17 July 1996 External T.I. 9615465 - TAX IMPLICATIONS OF CICA 3860

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:

1.Whether high-low preferred shares issued in the course of an estate freeze would be treated as capital stock or as debt for Part I.3 purposes in light of section 3860 of the CICA handbook? If they are treated as debt, which paragraph of the definition of "capital" in subsection 181.1(3) would they fall into?

2.If the preferred shares are treated as capital stock, would the amount added to capital under paragraph 181.1(3)(a) be the stated capital of the shares or the redemption amount as shown on the balance sheet?

3.If the corporation adopts an alternate presentation that shows the difference between the redemption value and the stated capital as a separate, negative component of shareholders' deficiency described as "Provision for redemption of preferred shares," would the provision be deductible in calculating the corporation's capital? If so, would the net of the provision and retained earnings be deducted as a deficit under paragraph 181.2(3)(i)?

4.Whether handbook section 3860 would affect the determination of capital for Part VI purposes?

5.Whether the preferred shares would be treated as debt or shares for the purposes of subsection 18(4).

6.If a deficit results from the application of handbook section 3860, can the negative adjustment be excluded in determining the corporation's retained earnings for the purposes of subsection 18(4) or, if the corporation adopts the alternate presentation, must the provision for redemption of preferred shares be deducted?

7.If dividends on preferred shares are deducted as interest expense or financing costs for income statement purposes in accordance with handbook section 3860, are there any circumstances under which that amount would not be added back in reconciling book income with income or loss for tax purposes?

Position:

1.Capital stock.

2.Amount reflected on the balance sheet in accordance with GAAP which appears to be the redemption amount.

3.Not deductible.

4.Generally same implications as for Part I.3.

5.Shares.

6.The negative adjustment is included in computing retained earnings to the extent that the amount of retained earnings is reduced to nil. If the alternate presentation is adopted, the provision for redemption of preferred shares is not deducted in computing retained earnings.

7.Generally, no.

Reasons:

1.Generally, it is the legal form of the financial instrument rather than the accounting treatment that determines its tax treatment.

2.Subsection 181(3) refers to the amounts reflected on the balance sheet using GAAP.

3.The provision for the redemption of preferred shares does not constitute a deficit under paragraph 181.2(3)(i).

4.Same as 1 above. In addition, subsection 190(2) provides that subsections 181(3) and (4) apply to Part VI with modifications.

5.Same as 1 above.

6.GAAP.

7.Unless the Act provides otherwise, the amount of dividends deducted as interest expense has to be added back to income.

									5-961546
XXXXXXXXXX							J. Leigh	

Attention: XXXXXXXXXX

July 17, 1996

Dear Sirs:

Re: Tax Implications of New CICA Handbook Section 3860

This is in reply to your letter dated April 25, 1996 in which you have requested our views with respect to the impact of new section 3860 of the CICA handbook on the determination of capital for purposes of Parts I.3 and VI of the Income Tax Act (the "Act"), the limitation on the deductibility of interest under subsection 18(4) of the Act and the computation of income for tax purposes. In particular, you are concerned with a situation where a corporation issues redeemable or retractable high-low preferred shares in the course of an estate freeze.

Part I.3 (Large Corporations Tax ("LCT"))

Subsection 181(3) of the Act requires that amounts reflected in a corporation's balance sheet, prepared in accordance with generally accepted accounting principles (GAAP), be used to determine the value or amount of the various components that comprise the Part I.3 tax base. The CICA handbook generally represents the accepted authority for the application of GAAP in Canada. New handbook section 3860 sets out requirements for the disclosure and presentation of financial instruments. As you noted, the general thrust of this new section is that a financial instrument, or its component parts, must be classified as a liability or as equity in accordance with the substance, rather than the legal form, of the contractual arrangement.

Your first LCT question relates to the classification of high-low preferred shares for Part I.3 purposes when they are reclassified as debt in accordance with handbook section 3860. For the purposes of Part I.3, it is the Department's position that it is the legal nature of the financial instrument that governs its classification irrespective of its accounting treatment. Accordingly, high-low preferred shares that are reclassified as debt for accounting purposes will continue to be treated as capital stock for Part I.3 purposes.

