23 October 1997 Internal T.I. 9705367 - DEFERRED REALIZED GAINS & APPROPRIATIONS OF SURPLUS

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:

The treatment of deferred realized gains and losses and appropriations of surplus by insurers.

Position:

They should be included in the capital base.

Reasons:

See attached

	 			October 23, 1997

	TORONTO EAST TAX SERVICES			HEADQUARTERS
				Michèle Trotier
	Attention:  Duncan McKay			(613) 957-8953
	              Insurance Specialist
				970536

Deferred realized gains and losses and Appropriations

This is in reply to your memoranda dated February 21 and March 18, 1997 wherein you requested our views with respect to the treatment of deferred realized gains and losses by resident and non-resident life insurers; and appropriations of participating and non-participating accounts (resident and non-resident mutual insurers) and appropriations of retained earnings (resident and non-resident stock insurers) for purposes of Parts 1.3 and VI of the Income Tax Act ("Act").

First Issue

Deferred realized gains and losses

Life insurers are required by the Office of the Superintendent of Financial Institutions ("OSFI") and other relevant authorities to defer for accounting purposes any realized gains and losses on the disposition of life insurance portfolio investments such as stocks, bonds, mortgages and real estate. It is our understanding that these deferred realized gains and losses are reported on a net basis in the "total liabilities" section on the annual returns prepared for OSFI.

Paragraphs 4210.04-.23 of the Canadian Institute of Chartered Accountants ("CICA") Handbook deal specifically with these deferred gains and losses. Please refer to the attached Appendix for a description of the more relevant paragraphs. The deferred realized gains and losses, pursuant to paragraph 4210.20, should be presented in the balance sheet outside of shareholders' equity. It is our understanding that this is how they are reported on the audited financial statements which are filed with the annual returns prepared for OSFI. We note that mutual life insurers report their equity as "policyholders' equity" since they normally do not have shareholders.

It has been the position of our Directorate that the deferred realized gains would be taken into account in the capital base of an insurer as a surplus or as a reserve. It is our understanding that the Department of Finance ("Finance"), in policy terms, has wanted and continues to want these deferred realized gains and losses taken into account in the computation of the capital of insurers for purposes of Parts 1.3 and VI of the Act. XXXXXXXXXX We note that certain amendments were made to exclude them for purposes of Part VI of the Act.

Surplus is not defined in section 181 of the Act. Surplus is defined in section 3250 of the CICA Handbook as "the excess of net assets over the total paid-in par value or stated value of the shares of the corporation. This usage is firmly established in company law and finance, and is not likely to be discontinued." The ordinary meaning of surplus can be found in the Oxford English Dictionary, 2nd Edition, and is defined as "what remains over and above what has been taken or used; an amount remaining in excess." It is defined in the Oxford Concise Dictionary, 8th Edition, as being "the excess value of a company's assets over the face value of its stock." Surplus is also defined in Black's Law Dictionary, 6th Edition, to mean "residue or excess assets after liabilities, including capital, have been deducted".

Since the insurers have realized and earned the gains we are of the view that they represent surplus to them and as such should be included in their capital base. We note that the deferred realized gains can be reported as "liabilities" for purposes of OSFI, however, they are not legally a liability since no part of these gains have to be repaid. The manner in which they are represented on the annual returns prepared for OSFI is not determinative as to the characterization of the amount reflected in the balance sheet.

The deferred realized gains would be included in the computation of the capital of the insurer as "any other surpluses" pursuant to subparagraph 181.3(3)(b)(ii) of the Act. Subsection 181.3(2) of the Act determines the taxable capital of the insurer which is the capital determined pursuant to subsection 181.3(3) of the Act less the investment allowance determined pursuant to subsection 181.3(4) of the Act. Pursuant to clause 181.3(1)(c)(ii)(A) of the Act only the proportion of the taxable capital that the "Canadian reserve liabilities" of the insurer is of its "total reserve liabilities" as defined in subsection 2405(3) of the Regulations would be included in the computation of the taxable capital employed in Canada of the insurer.

