4 June 1996 CICA Roundtable Q. 6, 9619120 - CICA 3860 SHARES RECLASSIFIED AS DEBT

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:

What is the impact of new CICA handbook section 3860 on the Large Corporations Tax (Part I.3), the Financial Institutions Capital Tax (Part VI), the thin capitalization rules and deductibility under Part I?

Position:

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

The carrying value or amount to be used in computing capital for Part I.3 and Part VI purposes and the amount of retained earnings to be used in computing "equity" for purposes of subsection 18(4) is the amount recorded on the balance sheet prepared in accordance with GAAP.

Reasons:Subsections 181(3), 190(2) and 18(4). November 1995 TEI Revenue Canada Round Table (9530990)

JUNE 1996 ONTARIO MANAGEMENT TAX CONFERENCE

Question 6 - GAAP Requirements to Re-Classify Shares as Debt

CICA Handbook Section 3860 contains new rules which require an issuer of a financial instrument to classify the instrument as a liability or as equity in accordance with the substance, rather than the legal form, of the contractual arrangement. The Handbook specifies that the reclassification requirement should be applied for fiscal periods ending December 31, 1996 or later.

For example, preferred shares that are mandatorily redeemable or are retractable at the option of the holder must be classified as debt rather than equity, and be shown at their redemption or retraction amount rather than at their legal stated capital amount (e.g., high-low shares). Dividends and interest on reclassified instruments may also have to be reclassified.

If these accounting reclassifications are respected for income tax purposes it could alter the tax results for a number of purposes including Large Corporations Tax (Part I.3), Financial Institutions Capital Tax (Part VI), the thin capitalization rules and deductibility under Part I.

Has Revenue Canada developed a policy on these new provisions?

Department's Position

The new reporting requirements set out in CICA Handbook Section 3860 are rather extensive and as suggested may have income tax implications that require consideration from a tax policy perspective. To the extent that you encounter such potential concerns they should be submitted to the Department of Finance for consideration. We will similarly refer any such potential policy concerns that we become aware of to the Department of Finance.

With regard to the new reporting requirements as they apply to preferred shares that are mandatorily redeemable, or are redeemable at the option of the holder as stated at the 1995 Tax Executive Institute Revenue Canada Round Table, it is the Department's position that the classification of a particular financial instrument as debt or equity for accounting purposes is generally not determinative of its treatment for income tax purposes since it is the legal form of the particular financial instrument, not its economic substance, that will usually determine its income tax treatment. By the same token payments of interest or dividends will derive their income tax consequences from the legal nature of the payment unless otherwise provided by the Income Tax Act.

Accordingly for purposes of the Tax on Large Corporations (Part I.3) the Department's position with regard to high-low preferred shares that are reclassified as debt for accounting purposes is that they will continue to be treated as equity. By virtue of subsection 181(3) the value to be assigned to these shares for the purpose of computing capital under paragraph 181.2(3)(a) is the amount reflected on the corporation's balance sheet prepared in accordance with generally accepted accounting principles (GAAP). Therefore where the high-low preferred shares are shown on the balance sheet at their redemption or retraction amount in accordance with GAAP, that same amount is to be used for Part I.3 purposes.

Similarly for purposes of the Financial Institutions Capital Tax (Part VI), notwithstanding that shares may be reclassified as debt for accounting purposes they will be regarded as capital stock the amount of which will be the amount recorded on the corporation's balance sheet prepared in accordance with GAAP.

Consistent with the above, for purposes of the thin capitalization rules (subsection 18(4)) the preferred shares would be treated as equity irrespective of their accounting classification. The relevant amount of such shares for purposes of subsection 18(4) is the paid-up capital thereof. The Department's position, as indicated in paragraph 8 of Interpretation Bulletin IT-59R3, is that the amount (positive) of retained earnings recorded on the balance sheet using GAAP is the amount to be used in the calculation of the corporation's "equity" for purposes of subsection 18(4). Accordingly the amount of the retained earnings that is reflected on the balance sheet is used for purposes of subsection 18(4) notwithstanding that retained earnings may have been reduced by the amount of the increase in the carrying value of the preferred shares.

J. Leigh
June 4, 1996