7 September 1995 External T.I. 9502825 - EFFECT OF TAX CREDITS ON SAFE INCOME

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.

Principal Issues:

effect of tax credits in calculation of safe income

Position TAKEN:

if credits are treated as a reduction of taxes payable, then income inclusion needs to be adjusted

Reasons FOR POSITION TAKEN:

consistent with Robertson rules

XXXXXXXXXX

September 7, 1995

Dear XXXXXXXXXX:

I am writing in response to your letters of January 27 and July 31, 1995, and further to our meeting of May 26, 1995, concerning the Department's proposed reassessment of XXXXXXXXXX under subsection 55(2) of the Income Tax Act. At issue is the calculation of the portion of the gain which is attributable to the "income earned or realized" (generally referred to as "safe income on hand") by XXXXXXXXXX.

I have considered your representations on this matter and will provide my comments on the various submissions that you have made to support your view that the proposed reassessment is not in accordance with section 55 of the Act and that in calculating XXXXXXXXXX share of the safe income on hand of XXXXXXXXXX the Department has unfairly applied a new administrative practice retroactively.

Subsection 55(2) applies to a dividend received by a corporation that is deductible under subsection 112(1) if the dividend reduces the portion of the capital gain on a share that could reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971. Although the term "income earned or realized" in the case of a private corporation is deemed to be the amount determined under paragraph 55(5)(c), income earned or realized can only contribute to a gain on shares if it is on hand and available for distribution to shareholders as a dividend. We believe that the concept of safe income on hand is consistent with the statutory provisions.

With respect to your submission that subsection 55(2) was not intended to apply to a situation such as XXXXXXXXXX the wording of subsection 55(2) clearly provides that where the dividend is a deemed dividend under subsection 84(3) of the Act, the recipient is entitled to receive its share of the payer's safe income on hand in the form of a tax-free intercorporate dividend. However, to the extent that the value of the shares at the time of the repurchase was attributable to anything other than the income earned by the corporation, subsection 55(2) would apply to this amount. Whether subsection 55(2) would have been applicable if XXXXXXXXXX had paid regular cash dividends is not relevant in this case since it is well established that a taxpayer's liability for tax must be determined on the basis of what was actually done, not what might have been done. I also understand that XXXXXXXXXX has recognized that subsection 55(2) is applicable to the deemed dividend received by it since it has reported a portion of the dividend as proceeds of disposition in filing its income tax return.

You have also suggested that the Department's administrative policy regarding the calculation of safe income on hand, as expressed in the so-called Robertson Rules,¹ did not provide for the adjustments proposed in the year under review and that the Department is therefore unfairly applying a new administrative policy on a retroactive basis. You believe this is contrary to the Department's practice that a change in interpretation which is adverse to taxpayers will not be applied retroactively.

As noted in your submission, at the time that XXXXXXXXXX repurchased its shares which were held by XXXXXXXXXX none of the published guidelines addressed the manner in which investment tax credits, share purchase tax credits or scientific research tax credits would affect the computation of a corporation's safe income on hand. However, the Department's response to question 8 at the end of the paper presented to the 1988 conference of the Canadian Tax Foundation noted that the

"effect that various tax credits will have on the safe income or safe income on hand of a corporation will depend on the nature of the particular credit involved, how it is claimed, and the facts of a particular case."²

You have also suggested that the papers presented to the 1981 and 1988 conferences of the Canadian Tax Foundation have been viewed by taxpayers and their advisors as a comprehensive set of rules regarding the calculation of safe income on hand. However, the paper presented at the 1988 conference of the Canadian Tax Foundation reiterated that the various papers were never intended to address every possible item which may affect the calculation of safe income on hand, but represented general guidelines which were provided to assist taxpayers and their advisors in the computation of a corporation's safe income on hand.³ In addition, the 1981 paper stated that "(w)hile this generally covers the simplest situations there are almost always complicating factors. Those we have considered, and for which we have arrived at a conclusion, are as follows: ...".⁴

The manner in which the Department has treated the various tax credits in the computation of XXXXXXXXXX safe income on hand is consistent with the approach it was taking at the time of XXXXXXXXXX share repurchase. Although this treatment may not have been described in any of the published papers, it was described in several technical interpretation letters issued by the Department prior to August 1989. I also believe that the Department's approach is consistent with the general principles set out in the so-called Robertson Rules that "only that portion of the income earned or realized that remains on hand immediately before the dividend can attribute to the gain"⁵ and can be paid out as a tax-free intercorporate dividend.

In view of these factors, I have some difficulty with your suggestion that the Department is retroactively changing its interpretation and should now be precluded from addressing the effect that these tax credits have on the calculation of XXXXXXXXXX safe income on hand.

You have also included as Annex 2 to your July 31 letter a theoretical calculation of safe income on hand which assumes that the investment which gave rise to the tax credit consisted of shares of a subsidiary which were still owned by the corporate taxpayer. Although, we would agree with the conclusion that the shares of the subsidiary continue to have value, it is our understanding that generally the value of the subsidiary's shares would be less than the subscription price paid by an amount equivalent to the tax credit. Also, since safe income on hand is intended to represent a corporation's tax-basis retained earnings, we believe that, for purposes of determining the extent to which income earned or realized is on hand, it is the cost of the asset for tax purposes which is relevant. Consequently, in the example submitted we believe that the increase in net assets of the company would only be $100, comprised of net cash of $50 and shares of the subsidiary having a tax cost and approximate fair market value of $50.

In summary, it is our view, that the manner in which XXXXXXXXXX has computed its safe income on hand is not consistent with the principles set out in the Robertson Rules since it has effectively double-counted the tax credits in computing its safe income on hand. In the situation where a corporation has applied tax credits as a reduction to taxes payable in the computation of its safe income on hand, any amount in respect of the tax credit that has also been included in the corporation's income, for example as a result of reduced capital cost allowance deductions, or any amount which can be considered to have been paid for the tax credit will not be on hand and available for distribution to its shareholders as a dividend. In our view this approach is consistent with the recent decisions in the cases of Nassau Walnut Investments Inc. and Corporation Notre-Dame de Bon-Secours referred to in your submission. Although the decision of the Supreme Court in the Corporation Notre-Dame de Bon-Secours case acknowledged that the rules of statutory interpretation may include a residual presumption in favour of the taxpayer, the following citation from that decision indicates that it significantly limited the circumstances where such presumption should be relied upon: "Two comments should be made to give Estey J.'s observations their full meaning: first, recourse to the presumption in the taxpayer's favour is indicated when a court is compelled to choose between two valid interpretations, and second, this presumption is clearly residual and should play an exceptional part in the interpretation of tax legislation."⁶ I do not believe that an interpretation which has the effect of double-counting tax credits in the computation of safe income on hand can be considered a valid interpretation as envisaged by the Supreme Court.

I trust I have explained the Department's position on this matter.

Yours sincerely,

	Denis Lefebvre
		Interim Assistant Deputy Minister
		Policy and Legislation Branch

T. Harris
(957-2114)
August 25, 1995

ENDNOTES

¹ John R. Robertson, "Capital Gain Strips: A Revenue Canada Perspective on the Provisions of Section 55", in Report of Proceedings of the Thirty-Third Tax Conference, 1981 Conference Report, Canadian Tax Foundation, 81 - 109.

² Robert J.L. Read, "Section 55: A Review of Current Issues," in Report of the Proceedings of the Fortieth Tax Conference, 1988 Conference Report, 18:1 - 28 at 18:27.

³ Supra footnote 2 at 18:3.

⁴ Supra footnote 1 at 88.

⁵ Supra footnote 1 at 83.

⁶ Corporation Notre-Dame de Bon-Secours v. Communauté urbaine de Québec and City of Québec, (1994) 3 S.C.R. 3 at p. 19.