7 February 1994 CTF Roundtable Q. 1, 4M09660 - 1993 CTF QUESTIONS & ANSWERS

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Questions and Answers Presented at
The Annual Conference of the
Canadian Tax Foundation
on December 1, 1993
in Montreal, Quebec

TABLE OF CONTENTS

1. R&D - Data Collection/
2. R&D - Agency/
3. R&D - Experimental Production/
4. Research and Development/
5. Retroactive R&D Claim/
6. Dividend Rental by Deferred Income Plan/
7. Tax Exempt Corporation/
8. Interest Deductibility on Preferred Shares/
9. Term Preferred Shares/
10. Short-Term Preferred Shares/
11. Gains on Interest Rate Swaps/
12. Safe Income vs Safe Income on Hand/
13. Paragraph 55(3)(b) - Butterfly/
14. Subsection 55(3.1) - Cross-Border Butterfly/
15. Safe Income/
16. Foreign Merger - Any Disposition of Debt?/
17. Home Purchase Loan/
18. Loans to Shareholder/Employee/
19. Friesen (FCA, 1993)/
20. First Fiscal Period/
21. Bonuses Paid to Shareholder/Partnership/
22. CCA Classes - Change in Control/
23. Resource Taxation - Crown Lease Rentals/
24. Principal Business Corporation Renunciations/
25. Amalgamations: The Pan Ocean Case/
26. Widespread Farm-Outs/
27. Farm-Outs - Mining/
28. Withholding Tax: Waiver/
29. Non-Residents - Payments for Computer Software/
30. Withholding Tax - Motion Picture Films and Video Tapes/
31. Withholding Tax on "Gross-Up"/
32. Canada-U.S. Income Tax Convention: Exempt Pensions/
33. Regulations to Section 482 of the Internal Revenue Code - Transfer Pricing/
34. Payments on Termination of Employment/
35. Carry Forward Balances on Notices of Assessment/
36. Income Attribution/
37. The New 12 Cent Per Kilometre Auto Benefit/
38. NISA Fund No. 2 on Death/
39. Capital Gains - Change in Value Prior to Closing/
40. Partnerships - Deemed Disposition/
41. Reserves - Availability/
42. Proceeds of Disposition/
43. Mortgage Foreclosures and Conditional Sales Repossessions/
44. Part IV Tax/
45. Small Business Corporation - Loans/
46. Losses - Section 80/
47. Freeze Share Rights/
48. Consolidation of Profits and Losses in a Corporate Group/
49. Interest Calculation/
50. Interest Calculation - Instalment Reminders/
51. Penalties - Non-Resident/
52. Trader or Dealer in Securities/
53. Mortgage Foreclosures and Conditional Sales Repossessions/
54. Capital Gains Deduction - Gain Not Reported/
55. Insurance Corporations/
56. Payments to Dissenting Shareholders in an Amalgamation/
57. Acquisition of Control - Implications in a Bankruptcy/
58. Limited Partnership and QSBC Shares/
59. Foreign Affiliates and Trusts/
60. Business & Property Income - Paragraph 18(1)(l)/

R&D - Data Collection

Question 1

The December 2, 1992 economic statement included proposed changes to the definition of SR&ED to specifically include testing and data collection. According to the explanatory notes, these changes were intended only as clarification and not as a policy change. Officials of the Department of Finance have stated that the changes to the legislation were not intended to change Revenue Canada's assessing policy in this area.

However, the Department is apparently denying as qualifying SR&ED in Canada wage and travel costs of Canadian employees sojourning outside Canada during testing and data collection.

Has there been a change in the Department's position and, if so, what is the rationale for the change.

Department's Position

The Department has taken the position that travel, including salary or wages and related benefits, of a Canadian employee undertaking foreign travel relating to SR&ED carried on outside of Canada qualifies under subsection 37(2) of the Income Tax Act and not under subsection 37(1). This was reflected in the answer to question 27 in the 1987 Conference Report.

Testing and data collection that is directly in support of and commensurate with the needs of basic research, applied research and experimental development is SR&ED as contemplated by subsection 2900(1) of the Income Tax Regulations. Consequently, the wage and travel costs of Canadian employees sojourning outside Canada during such testing and data collection taking place outside Canada only qualifies under subsection 37(2).

R&D - Agency

File 932765

Question 2

Assume that, under an arrangement, a Canadian subsidiary does not have the right to exploit the results of scientific research and experimental development (SR&ED) carried out on behalf of its U.S. parent; and all of the SR&ED expenditures are reimbursed by the parent company. Would these factors affect the ability of the subsidiary to obtain a deduction for the SR&ED expenditures and claim the related investment tax credit?

Department's Position

Provided that the requirements of subparagraph 37(1)(a)(i) of the Act are otherwise met, the fact that the subsidiary does not have the right to exploit the results of SR&ED that it carries out would not, in and by itself, affect its ability to deduct the SR&ED expenditures incurred by it and claim the related ITC in computing its income. To the extent that a reimbursement made in respect of the SR&ED can be considered to be "non-government assistance" or a "contract payment", as defined under subsection 127(9), the reimbursement would affect a claim made by the subsidiary for the SR&ED expenditures and the ITC. Where a subsidiary is acting as agent for its parent, the parent would have ownership rights to the SR&ED and would be considered to have incurred the SR&ED expenditure made by the subsidiary. In any given situation, it is a question of fact whether SR&ED carried out by a taxpayer on behalf of another person is performed by the taxpayer as agent for the other person, the determination of which would depend on the terms of the particular arrangement.

R&D - Experimental Production

File 932764

Question 3

In light of the recent decision in the case of Cultures Laflamme (1984) Inc. (93 DTC 607), will the Department change its position in respect of netting experimental production income against scientific research and experimental development expenditures, as stated in paragraph 15 of IT-151R3?

Department's Position

As stated in IT-151R4 dated August 16, 1993 in the section entitled "Explanation of Changes", the relief that this position was originally intended to provide is no longer required and, therefore, paragraph 15 of IT-151R3 has been deleted.

Research and Development

Question 4

What are the Department's views on the recent case, G. A. Borstad Associates Ltd. v. The Minister of National Revenue, 92 DTC 1743? There are two issues raised by this case.

The first is the denial of the taxpayer's claim for investment tax credits on accrued salaries for the personnel involved in research and development (R&D) activities and the second is the timing for the deduction of these accrued salaries. In this case, the judge denied the taxpayer's claim for investment tax credits on accrued salaries of two individuals involved in the corporation's R&D activities. Will the Department take a similar position in other cases?

The second issue is the deductibility of the accrued salaries. The judge stated that "In the final analysis, it seems to be in conformity with the scheme of the Income Tax Act that a direct deduction from the tax otherwise payable by the Appellant can only be granted if an expenditure in the form of salaries and wages has resulted in an outlay being effectively made by a taxpayer in a particular taxation year". If that statement is followed to its conclusion, then R&D expenses are only deductible when paid as opposed to when incurred.

How does the Department intend to assess in other cases? Both of these issues can have major impact on R&D performers.

Department's Position

Salaries and wages must be paid to qualify as directly attributable expenditures in respect of scientific research and experimental development (SR&ED) for 1989 and prior taxation years. The Department has followed the practice of applying the paid requirement only for purposes of calculating investment tax credits. However, provided the draft amendment to paragraph 2900(2)(b) of the Income Tax Regulations is adopted, accrued salaries and wages will be able to qualify as directly attributable expenditures for 1990 and subsequent taxation years.

Retroactive R&D Claim

Question 5

Some taxpayers have, in the past, been carrying on qualifying research and development activities, but did not claim the section 37 scientific research and experimental development deduction for the qualifying expenditures or the related investment tax credits available, or both. Our understanding is that the Department is allowing such taxpayers to make retroactive claims for these deductions and investment tax credits for tax years that are beyond the normal 3-4 year reassessment period.

Can the Department confirm its policy in this regard?

Department's Position

The Department has not adopted a practice of issuing reassessments to allow taxpayers scientific research and experimental development (SR&ED) incentives that are beyond the normal 3-4 year reassessment period. However, subject to the taxpayer being able to establish entitlement to the SR&ED investment tax credits and the restrictions on ITC carry-forwards, the Department will allow a taxpayer to carry-forward SR&ED tax credits in respect of the taxation years that are statute barred to offset federal taxes payable in open taxation years.

Dividend Rental by Deferred Income Plan

File: 932844

Question 6

Where a deferred income plan (as described in section 205 of the Act) enters into an agreement to purchase a share, in the future, at a price that equals the fair market value of the share at the time the agreement is made, will section 206.1 apply?