Notwithstanding the decision of the Tax Court of Canada in Oerlikon Aerospatiale Inc. ("Oerlikon") (1997) DTC 694 it continues to be our view that the definition of "reserves" in subsection 181(1) of the Act is broad. It is our understanding that Finance is also of the same view.

We are already on record with respect to our interpretation of the use of the word "reserve" in the Act as stated in paragraph 2 of Interpretation Bulletin IT-215R to the effect that "A "Reserve" in modern accounting practice is an appropriation from retained earnings or other surplus, at the discretion of the taxpayer or pursuant to the requirement of a statute, the instrument of incorporation, bylaws of the company, a trust indenture or otherwise. The term "reserve" as used in the Income Tax Act has a broader meaning than in current accounting terminology and it means more generally an amount "set aside that can be relied upon for future use." We note that the 1991 edition of the Dictionary of Insurance published by The Insurance Institute of Canada defines "reserve" as "Funds which are set aside by an insurance company for the purpose of meeting obligations as they fall due." Please refer to the attached Appendix for more details on the definition of "reserves".

In Oerlikon the Court concluded that "reserves" for purposes of Part 1.3 means reserves, provisions and allowances as determined for generally accepted accounting principles ("GAAP"). The Court also held by way of obiter dicta that "the terminology used in the Act to identify component parts of capital is that used by accountants in preparing the balance sheet". Our position has been thus far that in accordance with subsection 181(3) of the Act the balance sheet is relevant for purposes of determining "amounts" but not the nature of the particular items. If the accounting definition was to be applied then it is arguable that the actuarial liabilities of insurers which are not classified as reserves for accounting purposes may not be included in the capital base. Such a result could not have been intended by the legislator and would also render the measures referring to the book reserves as meaningless since no amount could be brought in for purposes of Part 1.3 tax with respect to these actuarial liabilities.

Given our view that the deferred realized gains can be included both as a surplus and as a reserve it is our interpretation that the effect of subsection 181(4) of the Act is that the amount which results in the highest capital base is to be included. Since subsection 181(4) of the Act provides that an amount cannot be included twice in the capital base of a corporation the result is that only the duplicated amount would be excluded (i.e. the lesser amount). For example if a Canadian multinational insurer has deferred realized gains of $110 for reasons noted above only $100 of deferred realized gains may be required to be included in capital as "any other surplus" while the entire $110 of these deferred realized gains would be included as "reserves". In such a case we are of the view that subsection 181(4) of the Act prevents the $100 from being included twice. Accordingly by default the $110, being the highest amount, would be the only one included in the capital base of the insurer. This is consistent with the treatment of "take or pay" amounts in respect of which it has been our view that both paragraphs 181.2(3)(b) and (c) of the Act are relevant.

We recognize that it may be argued that where two provisions of the Act apply the more specific provision should prevail. In this case, it is our view that there is no clear bias in favour of the characterization of the deferred realized gains either as a surplus or as a reserve. In addition, while it is consistent with the scheme of Part 1.3 of the Act to include the deferred realized gains in taxable capital, given the differing approach used in the calculation of the capital of resident and non-resident insurers there is no indication as to whether the surplus or reserve treatment would be the more appropriate.

We would note that in some cases non-resident insurers will be afforded different treatment that resident insurers. Pursuant to subparagraph 181.3(3)(d)(i) of the Act the greater of the "surplus funds derived from operations" (within the meaning assigned by subsection 138(12) of the Act) and the "attributed surplus for the year" (within the meaning assigned by subsection 2405(3) of the Regulations) is included in the capital of the insurer. Where the "surplus funds derived from operations" is the greater of the two, it is our view that the deferred gains and losses would be recognized in the calculation of the capital of a non-resident insurer pursuant to subparagraph 181.3(3)(d)(i) of the Act since they would be included in the computation of "surplus funds from operations".

