3 August 1990 Internal T.I. 901059 F - Inclusion or Exclusion of Certain Reserves in Determination of Capital of Large Corporation

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.

August 3, 1990

19(1)

Re:  Part I.3 Tax on Large Corporations

We are writing in response to your enquiries regarding the above referenced subject which were originally addressed to the Department of Finance.  Your queries have been forwarded to this department for reply.

With respect to the investment allowance, as defined in proposed subsection 181.2(4) of the Income Tax Act (the "Act"), we would concur with your interpretation that bonds of another corporation do not include bonds of the federal or provincial governments.

A number of your questions concern the extent to which certain reserved are either included or excluded in the determination of the capital of a corporation pursuant to proposed paragraph 181.2(3)(b) of the Act.

Your first question deals with the situation in which the reserve claimed for tax purposes exceeds that claimed for accounting.  Proposed paragraph 181.2(3)(b) of the Act requires that reserves are to be included in the determination of capital except to the extent they were deducted in computing income for Part I tax purposes.  This calculation can never result in a negative amount due to the use of the phrase "except to the extent of" within the particular paragraph.  Consequently the amount of the reserve claimed for tax purposes in excess of the amount claimed for accounting purposes is not reflected in or a component part of the calculation of capital.

You have requested our general opinion regarding differences which arise between tax and accounting with respect to the recognition of income.  These differences generally arise because of the unequal amount of the tax and accounting reserve claimed with respect to the specific income source. The amount of the accounting reserve in excess of the tax reserve will be included in the computation of the capital of the corporation pursuant to proposed paragraph 181.2(3)(b) of the Act.  As noted above, the excess of the tax reserve over the accounting reserve will not reduce the capital otherwise determined.

Your second query relates to differences between accounting and tax amounts which arise due to the timing of an expense and whether such differences would be included in computing the capital of a corporation.  Provided such expense cannot be considered to be reserves for accounting purposes we would agree with your conclusion that such differences should not be adjusted for in the calculation of capital pursuant to proposed subsection 181.2(3).

Your third query relates to differences between accounting and tax amounts which exist because of some contingency.  In general, the examples provided by you relate to amounts claimed for accounting purposes but not for tax purposes. You have also noted that such reserves are commonly not recorded as a reserve separate from retained earnings.  We would consider that, if the amount is a reserve which is not allowed for tax purposes, it is to be included in the determination of the capital of the corporation pursuant to proposed paragraph 161.2(3)(b) of the Act.  If, however, the amount is an accounting expense which is not expensed for tax purpose, then the balance sheet amount of retained earning should be utilized in the determination of capital. For example the unfunded pension liability which you referred to, appears to be a direct accounting expense rather than a reserve and, consequently, no adjustment would be made to retained earnings in calculating the capital of the corporation.  On the other hand a warranty reserve would be included by virtue of proposed paragraph 181.2(3)(b) as no amount of this particular reserve is deductible in computing income for Part I tax purposes.

You have also noted that dividends declared but unpaid are to be included in determining the capital of a corporation, however no relief is provided for the exclusion from retained earnings of accrued dividends.  We would advise that subclause 140(2) of the proposed amendments to the Income Tax Act as published by the Department of Finance in July 1990 provides an amendment to proposed subsection 181.2(4) to include accrued dividends receivable in the calculation of the investment allowance of the corporation.

Your fourth question relates to situations in which the shares of a corporation are acquired followed by a wind-up of the acquired corporation.  Upon the wind-up, the acquiring corporation increases the book value of the assets of the acquired corporation by the difference between the consideration paid for the shares of the acquired corporation and book value of those assets.  The retained earnings of the acquiring corporation will be reduced over time as this addition to the cost of the assets is amortized.  On the assumption that the offsetting credit is made against the account recording the investment in the acquired corporation lie the accounting entry is debt assets/credit investment in subsidiary) it is our view that the restatement of the assets of the acquired corporation in the year of winding-up does not in itself create a reserve for purposes of proposed subsection 181.2(3).

Your fifth question concerns situations in which depreciable assets are acquired pursuant to subsection 85(1) of the Act in exchange for shares of the transferee corporation.  From an accounting perspective, the transaction, are recorded at fair market value rather than the agreed amounts at which the transfers took place for tax purposes.  The purchaser corporation's cost of the assets for book purposes and the share capital issued will be recorded at fair market value. The difference between the cost of the assets for book purposes and the cost for tax purposes will be depreciated when determining accounting income.  Similarly, the vendor corporation will include an amount in income representing the accounting gain on the sale of the assets.  In this type of situation, the transferor of the assets includes the amount which is recorded as a gain in retained earnings, and consequently in the computation of the capital of the corporation.  The amount of the gain will, however also be reflected in the computation of the investment allowance, determined in respect of the shares of the transferee corporation, pursuant to proposed subsection 181.2(4) of the Act.  The effect upon the transferee corporation is that the increase in its issued share capital will be included in the computation of its capital pursuant to proposed paragraph 181.2(3)(a) of the Act.  Such capital will be reduced as the acquired asset is depreciated and charged to retained earnings over time.

Your sixth question is with respect to share issuance costs where such costs are shown for accounting purposes as a reduction to the amount of share capital.  Such amounts are deductible for tax purposes over a five year period pursuant to paragraph 20(1)(e) of the Act.  It is our opinion that, for the purpose of computing the capital of a corporation, the amounts indicated on the corporate balance sheet in respect of share capital and retained earnings, in accordance with generally accepted accounting principles, should be used with no adjustment for the portion of she issuance costs not deducted for tax purposes.

The final question is in regard to regulated industries where amounts are recorded for book purposes by increasing assets and recording an offsetting amount of "fictitious income".  As the assets are depreciated, the amount of the "fictitious income" is similarly reduced.  Neither the income nor  the, asset depreciation is recorded for tax purposes.  It would seem that in the calculation, of the capital of the corporation the retained earnings of the corporation at the particular time should be used with no adjustment for the amount of any of the "fictitious income" remaining in that account.

We would also advise that our opinions are based upon the amendments to the Income Tax Act proposed in Bill C-28 as passed by the House of Commons on December 20, 1989 and those published by the Department of Finance in July 1990. Further, while we trust that our comments are of assistance to you, they do not constitute an advance income tax ruling and are, therefore, not binding upon the Department in respect of a particular situation. We would also caution that our comments are provided with respect to very general situations without the benefit of much detail.  Should you have specific concerns and wish to make representations of a technical nature we would be please to consider them.

Yours truly,

for DirectorFinancial Industries DivisionRulings Directorate