Department's Position

Section 206.1 taxes the deferred income plan where the purchase price specified in the agreement may differ from the fair market value at the time the share may be acquired. In the circumstances described above, it is possible that the purchase price will not be equal to the fair market value of the share at the time it is to be acquired and, therefore, the tax is exigible for each month during which the agreement is in effect.

Tax Exempt Corporation

File: 932811

Question 7

Is it the Department's position that a pension corporation exempt from tax pursuant to subparagraph 149(1)(o.2)(ii) of the Act would lose its tax exempt status if it were to become the owner of an undivided 50% interest in a rental real estate project where the other undivided one-half interest is owned by a taxable corporation?

Department's Position

THE POSITION STATED AT THE CONFERENCE IS UNDER REVIEW.

Interest Deductibility on Preferred Shares

File 932812

Question 8

Would interest payable with respect to funds borrowed to purchase newly issued preferred shares of a corporation be deductible under paragraph 20(1)(c) of the Act where the provisions of the preferred shares provide that the holders are entitled to such dividends as the board of directors of the corporation in its discretion may declare and that they are only entitled to a return of the purchase price for the shares on dissolution of the corporation?

Department's Position

In general, such shares are not acquired for the purpose of earning income and the interest expense is only deductible to the extent of the dividend income.

Term Preferred Shares

File 932806

Question 9

A specified financial institution (SFI) owns common shares of a corporation but does not control that corporation either alone or together with other SFIs. Accordingly, the common shares held by the SFI do not constitute term preferred shares. If an arm's length person later enters into an agreement with the SFI to purchase these common shares, will the common shares become term preferred shares at the time that the agreement is entered into on the basis of subparagraph (a) of the definition of "term preferred shares" in subsection 248(1) of the Act - i.e., that "under the terms or conditions of the share, any agreement relating to the share....any other person is or may be required to redeem, acquire or cancel...the share"?

Department's Position

Given the broad wording of subparagraph (a)(ii) of the definition of "term preferred share" in subsection 248(1), such shares would be term preferred shares from the time the purchase and sale agreement is entered into until the time the agreement terminates.

Short-Term Preferred Shares

File: 932883

Question 10

Paragraph (b) of the definition of "short-term preferred share" in subsection 248(1) of the Act provides that, as a general rule, a share that is convertible or exchangeable within 5 years from the date of its issue is a "short-term preferred share".

Is a share considered to be "convertible" or "exchangeable" for purposes of the definition only if the holder has the option to convert or exchange, or does it apply also if the issuing corporation has such an option?

Department's Position

A share is considered to be "convertible" or "exchangeable" for purposes of paragraph (b) of the definition of "short-term preferred share" where either the holder or the issuing corporation has the option to convert or exchange.

Gains on Interest Rate Swaps

File: 932823

Question 11

A corporation resident in Canada (Canco) issues a floating interest rate debenture to finance a plant expansion. In order to eliminate the interest rate risk, Canco enters into an interest rate swap agreement with a financial institution whereby it agrees to make payments referenced to a fixed rate of interest and receive payments from the financial institution referenced to a floating rate of interest. In year 3, Canco redeems the debentures. In year 4, the interest rate swap agreement is terminated and Canco receives a cash settlement amount representing the gain on this instrument.

(a) Will the Department consider the amount of the gain on the termination of the interest rate swap agreement to be a capital gain or on account of income ?

(b) Would the answer to (a) change if the original indebtedness was used for general corporate purposes or inventory acquisitions ?

Department's Position

All amounts payable or receivable pursuant to an interest rate swap agreement will be considered to be on account of income and will be included in or deductible from the income of the taxpayer pursuant to section 9 of the Act.

The use of any underlying borrowed funds is no longer relevant in determining the treatment for income tax purposes of the amounts payable or receivable pursuant to the interest rate swap agreement.

Safe Income vs Safe Income on Hand

File 932834

Question 12

Could the Department clarify the distinction between "safe income" and "safe income on hand" and provide examples of items which would be included in one calculation and not the other?

Department's Position

"Safe income" with respect to a share of a corporation is equivalent to the "income earned or realized" by the corporation during the relevant holding period. The expression "income earned or realized" by a corporation is deemed to be the amount determined pursuant to paragraph 55(5)(b), (c) or (d) of the Act, as the case may be. Consequently, safe income with respect to a share of a corporation refers to the corporation's net income, as determined for purposes of the Act, as adjusted by paragraphs 55(5)(b), (c) or (d), as the case may be, that is attributable to that particular share during the relevant holding period.

In order to contribute to a gain on a share, income earned or realized must be on hand. Consequently, "safe income on hand" with respect to a share of a corporation refers to the portion of the income earned or realized by the corporation during the relevant period of time that could reasonably be considered to contribute to the capital gain that would be realized on a disposition at fair market value of the share at that time.

Since "safe income" is computed on the basis of net income as determined for purposes of the Act, amounts that have been distributed as a dividend or amounts laid out or set aside to pay income taxes, charitable donations or other amounts not currently deductible for tax purposes would not generally reduce a corporation's safe income. However, since such amounts will not contribute to the gain inherent in the corporation's shares they would reduce the corporation's safe income on hand. In addition, certain contingent liabilities, accrued interest on income debentures and certain accounting provisions which are not currently deductible for income tax purposes are other examples of items which would not affect a corporation's safe income but which would normally reduce its safe income on hand. A liability for dividends payable will not affect the calculation of safe income but will reduce the safe income on hand attributable to other classes of shares of the corporation.

Paragraph 55(3)(b) - Butterfly

File 932780

Question 13

Is it possible to distribute assets in accordance with paragraph 55(3)(b) of the Act, if the distribution does not include all of the assets of a particular type owned by the particular corporation, but those assets of the particular type that are being distributed are distributed on a pro-rata basis to all shareholders?

Department's Position

A distribution to all shareholders that does not include all the assets of a particular type owned by the distributing corporation would not meet the requirements of paragraph 55(3)(b) since it could not be said that each transferee received his proportion of the fair market value of all property of that type owned by the particular corporation immediately before the transfer.

Subsection 55(3.1) - Cross-Border Butterfly

File 932822

Question 14

The Amendments to the Income Tax Act and Related Statutes, released by the Minister of Finance on August 30, 1993, contain new subsection 55(3.1). This provision appears to provide that the exemption from the application of subsection 55(2) of the Act in paragraph 55(3)(b) will not apply where, as part of a series of transactions, a non-resident holds shares of a particular corporation or a transferee (within the meaning of those terms in paragraph 55(3)(b)) as taxable Canadian property and disposes of those shares to someone dealing at arm's length with the non-resident, notwithstanding that:

(a)the non-resident's share interest in the particular corporation or transferee is nominal;

(b)the gain realized by the non-resident on the share sale is not treaty-exempt; or

(c) there is no gain inherent in the non-resident's shares.

Is it the Department's position that such an arm's-length disposition by the non-resident would preclude all shareholders of the corporation from relying on paragraph 55(3)(b) to exempt any dividends received by them from the application of subsection 55(2)?

Department's Position

If the dividends received by the other shareholders are part of a series of transactions or events which includes the arm's-length disposition by the non-resident, subsection 55(3.1) will apply to preclude the other shareholders from relying on paragraph 55(3)(b) to exempt the application of subsection 55(2) to those dividends. Whether any particular transaction is considered to be part of a series of transactions depends on the relevant facts and circumstances.

Safe Income

File: 5-932784

Question 15

The Emerging Issues Committee of the CICA has indicated in Abstract #7 "Income Statement Classification of the Federal Large Corporations Tax", that the amount of a corporation's Large Corporation's Tax (LCT) should be included in its income tax provision for purposes of financial statement presentation on the income statement, even though the tax is a tax on capital.

Assume that a corporation has $1,000 of pre-tax income reported on its income statement for the current year. The income tax provision on the corporation's income statement is $400, of which $100 is the corporation's Large Corporations Tax for the current year.

For purposes of subsection 55(2) of the Act, is the corporation's addition to "safe income" for the current year equal to $600 or $700?

Department's Position

The expression "income earned or realized by a corporation" is defined in subsection 55(5) as essentially the income of the corporation as otherwise determined pursuant to the Act. On the facts given, the income earned or realized is $1,000. However, non-deductible expenses and outlays of a corporation, and amounts set aside to pay such amounts, including taxes, must be deducted in computing the safe income on hand of a corporation. This is the income earned or realized that remains on hand and contributes to the gain on the shares of the corporation. In the example, the safe income on hand would be $600.

Foreign Merger - Any Disposition of Debt?

File: 932866

Question 16

Is there a disposition of a debt of a foreign corporation owned by a Canadian corporation when that foreign corporation is merged with another foreign corporation?

Does it matter:

(a) whether the debt is capital property;

(b)whether the foreign corporation (i.e. the original debtor) ceases to exist rather than continues under the relevant foreign corporate law?

Department's Position

Where the foreign debtor corporation has ceased to exist and the other predecessor corporation is the surviving entity, there would be a disposition of the original debt owing by the corporation that ceases to exist. This would occur under "absorptive mergers" carried out under U.S. corporate statutes where the corporation that ceased to exist is the debtor.

Where the foreign law provides for a "continuation", it would be a question of fact whether there will be a disposition of the debt on the merger.

Whether a debt of a foreign corporation owned by a Canadian corporation is a capital property or not is irrelevant to the disposition issue .

Home Purchase Loan

Question 17

File: 5-932791

Assume a shareholder who is an employee of a corporation receives a loan which meets the criteria in subparagraph 15(2)(a)(ii) of the Act as a home purchase loan. Assume the terms of the loan are honoured and payments are made in accordance with the repayment terms. Assume further that no mortgage is given to the corporation as security. If the shareholder is required, for financial or other reasons, to sell the home in a subsequent year, does the Department consider that the loan continues to qualify as a home purchase loan, notwithstanding that the home itself is no longer owned and no replacement home has been acquired?

Department's Position

In order to be exempt from the application of subsection 15(2) in the year the loan is received, the borrower must establish that bona fide arrangements were made at the time the housing loan was made, for repayment within a reasonable time. In a given situation, one of the factors the Department will consider is the normal commercial practice which would prevail in a similar situation. While a mortgage on the property involved is not required, it is normally unreasonable and inconsistent with normal commercial practice for a lender to loan a large sum of money without security or not to require the reimbursement of the unpaid balance of the loan when the property is sold. In considering whether any arrangements for repayment were bona fide, the Department will review the extent to which they have been carried out by the borrower.

Loans to Shareholder/Employee

Question 18

In light of the recent FCA decision in Silden (93 DTC 5362), does the Department intend to continue its policy of only applying subsection 15(2) of the Act where a loan is made to a shareholder in his/her capacity as a shareholder and not when a loan is made to a shareholder in his/her capacity as an employee.

Department's Position

The Department is presently considering the effect that the Silden decision will have on its position.

Friesen (FCA, 1993)

File 932778

Question 19

In light of the recent Federal Court of Appeal decision in Friesen (93 DTC 5313), could the Department explain its views on the extent of the application of this decision?

Department's Position

The Department is studying the implications of this decision and would welcome comments from the tax community.

First Fiscal Period
Question 20

File: 932807

According to the definition of "fiscal period" found in subsection 248(1) of the Act, a "fiscal period" means the period for which the accounts of the business of the taxpayer have been ordinarily made up and accepted for purposes of assessment under the Act. It is also provided that the fiscal period of a corporation may not exceed 53 weeks.

Assume a corporation was incorporated on January 1, 1992 but did not start its operations until July 1, 1993. No accounts or financial statements were prepared for the period running from January 1, 1992 to July 1, 1993. Could such a corporation take the position that since it did not prepare any accounts for the period prior to July 1, 1993, its first fiscal period only started on July 1, 1993?

Department's Position

The corporation's first fiscal period will have commenced on the day of incorporation and because the definition states that a "fiscal period" cannot exceed 53 weeks, the first fiscal year end will have occurred at the end of or prior to the 53rd week after incorporation. Inactive corporations are not excluded from paragraph 150(1)(a) which requires that a return be filed within 6 months from the end of the fiscal year.

Bonuses Paid to Shareholder/Partnership

File: 932787

Question 21

Assume the case of a partnership that carries on an active business and owns all of the outstanding shares of a company. The company has no employees but contracts its work to the partnership and the work is carried on mainly by the partners and the partnership's employees. In order to reduce its income to either $200,000 or some other pre-determined amount, the company pays a large management fee/bonus to the shareholder/partnership. The Department stated its position on the deductibility of bonuses paid to shareholder/managers and shareholder/employees at the 1981 Round Table. Will the same position apply in this case?

Department's Position

The administrative position described in Question 42 of the 1981 Round Table and Question 56 of the 1990 Round Table applies only to bonuses paid to shareholder/managers and shareholder/ employees.

In this particular situation, the deductibility by the company of a management fee/bonus paid to the shareholder/partnership would be dependent on the conditions in paragraph 18(1)(a) and section 67 of the Act being met. Paragraph 18(1)(a) requires that the management fees/bonuses must be paid for the purpose of earning income from the business, and section 67 denies a deduction to the extent the management fees/bonuses are not reasonable in the circumstances. (See an analogous position in Question 25 of the 1991 Round Table dealing with intercorporate management fees.)

CCA Classes - Change in Control

File: 5-932777

Question 22

Generally, paragraph 111(4)(e) of the Income Tax Act permits a corporation to elect a deemed disposition of any capital property immediately before the year end resulting from the acquisition of control. The elected proceeds can be anywhere between the adjusted cost base and the fair market value of the property. The capital property is deemed to have been reacquired by the corporation.

(a)Where the property is depreciable property of the corporation, is there a deemed disposition for purposes of section 1100 of the Income Tax Regulations?

(b)Where the property is rental property acquired before 1972 that was not in a separate class prescribed under subsection 1101(1ac) of the Regulations, is a separate class prescribed for such rental property by reason of the deemed acquisition?

Department's Position

(a)Where a corporation designates depreciable property under paragraph 111(4)(e) of the Act, the depreciable property is deemed to have been disposed by the corporation and to have been reacquired by it for the purpose of computing the corporation's taxable income. The deemed disposition and deemed reacquisition rule applies for the purpose of the Regulations made under paragraph 20(1)(a) of the Act which include the Part XI Regulations.

Subsection 1100(2.21) of the Regulations provides that where a taxpayer is deemed by a provision of the Act to have disposed of and acquired or reacquired a property, the acquisition or reacquisition is deemed, for the purposes of paragraph 1100(2.2)(e) and subsections 1100(19), 1101(1ad), 1102(14) and 1102(14.1) to have been from a person with whom the taxpayer was not dealing at arm's length at that time. This rule may exempt the property from the half-year rule, from the leasing property rule or from a change of classification in certain circumstances as a result of the deemed disposition.

Department's Position (cont'd)

(b)By reason of the application of subsections 1100(2.21) and 1101(1ad) of the Regulations, each rental property (within the meaning given in subsection 1100(14)) which would otherwise be rental property of the taxpayer of a separate prescribed class is deemed not to be property of a separate prescribed class under subsection 1101(1ac) if it was not in a separate prescribed class before the deemed disposition. Since the rental property that was acquired before 1972 was not of a separate class before the deemed acquisition, it will be deemed not to be property of a separate class after the deemed disposition.

Resource Taxation - Crown Lease Rentals

File: 932759

Question 23

If a Crown lease rental that otherwise qualifies as a prescribed amount in accordance with paragraph 1211(d) of the Regulations is prepaid for a five-year period, will the payment be allocated over a five-year period pursuant to subsection 18(9) of the Act? If so, will the allocated amount for each year of the five-year period be a prescribed amount under paragraph 1211(d) of the Regulations?

Department's Position

For the purpose of a prescribed amount pursuant to paragraph 1211(d), the amount of the prepayment which relates to each year of the prepaid period will be considered to be the amount that "became payable" during that year provided that such amount otherwise satisfies all of the other requirements of paragraph 1211(d).

Principal Business Corporation Renunciations

File 932760

Question 24

Would the provisions of subsection 66(12.71) of the Act apply to limit a renunciation of Canadian exploration expenses (CEE) by a principal-business corporation (PBC) to the extent that the PBC would not, but for the renunciation, have been able to claim a CEE deduction of an equivalent amount due to its having insufficient income for purposes of subsection 66.1(2)?

Department's Position

The fact that the CEE deduction to which a PBC would otherwise be entitled is limited for a particular year under subsection 66.1(2) to the amount of the PBC's income for that year, will not, in and by itself, result in the application of the provisions of subsection 66(12.71).

Amalgamations: The Pan Ocean Case

File: 932836

Question 25

Does the Department accept as correct the decision of the Federal Court - Trial Division in Pan Ocean Oil Ltd v. The Queen, 93 DTC 5330, to the effect that an amalgamation does not result in an acquisition of resource properties for purposes of the successor corporation rules?

Department's Position

No, the Department has appealed this decision to the Federal Court of Appeal.

Widespread Farm-Outs

File: 932771

Question 26

At the 1992 Canadian Petroleum Tax Society's Annual Conference, the Department stated its position with respect to simple farm-outs in the oil and gas industry as follows:

In a simple farm-out arrangement, the owner (the farmor) of unproven resource property transfers an interest in that property to another person (the farmee) who conducts exploration and development on the property. Revenue Canada will continue the administrative position at paragraph 11 of Interpretation Bulletin IT-125R3 to treat the simple farm-out as not giving rise to proceeds of disposition.

What is the Department's position with respect to widespread farm-outs in the oil and gas industry?

Department's Position

In a widespread farm-out, the farmee agrees to conduct exploration and development on the farmor's unproven resource property in exchange for an interest in some other property of the farmor. The Department will treat widespread farm-outs in which the farmee receives unproven resource property of the farmor as not giving rise to proceeds of disposition irrespective of whether or not the unproven resource property is contiguous to the property being explored or developed by the farmee. Widespread farm-outs in which the farmor transfers property other than unproven resource property will be treated as a disposition by the farmor for proceeds equal to fair market value of the property transferred; the farmee's cost of the transferred property will equal the proceeds of the farmor; and subsection 66(12.1) of the Act will apply to reduce exploration and development expenses incurred by the farmee for the transferred property.

Farm-Outs - Mining

File: 932772

Question 27

At the 1992 Canadian Petroleum Tax Society's Annual Conference, the Department stated its position with respect to typical farm-outs in the oil and gas industry as follows:

In a typical farm-out, the farmor transfers all of the working interest to the farmee and takes back a percentage royalty in the unproven resource property transferred. The farmee agrees to incur the exploration and development costs and equipping costs. "Equipping costs" refer solely to the cost of equipment acquired to be used at the wellsite primarily for the purpose of producing petroleum substances from a completed well. Subsequently, upon pay-out of the farmee, a percentage of the working interest reverts to the farmor together with a pro rata ownership interest in the depreciable property that was acquired to equip and complete the well. Revenue Canada will treat the ownership transfer of the percentage interest in the resource property and the completed wells as not giving rise to proceeds of disposition.

Would the Department extend this position to the "typical farm-out" in the mining industry?

Department's Position

With respect to the "typical farm-out", this position is generally applicable to both the oil and gas industry and the mining industry. However, the Department is still studying what the "equipping costs" would be in the mining industry.

Withholding Tax: Waiver

Question 28

The Department has indicated that, where there is a tax saving because of the availability of a treaty provision, tax must be withheld as per regulation and recovered only when a return is filed. This sometimes creates withholding tax problems in tax planning for international executives.

Under what circumstances, if any, will the Department grant a waiver of withholding tax where the request relies on the provisions of an income tax convention between Canada and another country?

Department's Position

The Department will entertain waiver requests where the non-resident can demonstrate that the withholding is in excess of the tax that will be payable after taking treaty protection into account. The issuance of waivers will be done a case by case basis taking into account the specific circumstances of each case.

When a person seeks an exemption from Canadian tax pursuant to a tax treaty, that person should submit a description of the facts and the relevant provisions of the treaty to the Assistant Director, Revenue Collections, of the District Office that serves the area where the person will be working. The written application should be submitted to the District Office no later than one month prior to the commencement of the employment in Canada.

Non-Residents - Payments for Computer Software

File 932762

Question 29

What is currently the view of the Department with respect to payments to non-residents for the following rights relating to computer software?

(a) The right to use customized computer software;

(b) The right to use "packaged" or "shrink-wrap" computer software;

(c) The right to distribute computer software;

(d) The right to change the program and distribute as part of another program.

Department's Position

(a)A payment to a non-resident for the use of, or the right to use, a custom computer software program for a period of indefinite duration is a payment for the use of, or the right to use, a secret formula or process and is subject to tax under subparagraph 212(1)(d)(i) of the Act. Canada has no bilateral agreements presently in force wherein such payments are exempted from tax. We note that the Department of Finance announced, as part of the 1993 Budget, that it intends to negotiate on a bilateral basis exemptions from this tax. The Protocol to the Income Tax Convention between Canada and the Netherlands contains such an exemption. However, that protocol is not in force at this time.

(b)&(c)The taxation of payments made to non-residents for the right to distribute computer software and payments made to non-residents for the right to use "packaged" or "shrink wrap" computer software are presently under study.

(d)Copyright is defined in subsection 3(1) of the Copyright Act as "...the sole right to produce or reproduce the work or any substantial part thereof in any material form whatever...". The agreements granting the right to change the program and distribute it as a part of another program would have to be examined. If it is determined that the payment by the resident of Canada to a non-resident is in respect of a copyright in respect of the production or reproduction of the first program, it would be exempt from tax by virtue of subparagraph 212(1)(d)(vi).

Withholding Tax - Motion Picture Films
and Video Tapes

File 932767

Question 30

Subsection 212(5) of the Act provides for withholding tax in respect of, among other things, a payment for the right to the use of a motion picture film or video tape that is to be used in Canada. Is it the Department's position that the withholding obligation is limited to the portion of the payment that relates to the use of the motion picture film or video tape in Canada, or does it extend to the full payment notwithstanding that a portion of the payment relates solely to the use of the motion picture film or video tape outside of Canada?

Department's Position

The Department is prepared to review the facts in a particular situation to determine whether any portion of a particular payment is solely for the right to use a motion picture film or video tape outside Canada. If it is, the Department is prepared to exempt that portion from Part XIII tax.

Withholding Tax on "Gross-Up"

Question 31

Many loan agreements contain a "gross-up" clause which requires the borrower to make additional payments should the interest paid under the loan be subject to withholding tax. The gross-up clause generally provides that the amount of the additional payments must be such that, taking into account the withholding tax on the additional payments, the lender receives the same net amount as if no withholding tax were applicable. If withholding tax is payable on the additional payments, the calculation of the required payment could theoretically involve an infinite number of calculations (since each increase in the amount of the payment to take into account withholding tax would itself be subject to withholding tax). We understand that the Department's assessing practice is that only two calculations are required for purposes of determining the required payment. This would mean that the amount of the gross-up is equal to the withholding tax applicable on the actual interest payment (the First Amount) plus the withholding tax payable on the First Amount. Can the Department confirm that this is its assessing practice?

Department's Position

These calculations are not in accordance with the Department's assessing practice. The calculation of withholding tax is a single step procedure.

The grossed-up total of withholding tax is calculated by applying the following formula:

Required payment = tax rate X interest payment
100 minus tax rate

For example, the required payment of withholding tax on an interest payment of $1,000, assuming a withholding rate of 15%, would be calculated as follows:

15 X $1,000 = $176.47
(100 - 15)

Canada-U.S. Income Tax Convention:

Exempt Pensions

Question 32

File: 932800

The response to Question 2 at the 1992 Manitoba CBA/CICA indicated that RRSPs and RRIFs were considered as "pensions" for purposes of Article XVIII of the Canada-U.S. Income Tax Convention (the Convention).

(a)Would an U.S. Individual Retirement Account (IRA) be treated as a pension in the same manner as RRSPs and RRIFs and be entitled to the exemption from Canadian withholding tax, with respect to interest and dividends, contained in paragraph 2(a) of Article XXI of the Convention?

(b)Is the Department aware whether the U.S. Internal Revenue Service is treating RRSPs and RRIFs as pensions which are entitled to the exemption from withholding tax provided for in paragraph 2(a) of Article XXI of the Convention?

Department's Position

(a)The definition of "pensions" in paragraph 3 of Article XVIII of the Convention refers to a retirement plan and will therefore include a U.S. IRA. Since the term "pensions" is defined for the purposes of the whole Convention, the IRA will qualify for the exemption from Canadian tax provided in paragraph 2 of Article XXI of the Convention with respect to any interest and dividends received by it, subject to paragraph 3 of that Article.

(b)In some cases, the Internal Revenue Service has not treated RRSPs and RRIFs as pensions for purpose of the Convention and, therefore, such plans would not be entitled to the exemption from withholding tax (on interest and dividends received from the United States) provided in paragraph 2(a) of Article XXI of the Convention. It is Canada's objective that the U.S. position be clarified in any future protocol.

Regulations to Section 482 of the
Internal Revenue Code - Transfer Pricing

Question 33

The U.S. has recently issued regulations to section 482 of the Internal Revenue Code.

(a)If a Canadian taxpayer demonstrates that prices for its transactions with related companies in the U.S. are acceptable under the Comparable Profit Method (CPM) provided for in those regulations, will the Department also accept those prices?

(b)Does the Department have any suggestions as to how problems with the new U.S. rules may be avoided before they arise? How problems with those rules may be resolved where they cannot be prevented?

Department's Position

(a)The CPM redetermines a taxpayer's profit, rather than its transfer price, on the assumption that the taxpayer should have financial results comparable to other companies in the same industry. Many factors make it unlikely that this assumption will be valid. These factors include significant differences in markets, differences in major operating strategies; for example, means of financing, companies being at different stages of development, and varying cost effectiveness, due, for example, to relative ages of plant and equipment.

Because of the weaknesses of the CPM as a basis of computing transfer prices, the Department strongly recommends that corporations use the traditional pricing methods discussed in Information Circular 87-2 which continues to reflect its views on the determination of transfer prices.

(b)There are two possible means of avoiding problems arising from the new U.S. law. They are the use of a method which is superior to the CPM and endorsed under the arm's length principle, and obtaining an Advance Pricing Agreement with each of Canada and the United States. If a problem has not been foreseen, but arises as a result of the IRS applying the new rules, the client could refer the matter to Competent Authority.

Payments on Termination of Employment

File: 5-932792

Question 34

The Department appears to take the position that where an employment is terminated without cause and without notice, then "payments made in accordance with provincial standards legislation or required by the employment contract will not be considered retiring allowances". Could the Department clarify or confirm whether the following payments made to an employee in these situations would be treated as retiring allowances or employment income.

(a)The employee receives "termination pay" and "severance pay" as these terms are defined in the Employment Standards Act (Ontario). The amount of both payments is based on the employee's number of years of service.

(b)The employee receives a payment (e.g. equivalent to fifteen months salary) in addition to the statutory amount described above in recognition of the common law entitlement to pay in lieu of notice.

(c)The employee was employed under a written employment contract that provided for a pre-determined amount to be paid in the event of termination without cause and without notice. Such amount is to be equal to the employee's statutory entitlement plus the equivalent of six months salary.

(d)The employee was employed pursuant to a written contract of employment that is silent as to what the employee is entitled to in the event of termination without cause.

(e)The employee receives, as a result of settlement of litigation, any of the amounts described above.

(f)The employee receives, by order of a court or statutory tribunal, any of the amounts described above.

It should be assumed that none of the payments are made in consideration or partial consideration for a covenant with reference to what the employee is, or is not, to do before or after the termination of the employment and so not described by paragraph 6(3)(e) of the Act.

Department's Position

"Termination pay" is defined in section 1 of the Employment Standards Act (Ontario) (ESA) to mean the amount of pay to which an employee is entitled under section 57 of that Act . Section 57 imposes a minimum number of weeks notice prior to termination which is dependant on the years of employment. During the period of notice, the employee is entitled to receive his regular wages. If the employment is terminated without the written notice required by the ESA, the employee is entitled to termination pay equal to the regular wages payable over the same number of weeks for which notice was required. The termination pay constitutes the continuation of regular salary payments notwithstanding the termination of employment.

For the purposes of the definition of "retiring allowance" in subsection 248(1) of the Income Tax Act (ITA), a termination pay in lieu of notice received under section 57 of the ESA would not be a retiring allowance, whether or not received in a lump-sum amount. This position is in accordance with the comments in paragraph 15 of IT-365R2 which deals with damages, settlements and similar receipts, including amount received on termination of employment.

"Severance pay" is defined in section 1 of the ESA to mean the amount of pay to which an employee is entitled under section 58 of that Act. An employee is entitled to severance pay where fifty or more employees have been laid off by the employer within a six month period due to a permanent discontinuance of the business or where an employer with a payroll of $2.5 million or more terminates one or more employees. Furthermore, the employee must have been employed for at least five years with the employer in order to be entitled to the severance pay. The pay is calculated based on one week's regular wages for every year of completed employment and a proportionate amount for each incomplete year. Severance pay may not exceed 26 weeks regular wages. In cases of "severance pay", the employment relationship is severed before the employee is entitled to the pay.

For the purposes of the definition of "retiring allowance" in subsection 248(1) of the ITA, a "severance pay" under section 58 of ESA, would constitute a retiring allowance since it is compensation for loss of employment or recognition of long service.

Department's Position (cont'd)

Where an amount is paid by virtue of the terms of an employment contract to compensate an employee for the loss of employment or in recognition of long service, it will normally be considered a retiring allowance. This is not to say that any payment made upon termination of employment will qualify as retiring allowance, but rather that a payment of an amount which would otherwise qualify as a retiring allowance will not be disqualified as a retiring allowance solely because it is made pursuant to a contractual obligation.

Where a taxpayer received an amount in recognition of the common law entitlement for wrongful dismissal, the Department's position is as follows:

1.In case of reinstatement of employment status on a retroactive basis, the amounts received in settlement of the foregone salary, wages or other benefits are to be treated as income from employment rather than a retiring allowance.

2.The position in 1. would also be applicable where reinstatement was awarded, but the taxpayer did not return to work for his/her former employer.

3.Where a taxpayer has sued for wrongful dismissal and the court or a negotiated settlement has awarded an amount and no mention is made that the person is to be reinstated, the amount arrived at would probably be viewed as a retiring allowance as defined in subsection 248(1) of the ITA.

Carry Forward Balances on Notices of Assessment

Question 35

Can the various carry forward balances now referred to on Notices of Assessment be the subject of a Notice of Objection?

Department's Position

No. These balances have no bearing on the assessment of tax, interest, penalties or other amounts payable for the taxation year.

These balances are referred to for information purposes only. The taxpayer is invited to contact the district taxation office if additional information is needed, or when there is a disagreement in that respect.

The taxpayer can file a Notice of Objection if a deduction on account of such a carry forward provisions is subsequently claimed and disallowed, resulting in an assessment of tax, interest, penalties or other amounts payable. In addition, a taxpayer may request a Determination of the various losses incurred in a taxation year and formally object and appeal such a Determination.

Income Attribution

File: 932793

Question 36

There does not appear to be any express provision in section 74.1 of the Act governing the attribution of income in cases where an offending loan or outstanding indebtedness (arising from the transfer of property) is repaid in full. Where such a loan or indebtedness is repaid in full:

(a) does income attribution cease?

(b)does income attribution continue as if nothing has happened?

(c)is there a reduction in the amount of income attributed back to the lender or transferor and, if so, what is the basis for determining the amount of the reduction?

Department's Position

The Act does not provide specifically that attribution ceases when a low-interest or interest-free loan to which subsection 74.1(1) applies is repaid. If the loan is repaid with property other than the original property loaned or property substituted, the attribution continues.

The New 12 Cent Per Kilometre Auto Benefit

Question 37

In December 1992, the Department of Finance introduced a proposal to simplify the calculation of an employee's operating benefit related to his/her personal use of an employer-provided automobile. Effective January 1, 1993, an employee's operating benefit is equal to 12 cents multiplied by the personal kilometres driven.

This proposal has yet to become law.

(a)On what basis are employers to calculate the 1993 tax to be withheld from employees' salaries or wages in regards to their operating benefits? Is the operating benefit to be estimated based upon existing law or the 12 cents per kilometre proposal?

(b)If the 12 cents per kilometre proposal is not law before year end, on what basis should employers calculate the employees' 1993 operating benefits?

Department's Position

The December 1992 proposed amendment to subsection 6(2.2) of the Act should not be applied since the Department of Finance proposed to repeal that subsection in the draft legislation issued in August 1993. However, new proposed paragraphs 6(1)(k) and (l), containing similar rules, would apply, if enacted, to the 1993 and subsequent taxation years.

The Department will administer proposed paragraphs 6(1)(k) and (l) as if they were enacted. Therefore, benefits and tax withholding should be computed on the basis of 12 cents per kilometre to avoid having to file amended T4 Slips.

NISA Fund No. 2 on Death

Question 38

It has been suggested that an amount in a taxpayer's NISA Fund No. 2 on hand at the time of his/her death will be a right or thing. What is the Department's view in this regard?

Department's Position

The Department does not agree with the suggestion that an amount in a NISA Fund No. 2 is a right or thing to which subsection 70(2) or (3) of the Act may apply.

In particular, subsection 70(2) applies where a taxpayer has at the time of death rights or things "the amount of which when realized or disposed of would have been included in computing his income" (with the "value thereof at the time of death" being included in computing the taxpayer's terminal return of income). In this regard, subsection 70(5.4) states that:

"Where a taxpayer who dies has at the time of death a net income stabilization account, all amounts held for or on behalf of the taxpayer in the taxpayer's NISA Fund No. 2 shall be deemed to have been paid out of that fund to the taxpayer immediately before that time.

Given that all amounts held in a deceased taxpayer's NISA Fund No. 2 at the time of death are considered to have been paid to the taxpayer immediately before death, (pursuant to subsection 12(10.21)) they are to be included in the deceased taxpayer's income before death and are not amounts that would have been included in the taxpayer's income if the NISA Fund No. 2 had been subsequently realized or disposed of.

Finally, it should be noted that subsection 70(6.1) provides for a rollover of the amount in a deceased taxpayer's NISA Fund No. 2 where the net income stabilization account is transferred, as a consequence of the taxpayer's death, to a spouse or qualifying spousal trust. Given that subsection 70(6.1) is specific with respect to whom a rollover of a NISA Fund No. 2 may be effected, subsections 70(2) and (3) do not apply in this regard.

Capital Gains - Change in Value Prior to Closing

File 932798

Question 39

If a person enters into an agreement of purchase and sale (or an option) with a person with whom he was not dealing at arm's length on fair market value terms and the fair market value of the property on closing is greater than the value on the agreement date, would the Department apply paragraph 69(1)(b) of the Act to the vendor to increase the proceeds to fair market value at the time of disposition? Similarly, if the fair market value of the property at the time of disposition was less than the purchase price, would the Department apply paragraph 69(1)(a) to reduce the adjusted cost base of the purchaser?

Department's Position

As a general rule, subsection 69(1) applies to all acquisitions and dispositions of property between persons who do not deal at arm's length. In the above situation, the Department would readjust the proceeds of disposition or the purchase price of property, as the case may be, in accordance with subsection 69(1). However, as set out in paragraph 5 of IT-405:

"where it can be shown that the transfer of property occurred at an amount other that the fair market value by reason of an honest error and not by a deliberate attempt to evade or avoid tax, the Department may permit an adjustment in the amount of the proceeds of disposition or purchase price to reflect the amounts deemed by paragraph 69(1)(a) or 69(1)(b) to have been paid or received. The onus will be on either or both taxpayers, as the case may be, to substantiate a claim that the incorrect valuation was caused by an honest error."

Partnerships - Deemed Disposition

File 932766

Question 40

In light of the recent decision by the Federal Court of Appeal in Stursberg v The Queen, 93 DTC 5271, will the Department take the position that a partner in a professional partnership, such as a legal or accounting partnership, will be considered to have disposed of an interest in the partnership where the net effect is that there is no change in the capital of the partnership because the amount of capital withdrawn is equal to the amount of capital injected? This could occur in either of the following circumstances:

(a)A new partner or partners are admitted to the partnership and the new partner(s) make capital contributions to the partnership which, in the aggregate, are equal to the amount of capital withdrawn by individuals who cease to be partners.

(b)No new partners join or leave the partnership. However, the allocation of profits is altered and, consequently, some partners are required to make additional contributions to the partnership which, in the aggregate, equal the capital withdrawn by other partners.

Department's Position

It is not possible to provide general guidance on areas of potential application of the Stursberg decision as it is the facts of a particular case which will determine whether certain provisions of the Act apply. However, provided the applicable provincial laws and the partnership agreement maintain the continuation of the partnership on the admission or withdrawal of a partner, the Department would not need to rely on the reasoning in Stursberg with respect to the first scenario described. In this particular scenario, the persons who cease to be partners will dispose of their interest in the partnership. Assuming that the provisions of section 98.1 of the Act do not apply, the disposition will be subject to the rules found in paragraphs 54(c) and (h) and section 100.

In the circumstances described in the second scenario where the new allocation of profits results in an increase in the partnership interest of some partners and a corresponding reduction therein of other partners, the Department would apply the reasoning found in Stursberg in which the Federal Court of Appeal concluded that the appellant had disposed of part of his partnership interest within the meaning of paragraph 54(c).

Department's Position (cont'd)

In a partnership where there is a high frequency of partners joining and leaving the firm, we would not expect to apply the reasoning found in Stursberg. However, in light of the Stursberg decision, we are reviewing the comments in paragraph 3 of Interpretation Bulletin 338R.

Reserves - Availability

File 932813

Question 41

In many cases, the terms of a "take-back" note or mortgage may be changed, for example, to extend the due date and change the note from interest-bearing to interest-free. It is understood that the Department's policy under such circumstances, per Interpretation Bulletin IT-448, paragraph 7, is that these changes are considered to be so fundamental to the holder's economic interest in the property that they almost invariably precipitate a disposition of the promissory note or mortgage. Does this necessarily mean that any reserve otherwise available under subparagraph 40(1)(a)(iii) of the Act would no longer be available? If not, under what circumstances would the reserve continue?

Department's Position

Pursuant to subparagraph 40(1)(a)(iii), a taxpayer is entitled to a reserve related to proceeds of disposition that are not due until after the end of the taxation year.

If there is extinction of the debt in law, the vendor is considered to have accepted the new debt obligation as "absolute payment" of the old debt obligation and would thus be denied a reserve under subparagraph 40(1)(a)(iii) after that date because there is no longer anything due to the vendor from the purchaser in the original transaction.

On the other hand, if the note or mortgage is modified without being extinguished in law within the time limits set out in subparagraph 40(1)(a)(iii), a reserve will continue to be available to the vendor.

It should be noted that the Department is currently reviewing its position expressed in paragraph 7 of IT-448.

Proceeds of Disposition

File 932799

Question 42

Pursuant to subparagraphs 13(21)(d) and 54(h) of the Act, the proceeds of disposition in respect of depreciable and capital properties (respectively) includes the amount by which the liability of a taxpayer to a mortgagee is reduced as a result of the sale of the mortgaged property under the provision of a mortgage. Both of these provisions specifically refer to mortgages. What is the Department's position where a similar provision is contained in other types of security arrangements, e.g., a General Security Agreement?

Department's Position

Although subparagraphs 13(21)(d)(vii) and 54(h)(vii) refer specifically to mortgages and not to other types of security arrangements, as is indicated in paragraph 2 of IT-220R2, these provisions are not all-inclusive and do not exclude the possibility that there may be other forms of proceeds of disposition. Accordingly, if a security arrangement contains provisions regarding the power to sell property that are similar to those found in mortgages, the Department will treat the reduction in the liability of the taxpayer to the creditor in the same fashion as the above-mentioned subparagraphs treat such a reduction under a mortgage.

Mortgage Foreclosures and
Conditional Sales Repossessions

File: 932814

Question 43

Paragraph 79(f) of the Act deems the cost to the creditor of property acquired or reacquired to be the amount by which the cost of the creditor's claim exceeds the reserve, if any, claimed or deducted pursuant to subparagraphs 40(1)(a)(iii), 44(1)(e)(iii) or paragraph 20(1)(n) in the immediately preceding taxation year.

Where the creditor acquires or reacquires different types of property, say depreciable capital property, inventory and accounts receivable, there is no specific method for allocating the deemed cost between the different types of property.

(a)Does the Department have a position as to what method should be used for allocating the deemed cost between the different types of property?

(b)Would the same method of allocation apply for purposes of paragraph 79(c) in allocating the proceeds of disposition to the debtor among the different types of property disposed of?

Department's Position

It would be inappropriate to adopt a standard method for allocating the deemed cost or proceeds of disposition as the facts of a particular situation should normally dictate what base is more appropriate in the circumstances. However, the fair market value of the properties at the time of acquisition by the creditor would generally be an acceptable method of allocating the deemed cost and the proceeds of disposition.

Part IV Tax

Question 44

Assume two Canadian-controlled private corporations have December 31 year-ends and one owns all the shares of the other. The subsidiary earns investment income in year 1, giving rise to Part IV refundable tax. In year 1, the subsidiary pays a taxable dividend to the parent and recovers all the refundable tax, and the parent pays Part IV tax to the extent of the dividend refund of the subsidiary. In year 2, the subsidiary incurs a non-capital loss sufficient to offset its taxable income in year 1, by way of carry-back. If the subsidiary files an amended return for year 1, carries the loss back from year 2 and eliminates its taxable income and thus its refundable dividend tax on hand, it loses its entitlement to a dividend refund. However, the parent will have received a dividend upon which it will have been subject to Part IV tax.

Will the Department reassess the parent for year 1 and refund the Part IV tax paid in respect of a dividend which ultimately did not produce a dividend refund to the subsidiary?

Department's Position

In accordance with paragraph 186(1)(b) of the Act, the Part IV tax payable by the parent corporation on dividends received from its subsidiary is equal to the dividend refund received by the latter on the payment of such dividend.