Your second LCT question concerns the value to be assigned to the high-low preferred shares for Part I.3 purposes. By virtue of subsection 181(3) of the Act, the amount to be included in capital under paragraph 181.2(3)(a) of the Act is the amount reflected on the balance sheet prepared in accordance with GAAP. Handbook section 3860 does not deal with the measurement of financial assets, financial liabilities and equity instruments. However, the Emerging Issues Committee in Abstract EIC-69 (April 8, 1996) concluded that on issuance of high-low preferred shares in a tax planning arrangement the issuer would measure its liability at the current settlement amount and the difference between such amount and the carrying amount of the common shares reacquired would constitute a direct charge to equity. In applying this treatment, it is our view that the amount to be included in computing capital under paragraph 181.2(3)(a) of the Act would be the current settlement amount of the preferred shares, which would generally be their redemption amount.

Your third LCT question relates to the alternate presentation shown on page 6 of the Business Advisor Background in Appendix A of your letter. The presentation discloses the difference between the redemption amount and the stated capital of the high-low preferred shares as a separate, negative component of shareholders' deficiency described as "Provision for the redemption of preferred shares". We understand that as the preferred shares are redeemed in the future, the provision would be reduced by a charge to retained earnings. If a corporation chooses to adopt this alternate presentation, your question is whether the provision for redemption of preferred shares would be deductible in computing the corporation's capital. If the provision is deductible, your next query is whether the net of the provision and retained earnings would be deducted as a deficit under paragraph 181.2(3)(i) of the Act.

Since subsection 181(3) of the Act refers to amounts reflected on the corporation's balance sheet prepared in accordance with GAAP, it must first be determined whether this alternate presentation is consistent with GAAP. Assuming that it is, it must then be determined whether subsection 181.2(3) of the Act permits the provision for redemption of preferred shares to be deductible in computing capital. In this respect, paragraph 181.2(3)(i) provides a deduction in computing a corporation's capital in respect of any deficit deducted in computing its shareholders' equity. The word "deficit" is not defined in the Act. However, it is our understanding that it generally represents negative retained earnings or a loss. In our view, the provision for redemption of preferred shares would not constitute a deficit that would be deductible under paragraph 181.2(3)(i) of the Act.

Part VI (Financial Institutions Capital Tax)

One of your questions concerns the impact of handbook section 3860 on the determination of capital for purposes of Part VI. Consistent with our comments above, capital stock that has been reclassified as a liability for accounting purposes will continue to be regarded as capital stock for purposes of Part VI. Subsection 190(2) of the Act provides that subsection 181(3) and (4) of the Act apply to Part VI with such modifications as the circumstances require. Therefore, it would appear that changes to the carrying amounts of items resulting from the modification of accounting rules may have an effect on the computation of capital for Part VI purposes. Should you have specific concerns in this regard and wish to request a technical interpretation, we would be pleased to consider them.

Subsection 18(4) (Thin capitalization rules)

Your first thin capitalization question relates to the classification of the preferred shares for the purposes of subsection 18(4) of the Act. In our opinion, the preferred shares would be treated as shares for the reasons indicated in our response to your first LCT question.

Your second thin capitalization question is whether the negative adjustment can be excluded in determining the corporation's retained earnings for the purposes of subsection 18(4) of the Act when a deficit results from the application of the new accounting rules. The term "retained earnings" is not defined in the Act. As indicated in paragraph 8 of IT-59R3, Interest on Debts Owing to Specified Non-Residents (Thin Capitalization), GAAP should be followed in determining retained earnings and such amount cannot be a negative figure (deficit). Accordingly, for purposes of subsection 18(4) of the Act, no adjustment can be made to retained earnings reported in the financial statements to compensate or restore any reduction thereto resulting from the application of section 3860.

You also asked whether the provision for redemption of shares should be deducted in computing retained earnings for purposes of subsection 18(4) of the Act when the corporation adopts the alternate presentation. Since retained earnings and the provision are shown as two separate items on the balance sheet, our opinion is that the provision is excluded from the computation of retained earnings for the purposes of subsection 18(4) of the Act.

T2S(1) - Dividends treated as interest expense

Your final question relates to the treatment of dividends on preferred shares that are deducted as interest expense or financing costs for income statement purposes in accordance with new handbook section 3860. It is our position that while the Act does deem payments of dividends on certain financial instruments to be treated differently from their legal form (i.e., certain term preferred shares issued by non-residents), payments of dividends usually derive their income tax consequences from the legal nature of the payments. Accordingly, unless the Act provides otherwise, dividends on preferred shares that are deducted from income for accounting purposes must generally be added back in reconciling book income with income or loss for income tax purposes.

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.

Yours truly,

Chief
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch