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:

Capitalization of Expenses in the Regulated Natural Gas Transmission and Distribution Industry

Position:

(A) The costs relating to the installation of equipment rented to customers would be current expenses.

(B) The general and administration overhead expenses, which are directly related to the acquisition or construction of fixed assets, would be capitalized for the purposes of the Act.

(C) The general and administration expenses other than those in (B) above would be current expenses.

Reasons:

(A) Given that these costs are regularly incurred in the normal course of the taxpayers' businesses and that they cannot be attributed to the improvement or creation of a capital asset, current-expense treatment provides a more accurate picture of profit.

(B) Because these costs are incurred in order to bring into existence capital assets of the taxpayers, they should be capitalized.

(C) Given that these costs are regularly incurred in the normal course of the taxpayers' businesses and are not incurred principally for the purpose of earning a discrete and identifiable item of revenue, the current-expense treatment provides a more accurate picture of profit.

							September 24, 1998

	Large Business Audit Division		Resource Industries
R. C. Neville				  Section
	Coordinator, Resource Industries	Peter Lee
	Industry Specialist Services		957-8977

	Attention:  Rick Langridge		981256

XXXXXXXXXX
Capitalized Expenses in Regulated Gas Distribution Industry

This is in reply to your memorandum of May 14, 1998. You have requested our comments on whether the two recent Supreme Court of Canada decisions, which rejected the legal matching of the lease inducement expenditures with the future revenues, would affect Audit Directorate's current position in respect of the capitalization of general and administration overhead expenses (the "G&A Overhead") and installation costs of rental hot water tanks (the "Installation Costs") in the regulated natural gas transmission and distribution industry (the "Industry") for the purposes of Income Tax Act (the "Act").

Background

I. XXXXXXXXXX (collectively called the "Taxpayers") are in the business of transmitting and distributing natural gas. Companies in the Industry are guaranteed by their regulatory body a rate of return on their capital investment. Therefore, it is to their benefit to capitalize as much costs and expenses as they can in order to increase their capital investment amounts and hence to generate a greater stream of revenue in the future.

II. Pursuant to the previous presentations to Audit Directorate by the Industry, there are three categories of costs in the G&A Overhead:

A. overhead costs that are directly related to the acquisition or construction of fixed assets. An example of this would be the Engineering Department. These costs are capitalized for both book and tax purposes;

B. overhead that is not determined by specific identification of costs or expenses but by application of a formula that is based on the level of major capital expenditures for a year and total G&A Overhead (effectively capitalized for accounting purposes and deducted on a current basis for income tax purposes). An example would be 20% of the head office finance department costs capitalized for financial statement purposes but expensed for tax purposes; and

C. overhead that is not capitalized for either accounting or tax purposes.

Since 1995, Audit Directorate has taken the position that costs capitalized for rate setting and financial statement purposes should also be capitalized for income tax purposes by analogy to the case of West Kootenay Power and Light Company, 92 DTC 6023 (FCA).

III. Following the decision of the Federal Court of Appeal in The Elias Rogers Company Limited, 73 DTC 5030 (FCA), the Taxpayers expensed the installation costs in respect of rental hot water tanks as one time lost costs for tax purposes. The leases for rental hot water tanks are not for a fixed period, and the rate was not fixed. In 1995, Audit Directorate was of the opinion that subsequent to more recent case law such as West Kootenay Power and Light Company, 92 DTC 6023 (FCA) and Canderel Limited, 95 DTC 5101 (FCA), these costs should be capitalized.

IV. The Taxpayers entered into an agreement with Audit Directorate dated XXXXXXXXXX (the "Agreement") with respect to the computation of income of the Taxpayers for purposes of the Act on the following basis:

1. Beginning with the taxation year ended XXXXXXXXXX , the following costs, to the extent they have been capitalized for regulatory rate-setting and financial statement purposes, will be capitalized for tax purposes. This will require the inclusion of the cost into the cost amount of the property.

1. General and administrative overhead excluding costs specifically permitted as current deductions by the Act;

2. Costs relating to vehicles used jointly on capital and non-capital activities;

3. Costs relating to the installation of equipment rented to customers; and

4. Costs relating to the replacement of capital facilities. Costs related solely to abandonment will continue to be deductible in the year incurred.