The Department is prepared to consider requests for refunds of Part IV tax paid by the parent for the year in which it received the dividend provided that the parent requests such refund in writing, its taxation year is not statute-barred, and at the time of the request the parent has refundable dividend tax on hand in an amount equal to the Part IV tax payable in respect of the dividend received from the subsidiary.

Small Business Corporation - Loans

File 932779

Question 45

In determining whether the shares of a Canadian company are eligible for the enhanced capital gains deduction for qualified small business corporation shares, it is necessary to consider the definition of a small business corporation in section 248 of the Act. To meet this definition, it must be determined that the assets of the company are used primarily in an active business carried on primarily in Canada. Would the following loans receivable qualify as assets used in an active business?

(a)Loans to employees to acquire shares, a house or automobile, as described in subparagraphs 15(2)(a)(ii) through (iv).

(b)Loans to employees who are also shareholders unrelated to the corporation, for the same purpose as in (a).

(c)Loans to employees who are also shareholders related to the corporation, for the same purpose as in (a).

Department's Position

Generally, loans to employees who are not shareholders of the corporation, to acquire shares, a house or an automobile, would be considered to be assets used in the active business of the corporation.

Loans to employees who are also shareholders of the corporation, made under the same terms and conditions as loans made by the corporation to other employees, would generally be considered to be assets used in the active business of the corporation.

Losses - Section 80

File 932808

Question 46

A group of persons acquired the control of Company A, and the business that gave rise to the losses was not carried on. The non-capital losses were therefore no longer available to be carried forward against future profits. After the acquisition of control, a debt owed by Company A was forgiven.

Even though the non-capital losses are not available to be carried forward against future profits, are they otherwise available in the application of section 80 of the Act on the forgiveness of debt?

Department's Position

Pursuant to paragraph 80(1)(a), non-capital losses for preceding taxation years will not be reduced where they are not deductible in computing the taxpayer's taxable income for the year or a subsequent year. The amount forgiven will be applied to reduce losses that would otherwise be deductible in computing the taxpayer's taxable income for the year or a subsequent year.

Freeze Share Rights

File: 5-932783

Question 47

It is understood that the Department's policy is that shares issued on an estate freeze have voting rights in respect of a change of the rights, conditions or limitations attaching to these shares sufficient to protect those rights.

In some provinces, the corporate law contains significant protection in this respect. For example, section 170 of the Ontario Business Corporations Act allows shareholders who are adversely affected by proposed Articles of Amendment to vote as a class, requiring ratification by special resolutions of each class of share. Further, dissenting shareholders have a right to be paid fair value pursuant to section 185 of that same Act.

Are these provisions sufficient to meet the Department's requirements, so that protective provisions need not be included in the Articles? If not, what further rights or protection should the Articles specify?

Department's Position

The fair market value of the freeze shares should be equal, at the time of the rollover, to the value of the exchanged shares. Otherwise, subsections 51(2) and 86(2), and paragraph 85(1)(e.2) of the Income Tax Act could apply, depending on the way the freeze is carried out. The Department is prepared to accept that the fair market value of freeze shares is equal to the fair market value of the exchanged property, if the freeze shares have certain rights and characteristics. They should be redeemable at the option of the holder for an amount equal to the fair market value of the exchanged property and have priority in the event of a wind-up, liquidation or redemption. Also, the corporation should not be permitted to pay dividends on the other shares in an amount that would reduce the fair market value of the freeze shares below their redemption amount. While there is no requirement that shares be voting under all circumstances, they should at least have voting rights on any matter involving a change to their preference, rights, conditions or limitations attaching to them. These voting rights can be provided by corporate law or in the articles of incorporation.

Consolidation of Profits and Losses in a Corporate Group

File: 932821

Question 48

The Department has published numerous statements, most notably in the context of the general anti-avoidance rule, indicating that loss transfers within a group of related Canadian corporations are acceptable as a matter of policy. Based on these statements, most practitioners would have considered the transactions in Hickman Motors Ltd. v. The Queen, 93 DTC 5040 (FCTD) to have been acceptable in principle. Yet, it would appear that the Department attacked those transactions on a narrow technical ground.

Does the Department follow any particular guidelines in distinguishing loss transfers which are acceptable from those which are not? Can we expect that all such transfers are vulnerable to attack unless they are technically flawless?

Department's Position

The Department is presently studying the impact of the decisions in Hickman Motors and Mark Resources.

Interest Calculation

Question 49

An individual reports a taxable capital gain which is fully offset by the capital gains deduction. Three years later, it is determined that the capital gain should actually have been characterized as income. Consequently, the capital gains deduction is no longer applicable. How would arrears interest be calculated in the following two situations?

(a)The individual requests that non-capital losses from previous years be applied against the income.

(b)The individual requests that a non-capital loss incurred in the year subsequent to the year in question be applied to reduce the income.

Department's Position

(a) Assuming that the non-capital losses are sufficient to completely offset the increase in income, the individual's taxable income will not change. The non-capital losses incurred in previous years will simply offset the increase in income in the same way the capital gains deduction offset the taxable capital gain. Consequently, the tax calculation will not change, and there will be no arrears interest charged on the reassessment.

(b) The individual could not have requested the application of this loss at the time of filing the prior year's return since the existence of the non-capital loss would not have been known until the following year. Rather, the individual would have to request that the prior year's return be reassessed to apply the loss.

Unlike situation (a), situation (b) will have arrears interest implications. Since the loss being applied arose in a year subsequent to the year to which it is being applied, the loss is not available to reduce the taxable income as of the due date of the return. Rather, the tax reduction resulting from the application of the loss is considered to take place, for interest purposes, on the latest of the dates specified in paragraph 161(7)(b) of the Act. Therefore, arrears interest would be charged on the tax increase resulting from the disallowance of the capital gains deduction from the individual's balance due date to the date the loss is considered to have taken place.

Interest Calculation - Instalment Reminders

Question 50

In each of the taxation years 1991 and 1992, an individual's net federal tax payable exceeds $1,000 and more than three-quarters of the net income is subject to tax deductions at source. The individual was required to make quarterly instalments for at least one taxation year prior to 1991. In 1993, the individual has a large capital gain which is eligible for the enhanced capital gains deduction for qualifying small business corporation shares. Consequently, the income subject to tax deductions at source will constitute less than three-quarters of the individual's 1993 net income. The net federal tax payable for 1993 will exceed $1,000. Since instalments were not required for the 1991 and 1992 taxation years, the individual will not be sent instalment reminders during 1993.

If the individual does not remit quarterly instalments during 1993, will instalment interest and penalties be levied when the 1993 return is assessed?

Department's Position

The individual is clearly required to remit instalments for 1993, since both the 1992 and 1993 net federal tax payable exceed $1,000 and less than three-quarters of the 1993 net income is subject to tax deductions at source. The Income Tax Act does permit the levying of instalment interest and, if applicable, an instalment penalty, if the individual does not remit quarterly instalments during 1993. However, since the introduction of the instalment reminder system in March 1992, it has been departmental policy to charge neither instalment interest nor the instalment penalty in situations where instalment reminders were not sent. Therefore, no instalment interest or penalty would be levied in this situation.

Penalties - Non-Resident

Question 51

A non-resident corporation, resident in a treaty jurisdiction, offers goods for sale in Canada but does not have a permanent establishment here. Under the treaty, the non-resident is not subject to tax under Part I in Canada. In such a case, if the non-resident corporation does not file a Canadian tax return, will it be subject to penalties for not filing the return?

Department's Position

A return of income is required to be filed in these circumstances. However, penalties will not be applied provided no tax is payable by the non-resident corporation. The determination of whether a corporation has a permanent establishment in Canada can only be made when all the facts are known. To avoid the application of penalties for failure to file and if it is subsequently determined that the corporation has a permanent establishment in Canada, it is recommended that the corporation file a T2 return and claim the treaty exemption.

Trader or Dealer in Securities

File: 932794

Question 52

Section 39(4) of the Act was intended to allow certain taxpayers to avoid the uncertainty of tax treatment that may arise with respect to certain transactions in securities. In the Vancouver Art Metal Works Ltd. case (93 DTC 5116, FCA), a taxpayer was held to be a "trader or dealer" (and consequently precluded from making a section 39(4) election) even though it was not registered as such for securities law purposes. Taken to the extreme, this case would seem to say that unless a taxpayer can prove his transaction was on account of capital, he is a trader and unable to make such an election. Such an approach would render section 39(4) all but meaningless.