Where "attributed surplus for the year" is the greater of the two, we are of the view that deferred realized gains and losses would not be included in "attributed surplus for the year". Subsection 181(2) of the Act provides that the definition of "attributed surplus for the year" is as prescribed. Pursuant to section 8600 of the Regulations "attributed surplus for the year" means the amount of the "attributed surplus for the year" of the corporation as defined in subsection 2405(3) of the Regulations and within this definition deferred realized gains and losses are not included. As a result, deferred realized gains and losses are not included pursuant to subparagraph 181.3(3)(d)(i) of the Act. Consequently, it is our view that the deferred realized gains would be included either as "reserves" pursuant to subparagraph 181.3(3)(d)(iv) of the Act or as "any other surpluses" pursuant to subparagraph 181.3(3)(d)(ii) of the Act. There is no basis in the existing Act to permit a deduction with respect to the deferred realized losses.

Second Issue

Appropriation of surplus by insurers for purposes of Parts 1.3 and VI of the Act.

It is our understanding that appropriation of surplus is particularly important for purposes of Parts 1.3 and VI of the Act for multinational life insurers. It is our understanding that stock life insurers have been appropriating from their retained earnings and mutual life insurers have been doing the same but by appropriating amounts from their participating and non-participating accounts. In the example you submitted to us the appropriated amounts have been referred to as "reserves" in a note to the annual returns prepared for OSFI and included inter alia transitional solvency provisions, negative actuarial liabilities and cash surrender value deficiencies. It was stated in this note that the appropriations were either "pursuant to specific requirements of OSFI, or at the discretion of management to cover other undeterminable risks." In that example the participating and non-participating accounts were not reduced on the balance sheet by these appropriations. You have advised that in the example submitted to us even though there were appropriations reflected in the annual returns prepared for OSFI there were no such appropriations reflected in the audited financial statements of the mutual life insurer including the notes to the financial statements.

The insurers are of the view that they have reduced their retained earnings and the participating and non-participating accounts for purposes of Part 1.3 and VI of the Act. They segregate these appropriations between a Canadian and a foreign component and we were advised that the latter is generally very high in comparison to the former. Consequently, since the insurers consider these appropriations as reserves, only the Canadian component would be included in the capital base as "reserves" since only "reserves for the year...that may reasonably be regarded as having been established in respect of its insurance businesses carried on in Canada" are to be so included. In addition, because of the high foreign component determined by the insurers, they also reduce their "Canadian reserve liabilities" and "total reserve liabilities" ratio by the appropriations that are in respect of life insurance policies. XXXXXXXXXX

It is our view that these appropriations are "reserves" under GAAP. Pursuant to paragraph 3260.01 of the CICA Handbook it is stated that "The use of the term "reserve" should be limited to an amount which, though not required to meet a liability or contingency known or admitted or a decline in value which has already occurred as at the balance sheet date, has been appropriated from retained earnings or other surplus:

a) at the discretion of management, e.g. reserve for future decline in inventory values, reserve for general contingencies, reserve for future plant extension, or

b) pursuant to the requirements of a statute, the instrument of incorporation or by-laws of a company or a trust indenture, or other agreement, e.g. sinking fund reserve, general reserve, preferred stock redemption reserve."

Pursuant to paragraph 3260.02 of the CICA Handbook a reserve is defined for accounting purposes to "... be created or increased only by appropriations of retained earnings or other surplus..." Pursuant to paragraph 3260.04 reserves should be shown as part of shareholders' equity and the source from which they were created, i.e., retained earnings or contributed surplus, should be indicated."

These appropriations appear to us to fit within the CICA Handbook definition of a reserve. Paragraph 3250.07 of the CICA Handbook states that "additional information concerning segregation or availability of items of surplus to reflect contractual or statutory conditions or management policy may be presented by sub-classification under the headings of "Retained earnings" and "Contributed surplus". Such information, when required, often may be presented most conveniently and suitably in notes to the financial statements." It is our understanding that the above appropriations also remain part of the retained earnings and the participating and non-participating accounts of the insurers. As a result, we are of the view that even though they fit within the definition of "reserves" as defined in subsection 181(1) of the Act they nevertheless remain part of the retained earnings and the participating and non-participating accounts and should be reported as "retained earnings" and as "any other surpluses" respectively and this for purposes of Parts 1.3 and VI of the Act. As noted since the deferred realized gains are to be included both as surplus and as a reserve we are of the view that the effect of subsection 181(4) of the Act is that the amount which results in the highest capital base is to be included.

We trust that the above comments will be of assistance. If you require addition information please do not hesitate to call Michèle Trotier at 613-957-3494 or F. Lee Workman at 613-957-3497.

F. Lee Workman
Section Chief
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch

APPENDIX

CICA HANDBOOK

Paragraph 4210.10 of the CICA Handbook states that "Realized gains and losses on fixed-term portfolio investments held by life insurance companies are attributable primarily to changing interest rates. Accordingly, it is appropriate that the realized gains and losses be amortized to future periods as the benefits of the reinvested funds are realized, being reflected as an adjustment of the rates of return for those periods." It is also stated in paragraph 4210.13 of the CICA Handbook that "The Recommendations contained in paragraphs 4210.05 and .08 are based on the assumption that when particular portfolio investments are sold, the proceeds are retained within the portfolio and either reinvested in new investments or held until new investments opportunities arise. Sometimes the proceeds are not retained within the portfolio. This could occur, for example, when a life insurance enterprise withdraws from a particular jurisdiction. In such circumstances, the gains and losses related to the investments sold are being realized because the portfolio is being partially liquidated. It would not be appropriate to defer and amortize these gains and losses; rather they would be recognized in income immediately."

It also states in paragraph 4210.14 that "Simply replacing one type of investment, for example stocks, with another type of investment, such as bonds, would not, by itself, constitute a net disinvestment in a portfolio." It states in paragraph 4210.12 that "Where there is a net disinvestment in a portfolio held by a life insurance enterprise, a proportionate amount of the unamortized gains and losses should be written off and recognized in income immediately."

It is stated in paragraph 4210.20 that "The balance of any deferred realized gains and losses on portfolio investments held by life insurance enterprises should be presented in the balance sheet outside of shareholders' equity." It is then stated in paragraph 4210.21 that "The Recommendations contained in paragraphs 4210.05 and .08 require that realized gains and losses on portfolio investments held by life insurance enterprises be deferred and amortized to income. Because the unamortized balance of deferred realized gains and losses consists of amounts that will be included in the determination of income of future periods, it would be presented in the balance sheet outside of shareholders' equity."

WHAT IS A RESERVE? WHAT IS A SURPLUS?

The term "reserves" is defined in subsection 181(1) of the Act to mean "the amount at the end of the year of all of the corporation's reserves, provisions and allowances (other than allowances in respect of depreciation or depletion) and, for greater certainty, includes any provision in respect of deferred taxes."

It appears that the word "reserve" was previously defined in accounting practice as including three elements as indicated on page 377 of the 1960 decision Crane Ltd V M.N.R. (C.T.C, Ex Ct.) one of which was an appropriation of earned surplus. The Canadian Institute of Chartered Accountants apparently decided to adopt this element as the definition of a "reserve". The other two were elements, referred to therein as the "valuation reserve" and the "liability reserve" were then to be designated as an "allowance" and as a "provision" respectively for accounting purposes.

An allowance was defined on page 377 of this decision as "an estimate of the amount required to compensate for some over-valuation of assets which is known to exist but whose precise incidence or amount cannot be determined at the moment, e.g. estimated bad and doubtful accounts receivable and estimated depreciation of fixed assets. A provision was defined on page 377 of this decision as "an estimate of the amount required to meet some liability which is known to exist but whose precise amount cannot be determined at the moment, e.g. income taxes not yet assessed."