V. The Agreement also includes the following provision with respect to change of law (the "Change-of-Law Provision"):

Provided however, that if the computation of income on the basis described above is inconsistent with the decision of a Canadian court rendered after the date hereof, XXXXXXXXXX will not be precluded by reason of this agreement from computing or adjusting their income as the case may be in accordance with such decision beginning with the first taxation year for which a tax return is not due under the Act at the time the decision is first rendered. Returns for such taxation years will not be filed on the revised basis and the year(s) will be kept open with waivers until the expiration of all appeals of the decision permitted by law.

VI. The representative of the Taxpayers stated in the letter to Audit Directorate dated April 27, 1998 as follows:

... XXXXXXXXXX ...

Your Views

VII. In light of the Supreme Court of Canada decision in the case of Canderel Limited, it is your view that the Installation Costs should be allowed as current expenses for tax purposes. With respect to the issue of capitalizing G&A Overhead, given that these costs are used to establish a future revenue stream, it is your view that they should be capitalized for tax purposes because capitalizing these costs would present a more accurate profit picture for tax purposes.

Our Comments

VIII. In the case of Canderel Limited, on behalf of the Supreme Court of Canada, Iacobucci, J. summarized the principles in respect of the computation of income/profit for the purposes of section 9 of the Act at page 6110 as follows:

(1) The determination of profit is a question of law.

(2) The profit of a business for a taxation year is to be determined by setting against the revenue from the business for that year the expenses incurred in earning said income: M.N.R. v. Irwin, supra, Associated Investors, supra.

(3) In seeking to ascertain profit, the goal is to obtain an accurate picture of the taxpayer's profit for the given year.

(4) In ascertaining profit, the taxpayer is free to adopt any method which is not inconsistent with

(a) the provisions of the Income Tax Act;

(b) established case law principles or rules of law; and

(c) well-accepted business principles.

(5) Well-accepted business principles, which include but are not limited to the formal codification found in G.A.A.P., are not rules of law but interpretive aids. To the extent that they may influence the calculation of income, they will do so only on a case-by-case basis, depending on the facts of the taxpayer's financial situation.

(6) On reassessment, once the taxpayer has shown that he has provided an accurate picture of income for the year, which is consistent with the Act, the case law, and well-accepted business principles, the onus shifts to the Minister to show either that the figure provided does not represent an accurate picture, or that another method of computation would provide a more accurate picture.

9. In this case, Iacobucci, J. explained why well-accepted business principles must necessarily take a subordinate position relative to the legal rules which govern, at pages 6106 and 6108 as follows:

The reason for this is simple: generally speaking, well-accepted business principles will have their roots in the methodology of financial accounting, which, as was expressed in Symes, is motivated by factors fundamentally different from taxation. Moreover, financial accounting is usually concerned with providing a comparative picture of profit from year to year, and therefore strives for methodological consistency for the benefit of the audience for whom the financial statements are prepared: shareholders, investors, lenders, regulators, etc. Tax computation, on the other hand, is solely concerned with achieving an accurate picture of income for each individual taxation year for the benefit of the taxpayer and the tax collector. Depending on the taxpayer's commercial activity during a particular year, the methodology used to calculate profit for tax purposes may be substantially different from that employed in the previous year, which in turn may be different from that which was employed the year before. Therefore, while financial accounting may, as a matter of fact, constitute an accurate determination of profit for some purposes, its application to the legal question of profit is inherently limited. Caution must be exercised when applying accounting principles to legal questions...

Rather than trying to discern into which pigeonhole a particular income expenditure falls, the taxpayer's focus should be on attempting to portray his or her income in the manner which best reflects his or her true financial position for the year, that is, which gives an "accurate picture" of profit. To do otherwise is to lose sight of the taxation forest for the practice or principle trees. In other words, the competing concepts of running expenses and matching which appear to be at play in this appeal fall into the category of well-accepted business principles, no more, no less. They are simply important interpretive aids which may assist, but are not determinative, in the illumination an accurate picture of the taxpayer's income.

10. In this case at page 6109, Iacobucci, J. clarified his comments in respect of matching receipts with expenditures in the case of Friesen, 95 DTC 5551 (SCC), as follows:

In circumstances where an expenditure is incurred principally for the specific purpose of earning a discrete and identifiable item of revenue, it will generally yield a more accurate picture of profit to deduct that expenditure from taxable income in the year in which the revenue is realized. However, it will always be a matter of debate, in light of well-accepted business principles, whether a particular expenditure was in fact made principally for this purpose, and whether it is possible or appropriate to "match" the expenditure against some specific revenue, either current or future. Nothing in my remarks in Friesen serves to cast doubt upon this fundamental premise.