Will the Department indicate how it intends to assess securities transactions where elections are made under section 39(4) by taxpayers not registered as traders or dealers? What guidelines will be used to determine when taxpayers may make an election?

Department's Position

The conclusion in the Vancouver Art Metal Works Ltd. case was that "a taxpayer does not necessarily lose his election rights under subsection 39(4) when he buys and sells securities for his own account. However, he loses such right when he becomes a trader or a dealer, that is to say, when he professionally engages in the business of dealing in securities or when his dealings amount to carrying on a business and can no longer be characterized as investor's transactions or mere adventures or concerns in the nature of trade".

Therefore, in determining whether taxpayers not registered as traders or dealers can avail themselves of subsection 39(4), the Department will determine, based on the facts, whether the taxpayers are carrying on a business. In order to determine whether a taxpayer's course of conduct indicates the carrying on of a business, the Department will consider the factors set out in paragraph 11 of IT-479R.

Clearly, the Department will likely challenge elections by taxpayers with activities similar to those in the Vancouver Art Metal Works Ltd. case. On the other hand, it is unlikely that the Department will challenge a taxpayer's election in relation to isolated transactions.

Mortgage Foreclosures and
Conditional Sales Repossessions

File: 932815

Question 53

For purposes of section 79 of the Act, what are the results to a creditor of an acquisition of property as a consequence of the debtor's failure to pay a debt in circumstances where the property is transferred to the creditor in settlement of a debt and the creditor's adjusted cost base of the debt is lower than the cost to the creditor of that debt (e.g., due to the application of subsection 111(4) on an acquisition of control of the creditor after the loan was made but before the debt was settled)?

Would the creditor not have a gain or loss on the settlement of the debt and would it acquire the property with a cost equal to the cost of the debt at the time of acquisition or reacquisition?

Department's Position

In situations where section 79 applies, the creditor does not have a gain or loss on the settlement of the debt.

Pursuant to paragraph 79(f), it is the cost of the claim for the creditor at the time of the acquisition or reacquisition of property that is considered and not the adjusted cost base of that claim. Where the adjusted cost base of a claim is lower than its cost by reason of the application of subsection 111(4), the results achieved by the application of paragraph 79(f) and subsection 111(4) seem inconsistent. This issue will be referred to the Department of Finance.

Capital Gains Deduction - Gain Not Reported

Question 54

In the context of subsection 110.6(6) of the Act, what is the Department's position on the ability of a taxpayer to claim a capital gains deduction under section 110.6 in circumstances where the taxpayer did not report any gain in its return of income on the reasonably held belief that no gain was realized, which belief has subsequently been proven wrong by a subsequent challenge by the Department?

Department's Position

Paragraph 110.6(6) applies to deny the deduction of a taxable capital gain pursuant to subsections 110.6(2), (2.1) and (3) where a taxpayer, knowingly or under circumstances amounting to gross negligence, fails to report a capital gain. It is a question of fact whether a set of circumstances, under which a taxpayer did not report a capital gain, amounts to gross negligence. The fact that the taxpayer did not report a capital gain where he had reasonable grounds to believe that the disposition of an asset did not result in a capital gain, such as an opinion of a valuator as to the value of the asset, whether the V-Day or current value, would not in and by itself automatically trigger the application of subsection 110.6(6).

Insurance Corporations

Question 55

What is the Department's position on the treatment of gains and losses realized by members of the insurance industry on the disposition of portfolio securities?

Department's Position

As with any other industry, the determination of whether or not the disposition of property by an insurance company is on income or capital account continues to be a question of fact and will be determined on a case by case basis. All relevant facts will be considered and reference made to the tests and guidelines established by the courts.

In an effort to simplify the reporting process of property gains and losses, the Department is working with the CLHIA and the IBC to develop administrative guidelines to assist the industry to self-assess their property gains and losses.

Payments to Dissenting Shareholders in an Amalgamation

File: 932835

Question 56

In response to Question 59 of the 1987 Revenue Canada Round Table, the Department stated that "where a shareholder dissents from ... an amalgamation and receives cash for his shares from the amalgamated corporation, he will realize proceeds of disposition rather than a deemed dividend". Has the Department reconsidered this position in light of the decision of the Federal Court of Appeal in The Queen v. Guaranty Properties Limited et al., 90 DTC 6363, (1990) 2 CTC 94?

Department's Position

The Guaranty Properties case has been considered and is not changing the position stated in the response to Question 59 of the 1987 Round Table. Cash payments received from the amalgamated corporation for shares held by shareholders dissenting from the amalgamation will be proceeds of disposition.

Acquisition of Control - Implications in a Bankruptcy

File: 5-932785

Question 57

An individual makes an assignment in bankruptcy. One of the assets which the individual owns and which is transferred to his Trustee in Bankruptcy is shares of a corporation which has

non-capital losses and carries on an active business. In the course of the individual's bankruptcy, the assets of the corporation are liquidated resulting in further non-capital losses being realized. After the individual's discharge from bankruptcy, the shares of the corporation are re-registered in the individual's name so that a new business can be carried on through the corporation, the income of which would be sheltered by the non-capital losses.

Are the non-capital losses carried forward from pre-bankruptcy years subject to the limitations contained in subsection 111(5) of the Act and are the non-capital losses realized during the period between the assignment in bankruptcy and the discharge from bankruptcy subject to the limitations in subsection 111(5)?

Department's Position

Paragraph 128(2)(a) provides that a trustee in bankruptcy is deemed to be the agent of the bankrupt for all purposes of the Act. Therefore, there will be no change in control of the particular corporation in the above situation when the individual makes an assignment or is discharged from bankruptcy. As a result subsection 111(5) will not apply.

Limited Partnership and QSBC Shares

File: 5-932786

Question 58

Where a corporation has an interest in a limited partnership as one of its assets and the limited partnership is carrying on an active business in Canada, will the Department consider that the corporate partner uses its proportionate share of each asset of the limited partnership for purposes of the definition of a "qualified small business corporation share"?

Department's Position

The Department's position is as stated in paragraph 6 of IT-486R:

"Where a corporation has a partnership interest as one of its assets, it is the underlying partnership assets (to the extent of the corporation's interest therein) that are used in determining whether all or substantially all of the corporation's assets are used in an active business. Provided that these assets are used in an active business carried on primarily in Canada by the partnership, they will qualify."

This position applies for limited partners as well as for general partners.

In the case of the Robinson Trust (93 DTC 1179), it was held that the taxpayer, a limited partner, did not carry on an active business. The Department is appealing this case.

Foreign Affiliates and Trusts

File: 932763

Question 59

Under subsection 113(1) of the Act, where a corporation resident in Canada receives a dividend on a share in the capital stock of one of its foreign affiliates that it owns, certain deductions are available. Where all of the shares of a non-resident corporation are owned by a trust, the sole beneficiary of which is a corporation resident in Canada, will dividends that the non-resident corporation pays to the trust and the trust allocates or distributes to the Canadian resident corporation be eligible for the deductions under subsection 113(1)?

Department's Position

Where the trust is a "bare trust", the corporation resident in Canada would be considered the owner of the shares for purposes of the Act and subsection 113(1) deductions may be available in respect of dividends paid by the non-resident corporation.

Where the trust is not a bare trust, dividends paid by the non-resident corporation to the trust that are then paid by the trust to the Canadian corporation would be received as income from a trust and not dividends. Therefore, subsection 113(1) would not apply.

We were concerned that this produced an unintended result and raised the issue with officials of the Department of Finance. They are sympathetic to the problems that taxpayers may have and will be proposing an amendment to remedy the situation.

Business & Property Income - Paragraph 18(1)(l)

Question 60

What is the Department's current assessing practice in situations similar to Sie Mac Pipeline Contractors Ltd. (93 DTC 5158)? How far will the Department go in disallowing deductions for the use of a camp, lodge, yacht or golf course? Will a meal in the dining room of a golf club be non-deductible? Will green fees be non-deductible? In general, will a payment for short-term use of such a facility be restricted?

If so, this seems inequitable. If a taxpayer holds a seminar in a hotel conference room, the room rental will be fully deductible. If the same seminar is held in a conference room at a fishing lodge, it will be totally non-deductible.

Department's Position

At the 1984 Conference, the Department announced that, where property of a type described in subparagraph 18(1)(l)(i) of the Act is used for business purposes, which purposes do not include the entertainment or recreation of clients, suppliers, shareholders or employees, the Department will not consider that the related expenses, provided they are reasonable, fall within the provisions of paragraph 18(1)(l).

The Department is reviewing this position in light of Sie Mac. Until this review is complete, the Department will follow the 1984 position.