In the 6th Edition of Kohler's Dictionary for Accountants, an allowance is also defined as "a provision or an accumulation of provisions for the loss or decline in worth of an asset...an allowance for bad debts or for depreciation; on a balance sheet allowances appear as a reduction of the asset value to which they are related." A provision is defined as "a charge for an estimated expense or loss or for a shrinkage in the cost of an asset offsetting an addition to a valuation account such as a reserve for or accumulation of depreciation or the accrual of a liability such as an income tax."

In the text Lawyer's Guide to Accounting, 1955, by Harry A. Finney and Richard S. Oldberg, Prentice-Hall, Inc., on page 55 they refer to reserve provisions for bad debts and depreciation and this within the context of the accrual basis of accounting. They also classify reserves as "reserves related to assets; reserves representing liabilities; and reserves representing elements of net worth". This appears to follow what was described in the Crane decision referred to above. They define the net worth reserves as being classified as including "surplus reserves" and "reserves for unrealized appreciation disclosed by appraisals". They define "surplus reserves" as resulting from:" statutory restrictions; contractual restrictions; and voluntary appropriations." The latter one is of special interest when dealing with deferred realized gains and appropriation of surplus since they indicate that even though certain amounts may be appropriated from surplus they nevertheless remain earned surplus.

Words and Phrases, Supplement June 1996 A-Z by Carswell define "reserve fund" as "Such a fund is a very common feature in well managed and prosperous companies of all kinds, and it consists of moneys made or saved as the result of their operations from year to year and not paid out in dividends to their shareholders. Instead of being left as a floating balance at the credit of the profit and loss account, it is transferred to another account and called the rest account or reserve fund or surplus: but, whatever name it may exist, it is simply the company's current surplus of assets over liabilities, treating the paid-up capital as a liability."

Words and Phrases, Volume 7, R-S, by Carswell the word "reserve" can be defined in Federal cases as "In ordinary parlance the word "reserve" signifies something set aside that can be relied upon for future use; and in good accounting practice, since 1954 it has been recognized that it is a misnomer to apply the word to an amount which the taxpayer never anticipated receiving and never received." It also refers to Ontario decisions which defined "reserve" to mean "to hold back; to keep as one's own; to retain."

The Canadian Dictionary of Business and Economics by David Crane defines surplus as "1. What is left over - for example, the excess of government revenue after its expenditures have been made, the remaining value of goods or services after deducting all costs, the remaining crops after the year's food needs have been met. 2. The RETAINED EARNINGS of a corporation. 3. The contributed surplus of a corporation, which arises when a corporation is able to sell new shares above their par or stated value."

The Terminology for Accountants, Fourth Edition, by The Canadian Institute of Chartered Accountants defines surplus as "The excess of assets over liabilities (accumulated surplus), or of revenues over expenditures (surplus for the reporting period), of a public sector or non-profit organization. Converse of deficit."

The Dictionary of Canadian Law, Second Edition, by D. Dukelow published by Carswell defines surplus as "1. The aggregate balances of undivided earnings, statutory reserve and other reserves. Credit Union Acts 2. The excess of assets over liabilities including the reserve of unearned premiums calculated pro rata for the unexpired term of the policies of the company in force. Mutual Insurance Companies Act, R.S.N.S. 1967, c.204, s.25. 3. The surpluses of a corporation and includes any amount by which any property has been valued in excess of its cost."

The Dictionary of Canadian Law, Second Edition, by D. Dukelow published by Carswell defines "reserve" to include " (a) Amounts appropriated from earned surplus at the discretion of management for some purpose other than to meet a liability or contingency known or admitted or a commitment made as at the statement date or a decline in value of an asset that has already occurred; (b) amounts appropriated from earned surplus pursuant to the articles or by-laws of a corporation for some purpose other than to meet a liability or contingency known or admitted or a commitment made as at the statement date or a decline in value of an asset that has already occurred; and (c) amounts appropriated from earned surplus in accordance with the terms of a contract and that can be restored to the earned surplus when the conditions of the contract are fulfilled."