11. Based upon the above-noted principles and the fact that the tenant inducement payments related to both the future benefits (generating leasing revenue) and the immediate benefits (satisfaction of interim financing requirements and maintenance of market position and reputation) and that there was no specific legal formula for the apportionment of the expenses among the various benefits, Iacobucci, J. concluded in this case at page 6112 as follows:

I do not see how, under these circumstances, it is possible with any accuracy to amortize the payments over the term of the lease, in the absence of an established formula acceptable for tax purposes... It follows, then, that the TIPs were not referable to any particular items of income, i.e., they cannot be correlated directly, or at least not principally, with the rents generated by the leases which they induced. They therefore qualify as running expenses to which matching principle does not apply: see Oxford Shopping Centres, supra... While the matching principle will certainly be useful in some cases, its specific application in the present case is unnecessary, as the payments related at least partially to benefits realized entirely in the year incurred, and the taxpayer therefore should not be constrained to amortize. The method employed by Canderel was consistent both with the law and with well-accepted business principles, and gave at least as accurate a picture of the taxpayer's income as would the amortization method.

12. With respect to the Installation Costs in the case at hand, based upon the above-noted principles of interpretation and given the fact that these costs are regularly incurred in the normal course of the Taxpayers' businesses and that they cannot be attributed to the improvement or creation of a capital asset (by analogy, see the cases of Elias Rogers Company Limited and Johns-Manville Canada Inc., 85 DTC 5373 (SCC)), it is our view that the Installation Costs would be current expenses to the Taxpayers for the purposes of section 9 and paragraph 18(1)(b) of the Act. This is the case notwithstanding that these costs are capitalized in accordance with the well-accepted business principles for the Industry regulatory and financial statement purposes, because such business principles must be subordinated to this rule of law governing the matter which provides the more accurate profit picture of the Taxpayers for tax purposes.

With respect to the G&A Overhead other than those described in 2(a) above, it is our understanding that these overhead costs include marketing charges, financing expenses, general expenses related to client billing, office administration expenses, and related fringe benefits. Based upon the above-noted principles of interpretation and given the fact that these costs are regularly incurred in the normal course of the Taxpayers' businesses, that they cannot be attributed to the improvement or creation of a capital asset, and that they are not referable to any particular items of income (i.e., they cannot be correlated directly nor principally with any discrete and identifiable items of revenue, even though capitalization of these costs would lead to greater future revenue stream due to the regulated rate-setting mechanism), it is our view that these costs would be current expenses to the Taxpayers for the purposes of section 9 and paragraph 18(1)(b) of the Act. This is the case irrespective of whether or not capitalizing these costs presents the more accurate profit picture of the Taxpayers for the Industry regulatory and financial statement purposes, because capitalizing these costs does not necessarily present a more accurate profit picture of the Taxpayers for tax purposes (see the comments referred to in 9 to 11 above). Furthermore, it is our understanding that under well-accepted business principles in respect of the industries other than the Industry, general and administration overhead expenses are generally deductible in computing income for tax purposes. Accordingly, the Taxpayers could claim these costs as expenses for tax purposes pursuant to the principles (4) and (6) in 8 above as long as it is not inconsistent with the rules of law and any provisions of the Act. (By analogy, see the case of Albert D. Friedberg, 93 DTC 5507 (SCC).) As discussed in the above, there appears to be no such inconsistency in the case at hand.

With respect to the G&A Overhead described in 2(a) above, because these costs are incurred in order to bring into existence capital assets of the Taxpayers, they would be capitalized as capital costs of the Taxpayers for tax purposes. (See the cases referred to in 11 above and the case of Consumers' Gas Company Ltd., 84 DTC 6058 (FCA), wherein the Court agreed with the House of Lord's comments in the case of Birmingham Corp. v. Barnes [1935] A.C. 292 - "the actual cost to" a taxpayer of depreciable property is equal to the amount paid by the taxpayer.)

13. We note that the Taxpayers would like to treat the costs referred to in 4 above under 1(i) to (iv) as the current expenses of the Taxpayers for tax purposes pursuant to the Change-of-Law Provision of the Agreement. However, this memorandum only addresses the issues relating to 1(i) and (iii) as requested.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version or they may request a severed copy using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Jackie Page at (613)957-0682. The severed copy will be sent to you for delivery to the client.

If you have any further queries in respect the above, please contact the writer.

Manager
Resource Industries Section
Resources, Partnerships and
Trusts Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch