5 August 1993 Income Tax Severed Letter 9310907 F - Large Corporation Tax Mutual Fund

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 5, 1993

Attention:  D. Putz  

Section 198-1-1

Tax on Large Corporations - Mutual Fund and Investment Corporations

We are writing in response to your memorandum of April 8, 1993 regarding certain aspects related to the calculation of the amount of Part I.3 tax payable by a mutual fund or investment corporation. We are assuming, for the purposes of this memorandum, that the particular corporations are not "financial institutions" as that term is defined for the purpose of Part I.3 tax in subsection 181(1) of the Income Tax Act (the "Act")

It is our understanding that the difficulty relates to situations in which the particular corporation invests in shares or debt obligations and, at the end of its fiscal period, values any such investments on hand for financial statement purposes at their respective fair market value at that date. Any net change to the fair market value of all of these assets of the corporation is, in the particular case at hand, reflected in the Statement of Operations as the "unrealized appreciation (depreciation) of investments". This account is then aggregated with net retained investment income, net retained profit (loss) from sale of investments and foreign exchange and proceeds from the sale of mutual fund shares less payments on the redemption of mutual fund shares for the year to form "net assets applicable to outstanding shares". This amount (net assets applicable to outstanding shares) is included in the determination of the capital of the corporation for purposes of Part I.3 pursuant to paragraph 181.2(3)(a) of the Act.

The result of the inclusion of the net unrealized appreciation (depreciation) of investments as a component of the capital of the corporation is that both unrealized gains and unrealized losses attributable to changes in the fair market value of investments is included in that calculation.

As you have noted in your memorandum, the Department is generally of the view that the write down of an asset of a corporation will constitute a "reserve", as that term is defined in subsection 181(1) of the Act, of the corporation for purposes of Part I.3 tax to the extent that the write down reflects an impairment in the value of the asset which is other than permanent. In those situations in which the write down reflects a decline in the carrying value of an asset which is other than temporary, it is the view of the Department that no amount would be included in the capital of a corporation for the purpose of Part I.3 tax as a "reserve". These positions are based upon recommendations contained in section 3050 of the Handbook (the "Handbook") of the Canadian Institute of Chartered Accountants (the "CICA") which is considered to be the authority for generally accepted accounting principles in Canada. Generally, these positions are applicable to "long-term investments" as described in that section of the Handbook.

That section of the Handbook, however, also states at paragraph 3050.01(a) that the recommendations contained therein do not apply to "investments held by companies that account for security holdings at market values in accordance with the practice in their industry". Further, Note 1 to August 31, 1990 financial statements for "Summary of Significant Accounting Policies" attached to the financial statements enclosed with your memorandum for the XXXXXXXXXX states that,

"the accounting policies of the Company conform with generally accepted accounting principles appropriate to the mutual fund industry as follows:

a)     Investments are recorded at market value, established by the closing sale price for trading on the Toronto Stock Exchange or the recognized exchange on which the security is traded."

Accordingly, the issue to be resolved in the case at hand is whether the financial statement presentation of the investments of the mutual fund at their respective market quoted values represents generally accepted accounting principles applicable to mutual funds. To the extent that the revaluation of all of the assets of a fund is in accordance with and required by GAAP, as those principles are appliclable to mutual funds, it is our view that such a revaluation would not constitute a reserve for purposes of Part I.3 tax.

Although the Handbook does not provide specific recommendations regarding accounting for investments held by mutual funds or investment corporations, it does note in paragraph 1000.60 of the Handbook that, in those circumstances in which no specific recommendations are given, it is appropriate to use other accounting principles that either,

"(a)      are generally accepted by virtue of their use in similar circumstances by a significant number of entities in Canada; or

(b)     are consistent with the Recommendations in the Handbook and are developed through the exercise of professional judgment, including consultation with other informed accountants where appropriate, and the application of the concepts described in this Section. In exercising professional judgment, established principles for analogous situations dealt with in the Handbook would be taken into account and reference would be made to:

(i)     other relevant matters dealt with in the Handbook;

(ii)     Accounting Guidelines published by the Accounting Standards Committee;

(iii)     Abstracts of Issues Discussed by the CICA Emerging Issues Committee;

(iv)     International Accounting Standards published by the International Accounting Standards Committee;

(v)     standards published by bodies authorized to establish financial accounting standards in other jurisdictions;

(vi)     CICA research studies; and

(vii)     other sources of accounting literature such as textbooks and journals."

With reference to item (vi) above, we would refer you to a research study undertaken by the CICA entitled "Accounting for Portfolio Investments". The study is applicable to all entities defined by the study group as having "portfolio investments" and included among these are investment companies and mutual funds. The following excerpt is taken from the Summary of this study:

"This Study applies to all entities having investments defined by the Study Group as portfolio investments. The following definition should be used for portfolio investments:

Portfolio investments are investments that are intended to fulfil a long-term investment strategy of an enterprise and are generally passive in nature. Portfolio investments include both fixed- term and equity investments, but exclude nonpassive investments such as investments in subsidiaries, joint ventures, partnerships and companies subject to significant influence by the investor.

It should be noted that this definition is narrower than that contained in the CICA Handbook, which defines portfolio investments as "long-term investments that are not investments in subsidiaries, joint ventures, or partnerships, of the reporting enterprise nor investments in companies that are subject to significant influence by the reporting enterprise"."

Further, the summary of the Study continues by noting:

"Portfolio investments should be carried at market value in the balance sheet. This represents the most relevant and neutral information for decision-making purposes."

As part of the Study, the current practice for reporting carrying values was reviewed and it was noted with respect to mutual funds that;

"Portfolio investments (fixed-term and equity) are carried at market. For equity securities, market is usually the sales price on a national securities exchange at the balance sheet date."

With respect to the current practice utilized by mutual funds for financial statement disclosure including the recognition of gains and losses, the Study notes that:

"In addition to a statement of net assets (balance sheet) and an income statement, the following additional financial statements and schedules are normally provided:

-     Statements of changes in net assets. - Statements of changes in investments. - Detailed schedules showing individual portfolio investments, usually disclosing both cost and market.

Realized gains and losses on sales of portfolio investments are included either in the income statement or in the statement of changes in net assets, and in the statement of changes in investments. Changes in accumulated unrealized gains and losses are normally included in the statement of changes in net assets. The accumulated unrealized balance of unrealized gains and losses is sometimes disclosed as a separate item in the shareholders' equity section of the balance sheet."

The copy of the financial statements for XXXXXXXXXX enclosed with your referral appears to conform with the above noted current practices for mutual funds as described in the Study.

We would also note, however, that the Study contains a proviso which states that:

"This Study is one of a series of Research Studies commissioned by the Research Department as part of the CICA's continuing research program. Each study in the series expresses the views of the Study Group or author concerned; the Studies have not been adopted, endorsed, approved, disapproved or otherwise acted upon by the Committee, the governing body or membership of the CICA or any provincial Institute/Ordre."

In September 1991, the CICA Accounting Standards Committee published an exposure draft relating to proposed accounting recommendations for financial instruments. Paragraph .063 of that exposure draft categorizes financial instruments, which, at paragraph .005 includes an equity instrument of another entity, by noting that:

"In general, financial instruments are classified as investing or financing when they are held for the long term, hedging when they are held to offset an exposure to financial risk (regardless of the expected holding period), and operating when they do not fall into one of the other categories."

With specific reference to mutual funds, the exposure draft states at paragraph .071:

"Mutual funds, pension plans and certain other types of entities acquire financial assets principally to maximize periodic investment returns on a portfolio of financial instruments held to achieve the entity's purposes, rather than to hold any instrument for the long term. Accordingly, these entities would classify their financial instruments as operating rather than investing and financing."

With respect to the accounting treatment for assets classified as "operating" the exposure draft recommends at paragraph .094:

"Subsequent to initial recognition and measurement, a financial asset or financial liability resulting from operating activities should be remeasured at each balance sheet date and reported at its fair value."

With respect to gains or losses on such instruments, the exposure draft states at paragraph .095:

"A gain or loss from a change in the fair value of a financial asset or a financial liability resulting from operating activities should be recognized in income as it arises."

We would note that, although an exposure draft is issued primarily to solicit public comment on proposed additions to the Handbook, the recommendations of the draft with respect to mutual funds do not differ substantially from the summary conclusions reached in the previously discussed research study, "Accounting for Portfolio Investments", nor the industry practices described therein.

Accordingly, the accounting practice followed by the particular funds under review by yourself would appear to conform with several of the criteria provided by the Handbook as being appropriate in circumstances in which the Handbook does not provide specific recommendations. In the case at hand, the accounting principles employed;

(i)     are generally accepted by virtue of their use in similar circumstances by a significant number of entities in Canada;

(ii)     are consistent with the recommendations of the above referenced Research Study; and,

(iii)     are consistent with the recommendations in the aforementioned exposure draft.

Based upon the above considerations, it is our view that the accounting methods employed in the present case would, in the absence of any specific recommendation to the contrary in the Handbook, constitute generally accepted accounting principles insofar as a mutual fund is concerned. The result would be that the revaluation, including any write-downs, of all of the investments of the mutual fund in accordance with and as required by GAAP to reflect the market value thereof would not constitute a "reserve" for purposes of Part I.3 of the Act.

We would also note that, for purposes of determining the investment allowance of the corporation pursuant to subsection 181.2(4) of the Act, the value of the various investments of the corporation subsequent to revaluation to reflect fair market value would be used.

We trust that this is the information which you require. Should you require any further information or require clarification of any of our comments, please do not hesitate to contact the writer.

for DirectorFinancial Industries DivisionRulings Directorate