $500, respectively. A Co and B Co are taxable Canadian corporations. C Co is a foreign affiliate of A Co. Its only activity consists of carrying on an active business through a permanent establishment in a listed country.

A Co's property consists solely of shares of B Co and C Co. B Co's property has an ACB of $600, which represents the share subscription of $100 and income earned or realized of $500, which is on hand. There is a $900 unrealized gain in respect of B Co's property.

C Co has no property. The amount invested in share capital is now represented by the exempt loss of $500.

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X Co proposes to sell A Co. Before the sale, X Co will cause A Co to pay a dividend of $500 to X Co, which will reduce the FMV of the A Co shares to $1,000. X Co will then sell the shares for $1000 and report a capital gain of $400. In computing the income earned or realized on hand in A Co with respect to X Co, X Co includes B Co's income earned or realized of $500 but does not include C Co's exempt loss.

The $900 gain inherent in the shares of A Co before the payment of the dividend is the difference between the $1,400 gain in respect of the shares of B Co and the $500 loss in respect of the shares of C Co. The $1,400 gain on the B Co shares is attributable to the unrealized gain of $900 in respect of the property of B Co and to $500 of income earned or realized in B Co. The $500 loss on the shares of C Co is attributable to the $500 exempt loss in C Co. The gain on the A Co shares is only $900 because $500 of the amount (of cash) that was included in the ACB of the A Co shares and in the ACB of the C Co shares was lost by C Co and is not on hand, and therefore cannot contribute to the FMV of the A Co shares.

If the amount of income earned or realized on hand of A Co with respect to X Co is not reduced by the exempt loss, there will be an overstatement of income earned or realized. If A Co paid a dividend to X Co in an amount equal to the overstated income earned or realized, the gain on the shares of A Co after the payment of the dividend would be less than the unrealized gain inherent in the property of B Co. As mentioned above, it is the object of subsection 55(2) to tax a shareholder - X Co, in this case - in respect of a capital gain equal to the full amount of such unrealized gain in respect of the property of B Co. If the income earned or realized of A Co with respect to X Co is not reduced by the amount of the exempt loss, X Co may receive a tax-free dividend equal to part of the unrealized gain on such property.

When the exempt loss is taken into account, the consolidated income earned or realized on hand of A Co with respect to X Co will be nil, and the payment of the $500 dividend will reduce the gain inherent in the shares of A Co that is attributable to something other than income earned or realized, namely, the gain of $900 inherent in the property of B Co.

Subsection 248(24)

The Act has been amended by the addition of subsection 248(24), which reads as follows:6 "For greater certainty, it is hereby declared that, unless specifically required, neither the equity nor the consolidated method of accounting shall be used to determine any amount for the purposes of this Act". The enactment of proposed subsection 248(24) of the Act will not affect the requirement to consolidate earned or realized income. The word "any" in the phrase "income earned or realized by any corporation" (in subsection 55(2)) will allow income earned or realized or losses of a corporation in the corporate group to be included in the computation of the income earned or realized of another corporation in the corporate group.

Government Grants and Investment Tax Credits

General

A corporation that receives a government grant or deducts an investment tax credit from its tax otherwise payable in computing its tax payable may be required to recognize an amount in respect of the grant or credit in computing its income earned or realized.

A corporation may receive government assistance in respect of property purchased or an expense incurred. Pursuant to subsection 127(5), a corporation may deduct from its taxes otherwise payable under Part I of the Act an amount in respect of its investment tax credit at the end of a taxation year. Basically, a taxpayer that is a corporation includes in computing its investment tax credit at the end of a taxation year a specified percentage of the capital cost of certain property acquired or expenditures made in that year.7 Also, a taxpayer that is a Canadian-controlled private corporation may be deemed to have paid on account of tax under Part I an amount not exceeding its refundable investment tax credit.8 The amount deemed to be paid is deemed to have been deducted under subsection 127(5).9 A refundable investment tax credit for a taxation year is essentially 40 percent of the amount included by the taxpayer in computing its investment tax credit at the end of a year.10

There are numerous provisions in the Act that require a reduction for tax purposes of outlays made where government assistance has been received or a deduction has been made under subsection 127(5). To illustrate the manner in which income earned or realized may be affected by the application of such a provision, an analysis will be made of the effects of a reduction in the capital cost of depreciable property acquired by a taxpayer, and in the cumulative Canadian exploration expense of a taxpayer, as a result of the receipt of government assistance and the deduction of an amount under subsection 127(5).

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Depreciable Property

Government Grant

The income earned or realized of a corporation that purchases a property in a year and receives a grant in the same year may be affected by reason of the application of subsection 13(7.1).ll Subsection 13(7.1) reduces the capital cost of the property and, therefore, the amount of capital cost allowance that may be claimed in the year. If the corporation has income in the year that otherwise could have been reduced by a deduction for capital cost allowance (which has been reduced by virtue of the application of subsection 13(7.1)), the income earned or realized of the corporation in that year will be increased. The grant itself is not included in income or in income earned or realized.

Investment Tax Credit

The income earned or realized of a corporation in a year that acquired a depreciable property in that year will not be affected by reason of the deduction in the year of an amount in respect of such property under subsection 127(5). In other words, the tax credit deducted is not included in income or in income earned or realized. In the following year, however, the capital cost of the property will be reduced by reason of the application of paragraph 13(7.1)(e). As a result, the income and, therefore, the income earned or realized of the corporation will increase in the following and subsequent years.12

Exploration Expense

Government Grant

Cumulative Canadian exploration expense of a taxpayer at any time is defined in paragraph 66.1(6)(b). It includes all Canadian exploration expenses, including a qualified Canadian exploration expenditure (within the meaning assigned by subsection 127(9)), made or incurred by a taxpayer before that time.13 It is reduced by assistance received in respect of any Canadian exploration expense incurred after 198014 and the portion of amounts deducted by the taxpayer under subsection 127(5) for a taxation year ending before that time that may reasonably be attributed to a qualified Canadian exploration expenditure made in a preceding taxation year.15

A corporation that incurs an expense in a year that is a qualified Canadian exploration expenditure will include that amount in its cumulative Canadian exploration expense. If the corporation receives government assistance in respect of the expense in the same year, the income earned or realized of the corporation in that year may be affected by reason of the reduction in the cumulative Canadian exploration expense required by subparagraph 66.1(6)(b)(ix). If the corporation has income in the year that otherwise could have been reduced by claiming an amount under subsection 66.1(2), the corporation's income earned or realized in that year will be increased. As in the case of a grant received in respect of depreciable property, the grant in respect of a Canadian exploration expense will not be included in income or in income earned or realized.

Investment Tax Credit

A corporation that incurs an expense in a year that is a qualified Canadian exploration expenditure will include that amount in its cumulative Canadian exploration expense. The specified percentage of the qualified Canadian exploration expenditure will be included in the corporation's investment tax credit at the end of the year.16 If the corporation deducts an amount under subsection 127(5) for the year which may be attributed to the qualified Canadian exploration expenditure, the deduction will have no effect on the income earned or realized of the corporation in that year. The tax credit deducted is not included in income or in income earned or realized. In the following year, however, the cumulative Canadian exploration expense will be reduced by the amount deducted under subsection 127(5), pursuant to subparagraph 66.1(6)(b)(xi). This reduction in the amount of the cumulative Canadian exploration expense that the corporation may deduct may result in an increase in income and, therefore, in income earned or realized in the following and subsequent years.

Examples

The examples that follow are based on the assumption that a corporation that receives a government grant in a year or reduces its tax otherwise payable in the year by deducting an amount under subsection 127(5) will, at the end of the year, own property that represents the value of the grant received or the saving in tax otherwise payable resulting from the deduction under subsection 127(5). As a result, the property is on hand and the fair market value of the shares of the corporation will reflect the value of the property.

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Government Grant
Depreciable property

A person incorporates A Co and subscribes for common shares for $100. A Co purchases for $100 a class 12 depreciable property in respect of which it receives a government grant of $20. A Co earns income of $200 in the year and is taxed at a 50 percent rate. It is assumed that the depreciable property is worthless at the end of the year and that A Co has no property other than the depreciable property and property representing the net income after tax and the amount of the grant.

If the government grant is not included in income and does not reduce the capital cost of the depreciable property, the income and taxes payable of A Co will be computed as shown in example 6.

Example 6

Income . . . . . . . . . . . . . . . . . . . $200
Less CCA . . . . . . . . . . . . . . . . . . 100
Net income . . . . . . . . . . . . . . . . . $100
Tax @ 50% . . . . . . . . . . . . . . . . . 50
Income earned or realized on hand . . . . . $ 50

The property of A Co (in addition to the depreciable property that is worthless) will consist of property representing the government grant of $20, the capital cost returned through the capital cost allowance (CCA) deduction of $100, and the $50 of income remaining after payment of taxes. The fair market value of the shares of A Co is $170, and there is an unrealized gain of $70 in respect of the shares.

To what is the $70 gain inherent in the A Co shares attributable? The $100 of revenue that was sheltered by the CCA deduction is not included in income and cannot form part of the income earned or realized of A Co.17 The $20 government grant is not included in income and cannot form part of income earned or realized. Therefore, the unrealized gain of $70 in respect of those shares is attributable, as to $20, to the grant that was not included in income and, as to $50, to income earned or realized that is on hand.

Example 7 illustrates the effect of the reduction by subsection 13(7.1) of the capital cost of the depreciable property by the amount of the government grant. The income and taxes payable of A Co will be computed as indicated below. Example 7

Income . . . . . . . . . . . . . . . . . . . . $200
Less CCA . . . . . . . . . . . . . . . . . . . 80
Net income . . . . . . . . . . . . . . . . . . 120
Tax @ 50% . . . . . . . . . . . . . . . . . . 60
Income earned or realized on hand . . . . . . $ 60

The property of A Co (in addition to the depreciable property that is worthless) will consist of property representing the amount of the government grant of $20, the capital cost returned through the CCA deduction of $80, and the $60 of income remaining after payment of taxes. The fair market value of the shares of A Co is $160, and there is an unrealized gain of $60 in respect of these shares.

An analysis must be made of the composition of the gain inherent in the shares of A Co. The revenue sheltered by the CCA deduction is not included in income and does not form part of income earned or realized. Although the amount of the government grant reduces the capital cost of the depreciable property pursuant to subsection 13(7.1), it is not included in income and therefore is not included in income earned or realized. As a result, the entire unrealized gain of $60 in respect of the A Co shares is attributable to income earned or realized that is on hand. However, it should be noted that, because the capital cost of the depreciable property is reduced, the amount of CCA that may be deducted is reduced. Therefore, the income of A Co is higher to the extent of the reduced deduction. The income earned or realized of A Co is increased by $20, and the income earned or realized on hand (after payment of taxes) is increased by $10.

In cases where the amount deductible by a corporation in respect of property in a class in schedule II is less than 100 percent, provided that the corporation has sufficient income in the years in question before the deduction for CCA, an amount equal to the government grant received will be included in income eventually by reason of the reduction in capital cost of the property. The income earned or realized of the corporation will be increased in each year where there is a reduction in the amount of CCA that could have been deducted in that year if the capital cost of the property had not been reduced by subsection 13(7.1).

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Exploration Expense

The same analysis applies to a corporation that has $200 of revenue in a year, incurs Canadian exploration expense of $100, and receives a government grant of $20 in the same year. Subparagraph 66.1(6)(b)(ix) reduces the cumulative Canadian exploration expense in the year by the amount of the grant received. The corporation will have revenue in the year of $200, net income after deduction of cumulative Canadian exploration expense of $120, and income earned or realized of $60. The fair market value of the shares of A Co will be $160, and there will be an unrealized gain of $60 in respect of the shares.

Neither the amount of the grant nor the revenue sheltered by the deduction in respect of cumulative Canadian exploration expense has been included in income, therefore, neither is included in income earned or realized. The inherent gain of $60 in the shares of A Co is attributable to income earned or realized that is on hand. However, the income of the corporation has been increased by $20 as a result of the decrease in the cumulative Canadian exploration expense. As a result, the income earned or realized is increased by $20, and the income earned or realized on hand (after payment of taxes) is increased by $10.

Investment Tax Credit

Depreciable Property

A corporation that has acquired a property, or made an expenditure, the specified percentage of which is included in its investment tax credit as defined in subsection 127(9) may claim a deduction from its tax otherwise payable under Part I of the Act as permitted in subsection 127(5), or it may be deemed by subsection 127.1(1) to have paid an amount on account of its tax under Part I of the Act, which amount is deemed to have been deducted under subsection 127(5).

• 1) Subsection 13(7.1)

A incorporates A Co and subscribes for common shares for consideration of $100. A Co purchases for $100 a class 12 depreciable property, the cost of which is included in the calculation of its investment tax credit under subsection 127(9). A Co is entitled to an investment tax credit in the amount of $20. In the year of acquisition of the property, A Co has net revenue from operations of $200 (before a deduction for CCA) and no revenue from operations in the following year. It is subject to an income tax rate of 50 percent. A Co claims the entire $20 investment tax credit as a deduction under subsection 127(5) from its tax under Part I of the Act in the first year.

Example 8
Year 1 Year 2

Revenue from operations . . . . . . . . . . $200 -
Less CCA . . . . . . . . . . . . . . . . . 100
Subsections 13(7.1) and 13(1) . . . . . . . nil $ 20
Net income subject to tax . . . . . . . . $100 $ 20
Tax @ 50% . . . . . . . . . . . . . . . . . $ 50 $ 10
Income earned or realized . . . . . . . . . $ 50 $ 10
Income earned or realized on hand . . . . . $ 50 $ 60
Taxes payable . . . . . . . . . . . . . . . $ 50 $ 10
Paid: investment tax credit . . . $ 20 nil
cash . . . . . . . . . . . $ 30 $10
$ 50 $ 10

At the end of year 1, the property of A Co (in addition to the depreciable property that is worthless) consists of property representing the investment tax credit of $20, the revenue of $100 sheltered by the CCA deduction, and the $50 of income remaining after payment of taxes. The fair market value of the shares of A Co is $160 (the difference between the $200 of revenue less taxes paid of $30 and the liability for taxes payable of $10 in year 2). The shares of A Co have an inherent capital gain of $60.

The revenue sheltered by the CCA deduction is not included in income. Also, no amount in respect of the investment tax credit has been included in income. Therefore, although property representing both amounts is on hand and contributes to the fair market value of the shares of A Co, neither amount is included in income earned or realized. As a result, of the gain of $60 inherent in the shares of A Co, $50 is attributable to income earned or realized on hand and $10 is attributable to the difference between the property representing the $20 investment tax credit and the $10 liability for taxes payable in year 2.

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At the end of year 2, the fair market value of the shares remains at $160 and the shares of A Co have an inherent capital gain of $60. The property on hand consists of the same property that was on hand at the end of year 1, except for property representing the $10 that was laid out to pay the $10 tax liability in year 2. The $20 of income in year 2 results from the recognition for tax purposes of the investment tax credit claimed in year 118 and will be included in income earned or realized in year 2. The total income earned or realized that is on hand and therefore contributes to the gain on the shares of A Co is $60. This is the sum of the incomes of $100 and $20 for years 1 and 2, respectively, less the taxes paid of $50 and $10 in respect of those incomes. The entire capital gain of $60 inherent in the A Co shares is, therefore, attributable to income earned or realized. 2) Subparagraph 66.1(6)(b)(xi)

A incorporates A Co and subscribes for common shares for $100. A Co incurs a qualified Canadian exploration expenditure (within the meaning assigned by subsection 127(9)). A Co is entitled to an investment tax credit of $20. In the year in which it incurs the expenditure, A Co has net revenue from operations (before the deduction under subsection 66.1(2)) of $200 and no revenue from operations in the following year. It is subject to tax at a rate of 50 percent. A Co claims the entire investment tax credit of $20 in the first year.

Example 9
Year 1 Year 2

Revenue from operations . . . . . . . . . . $200 nil
Less subsection 66.1(2) deduction . . . . . 100 nil
Subparagraph 66.1(6)(b)(xi) and
Sub-section 66.1(1) . . . . . . . . . . nil 20
Net income subject to tax . . . . . . . . . $100 $20
Tax @ 50% . . . . . . . . . . . . . . . . . 50 10
Income earned or realized . . . . . . . . . $ 50 $ 10
Income earned or realized on hand . . . . . $ 50 $ 60
Taxes payable . . . . . . . . . . . . . . . $ 50 $ 10
Paid: investment tax credit . . $ 20 nil
cash . . . . . . . . . . . 30 $10
$ 50 $ 10

At the end of year 1, the property of A Co consists of property representing the investment tax credit of $20, the revenue of $100 sheltered by the cumulative Canadian exploration expense deduction, and $50 of income remaining after payment of taxes. The fair market value of the shares of A Co is $160 (the difference between the $200 revenue less taxes paid of $30 and the liability for taxes payable of $10 in year 2). There is an inherent gain in the shares of $60.

The revenue sheltered by the cumulative Canadian exploration expense deduction is not included in income. Similarly, no amount in respect of the investment tax credit is included in income. Neither amount is included in income earned or realized. As a result, the part of the gain of $60 that is attributable to income earned or realized on hand is $50. The balance of the gain, $10, is attributable to the difference between the value of the property representing the investment tax credit claimed and the liability of $10 for taxes payable in year 2.

At the end of year 2, the fair market value of the A Co shares remains at $160 and the shares of A Co have an inherent capital gain of $60. The property on hand consists of the same property that was on hand at the end of year 1, except for property representing the $10 that was laid out to pay the $10 tax liability in year 2. The $20 of income in year 2 results from the recognition for tax purposes of the investment tax credit claimed in year 119 and will be included in income earned or realized in year 2. The total income earned or realized that is on hand and contributes to the gain on the shares of A Co is $60. This is the sum of the incomes of $100 and $20 in years 1 and 2, respectively, less the taxes paid of $50 and $10 in respect of these incomes. Therefore, the entire capital gain of $60 inherent in the A Co shares is attributable to income earned or realized.

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• 3) Paragraph 12(1)(t)

The facts are the same as those in example 8 except that subsection 13(7.1) does not apply. Example 10

Year 1 Year 2

Revenue from operations . . . . . . . . . . . . $200 nil
Less CCA . . . . . . . . . . . . . . . . . . . 100 nil
Add paragraph 12(1)(t) adjustment . . . . . . . nil 20
Net income subject to tax . . . . . . . . . . . $100 $20
Tax @ 50% . . . . . . . . . . . . . . . . . . . $ 50 $10
Income earned or realized . . . . . . . . . . . $ 50 $10
Income earned or realized on hand . . . . . . . $ 50 $60
Taxes payable . . . . . . . . . . . . . . . . . $ 50 $10
Paid: investment tax credit ITC . . . $ 20 nil
cash . . . . . . . . . . . . . . 30 $10
$ 50 $10

At the end of year 1, the property of A Co (in addition to the depreciable property that is worthless) consists of property representing the investment tax credit of $20, the revenue of $100 sheltered by the CCA deduction, and $50 of income remaining after provision for taxes. The fair market value of the shares of A Co is $160, and there is an inherent capital gain of $60 in respect of those shares.

Although an amount equal to the investment tax credit claimed and the sheltered revenue is on hand and contributes to the fair market value of the A Co shares, no amount in respect of the sheltered income or investment tax credit has been included in income. Therefore, neither amount is included in income earned or realized. As a result, of the capital gain of $60 that is inherent in the shares of A Co, only $50 is attributable to income earned or realized on hand. The balance of the gain of $10 is attributable to the property representing the $20 investment tax credit less the related tax liability of $10.

At the end of year 2, the fair market value of the common shares of A Co remains at $160 and the shares of A Co have an inherent gain of $60. The property on hand consists of the same property that was on hand at the end of year 1, except for property representing the $10 that was laid out to pay the $10 tax liability in year 2. The $20 included in income by reason of the application of paragraph 12(1)(t) in year 2 represents the amount of the investment tax credit claimed in year 1 and will be included in income earned or realized in year 2. The total amount of income earned or realized that is on hand and contributes to the gain on the shares of A Co is $60. This is the sum of the incomes of $100 and $20 for years 1 and 2, respectively, less the taxes paid of $50 and $10 in respect of those incomes. The entire capital gain of $60 inherent in the A Co shares is attributable to income earned or realized.

