23 March 1992 Internal T.I. 9205027 F - Valuation of Securities

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.

Industry Specialist Services Financial Industries Division

Attention:  Blair Chisholm

XXXXXXXXXX

Valuation of Securities

We are responding to your memorandum of February 19, 1992, concerning a letter from XXXXXXXXXX The letter addressed a memorandum previously written by this group regarding the valuation of securities held by a financial institution as inventory. We have had an opportunity to review the letter and are of the opinion that nothing therein causes us to change our initial position. We would, however, comment as follows on the arguments put forth in XXXXXXXXXX letter.

1.     We agree with XXXXXXXXXX observation that the accounting principles set forth in chapter 3030 of the CICA Handbook were not designed to address the situation where securities and similar instruments are held in inventory, nor, arguably, was subsection 10(1) of the Income Tax Act ("the Act"). However, in our view, if a taxpayer chooses to characterize its securities as inventory for the Act, the taxpayer must also accept the legal and accounting principles applicable to inventory.

While securities may be purchased at a premium or a discount, if those securities are characterized as inventory for tax purposes, we are of the view that cost is the laid out cost and the premium or discount would only be relevant to the extent that it is a factor in the determination of the purchase price. In the present situation, any premium or discount incurred or received by the taxpayer would be considered to be an adjustment to the purchase price of the securities and calculated as such. So, for example, a security with a face value of $100 purchased for $90 would have a purchase price or cost of $90. The discount or premium is reflected in the purchase price.

2.     We also agree that it is incorrect to establish a relationship between income and the cost of an inventory asset. It follows, in our view, that an amount that is required to be included in income for tax purposes (the subsection 12(9) of the Act interest accrual) should not have, and does not have, any effect on the cost of an inventory asset.

3.     Accordingly, we are unable to agree that an interest/discount receivable will alter the cost of the security subsequent to the purchase thereof or that the interest/discount receivable in itself constitutes an inventory asset, the cost of which will equal the income reported on the income statement. The discount is not an asset that is severable from the security and, in any event, does not have a cost.

4.     With respect to the possibility of double taxation, it is our position that the accrued interest included in income pursuant to subsection 12(3) of the Act constitutes a receivable of the taxpayer. A portion of the sales price would be in satisfaction of such receivable with the balance representing proceeds of disposition against which the cost of the security would be charged. If the security is held to maturity, the balance would represent interest income with the result that the proceeds of disposition would equal cost. We have included a simplistic example in the Appendix to this memorandum to illustrate this point.

5.     We agree that not adding the discount/interest receivable to the cost of the securities may well have the effect of not recognizing a loss incurred on the adjustment of the yield of a security as a result of market fluctuations. However, the "lower of cost or market" formula in subsection 10(1) of the Act permits the recognition of a loss where the fair market value falls below cost. Accordingly, an adjustment pursuant to subsection 10(1) of the Act will only result where market fluctuations result in a fair market value that is less than cost. In this regard, we do not see any merit to an argument that subsection 10(1) of the Act should be available to reduce the amount of interest required to be included in computing a taxpayer's income pursuant to subsection 12(3) of the Act. Rather, its purpose is to allow for a deduction for an impairment to cost.

6.     With respect to the taxpayer's comments concerning dispositions on the final day of the fiscal year and the reacquisition of identical securities shortly thereafter, we would note that this is exactly the type of situation that subsection 18(13) of the Act is intended to apply to. In such circumstances any loss would be deferred.

7.     As to the suggestion that if the interest or discount receivable that has been reported in respect of a security is not includable in the cost of that security, then an equal amount should be excluded from the fair market value of that security, we are of the view that this would not result in the fair market value of the security, being the value the security could sell for on the open market. While we appreciate that the interest/discount receivable is a component of the fair market value of the security, there does not appear to be any reasonable basis for the "creation" of two properties out of one. A security acquired for $90, with a term of two years and a face value of $100 would be saleable for $95 at the end of year one, assuming no market fluctuations. If the interest/discount receivable of $5 was to be excluded from the fair market value calculation, the "fair market value" would not represent fair market value. In our view, fair market value of the security is determined with respect to the yield which leaves no reasonable basis for treating the discount/interest as a separate inventory property or excluding any amount in respect thereof from the fair market value of the security.

8.     The earlier memorandum did not suggest that "capitalized" costs should be added to the "cost" of an asset in inventory. It was stated that manufactured assets may include a portion of the overhead in "cost" in certain circumstances. However, a security is not a manufactured item and cannot be compared to one in arriving at the most accurate method of determining cost. Moreover, we do not consider the interest/discount receivable to be a "capitalized" cost.

9.     In summary, we are confirming our earlier opinion that the cost of a security is the amount paid therefore and such cost is not adjusted for the amounts of interest/discount which is accrued and included in income for tax purposes, Furthermore, in our view, the position which the taxpayer proposes effectively results in subsection 10(1) of the Act providing a reserve or deduction against interest which is required to be included in income. Clearly, this would not be appropriate and is not what subsection 10(1) of the Act is intended for. Finally, we have reconsidered the matter as a consequence of the taxpayer's suggestion that our position would result in double taxation and do not believe this to be the case.

We trust the foregoing comments are of some assistance.

for DirectorFinancial Industries DivisionRulings Directorate Appendix

Assumptions:

-     two year treasury bill with a face amount of $100 is purchased for $90 - interest to be accrued and included in income pursuant to subsection 12(3) in each of years 1 and 2 is $5 - market price of the treasury bill at the end of year 1 is $93 - $100 is received at the maturity of the treasury bill in year 2 - taxpayer values its inventory at the lower of cost or market

Income Tax Implications:

-     cost of the treasury bill is $90 - amount included in income in year 1 is $5 - no adjustment under subsection 10(1) in year 1 as cost ($90) is below market ($93) - the $100 received upon maturity is allocated as follows:

$5 accrued interest receivable (no income effect) $5 interest income (included in income under paragraph 12(1)(c)) $90 proceeds of disposition (equals cost of $90)

-     if the treasury bill was sold early in year 2 for $93, the income tax implications would be as follows:

$3 accrued interest receivable (no income effect) $2 deduction pursuant to subsection 20(21) $90 proceeds of disposition