• 4) Subsection 127.1(1)

The corporation may be deemed by subsection 127.1(1) to pay on account of its tax under Part I for a particular taxation year an amount not exceeding its refundable investment tax credit, as defined in subsection 127.1(2), for that taxation year. Basically, the refundable investment tax credit cannot exceed 40 percent of the amount of investment tax credit that the corporation has not deducted under subsection 127(5) for the year or a preceding year.

Where the corporation designates an amount under subsection 127.1(1), a deemed payment of Part I tax will arise. This deemed payment could result either in a reduction of the corporation's income tax otherwise payable, in the creation of a refund, or in an increase of a refund to which the corporation otherwise would have been entitled. Pursuant to subsection 127.1(3), the amount of this deemed payment is deemed to have been deducted by the corporation under subsection 127(5) for the same taxation year.

The results of the application of section 127.1 are similar to those described with respect to the deduction of a tax credit under subsection 127(5). An amount equal to the tax credit will be on hand in A Co in the year in which it is deemed to have been deducted under subsection 127(5) and will therefore contribute to the fair market value of the shares of A Co. As in the preceding examples, the tax credit will be accounted for pursuant to subsection 13(7.1) or subparagraph 66.1(6)(b)(xi) in a subsequent year and will result in a decrease in the amount of undepreciated capital cost or cumulative Canadian exploration expense that can be deducted in that and later years. The reduction in the amount that can be deducted will result in an amount equal to the tax credit being included in the computation of income earned or realized of A Co in those later years.

1 RSC 1952, c. 148, as amended by SC 1970-71-72, c. 63, and as subsequently amended (herein referred to as "the Act"). Unless otherwise stated, statutory references in this paper are to the Act.

Document Disclosed Pursuant to The Access To Information Act Document Divulgué en vertu de la loi sur l'accès à l'information 2Paragraphs 55(2)(b) and (c).

3 John R. Robertson, "Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55," in Report of Proceedings of the Thirty-Third Tax Conference, 1981 Conference Report (Toronto: Canadian Tax Foundation, 1982), 81-109, at 87; and Robert J.L. Read, "Section 55: A Review of Current Issues," in Report of Proceedings of the Fortieth Tax Conference, 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989), 18:1-28, at 18:6.

4 Canadian Institute of Chartered Accountants, CICA Handbook (Toronto: CICA) (looseleaf).

5It should be noted that a $500 dividend paid by B Co to A Co would be paid out of the income earned or realized with respect to A Co's shares in B Co. Therefore, it would be included in computing the income earned or realized of A Co with respect to A Co's shares in B Co. However, since the losses of C Co must be taken into account in computing the income earned or realized of A Co with respect to X Co, A Co will have no income earned or realized with respect to X Co's shares in A Co.

6 Subsection 248(24) was added by SC 1991, c. 49, subsection 192(18), applicable on royal assent, December 17, 1991.

7 Subsection 127(9), Paragraph (a) of the definition of investment tax credit. The capital cost and the amount of qualified expenditures, determined without reference to subsections 13(7.1) and (7.4), will be reduced under subsection 127(11.2) by government assistance or contract payments relating thereto.

8 Subsection 127.1(1).

9 Subsection 127.1(3).

10 Subsection 127.1(2), paragraph (a) of the definition of refundable investment tax credit.

11 It is assumed that the taxpayer does not dispose of the property before the grant is received.

12 If paragraph 13(7.1)(c) does not apply to decrease the capital cost of the property, paragraph 12(1)(t) will require an income inclusion in an amount equal to the investment tax credit previously claimed.

13 Regulation 4608.

l4 Subparagraph 66.1(6)(b)(ix).

15 Subparagraph 66.1(6)(b)(xi).

16 Subsection 127(9), subparagraph (a)(iii) of the definition of investment tax credit.

l7 The revenue that was sheltered by the CCA deduction is not included in income and therefore does not form part of income earned or realized that, as defined by paragraph 55(5)(b) or (c), is the income of the corporation as otherwise determined, subject to certain adjustments that are not relevant for the purposes of this discussion.

18 It is assumed that the depreciable property purchased for $100 is the only property in the class.

19 It is assumed that the only amounts included in the cumulative Canadian exploration expense are the $100 of expenses incurred in year 1 and the recognition of the $20 tax credit claimed in year 2.

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