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. Do items which an insurer identifies in a note to its financial statements prepared for OSFI as "appropriated" retained earnings constitute reserves?
2. Do appropriations of retained earnings or surplus remain as part of the retained earnings or surplus?
3. Do appropriations of retained earnings or surplus form part of Canadian reserve liabilities and total reserve liabilities?
Position:
1. No. Even if it could be substantiated that for accounting purposes these items could constitute reserves they constitute retained earnings or surplus.
2. Yes.
3. No.
Reasons:
1. There are no restrictions on the distribution of retained earnings or surplus by OSFI. OSFI does not consider these items to be appropriations of retained earnings or surplus nor to be reserves. Even if such amounts were considered to constitute reserves they remain part of retained earnings.
2. They retain their legal character of retained earnings or surplus.
3. They are not reserves for OSFI purposes and therefore are not CRL or TRL as defined in subsection 2405(3) of the Income Tax Regulations.
April 14, 1999
Toronto East TSO Headquarters
Michèle Trotier
Attention: Duncan McKay (613) 957-3494
Insurance Specialist
982474
Parts I.3 and VI Taxes
This is in reply to your memoranda dated August 31, 1998 and January 4, 1999, with respect to the treatment of certain items which life insurers have reported in notes to the financial statements prepared for the Office of the Superintendent of Financial Statements (“OSFI”) as “appropriations” of retained earnings or other surplus for purposes of Parts I.3 and VI Taxes of the Income Tax Act. You have provided us with additional information to assist us in our review.
All references to statute will be to the Income Tax Act unless otherwise specified.
We note that certain life insurers are stock companies and as such recorded their surplus derived from earnings in retained earnings on their balance sheet whereas other life insurers which are mutuals recorded their surplus derived from earnings in participating /non-participating accounts.
For purposes of this memorandum the above accounts are referred to as either retained earnings or surplus.
In the notes to the financial statements prepared for OSFI certain life insurers report as appropriated retained earnings specific amounts that generally are covered by the following four descriptions - cash surrender value deficiencies, negative actuarial liabilities, reserves required for foreign jurisdictions and a transitional solvency provision. The retained earnings on the balance sheet statement is not adjusted to reflect the amounts described in the notes.
You have asked us to provide you with our views as to the following queries:
1. Do the items which an insurer identifies in a note to its financial statements prepared for OSFI as “appropriated” retained earnings constitute reserves?
2. If they are, do they nevertheless remain as part of the retained earnings of the insurer?
3. If they are, do they form part of the CRL and TRL of the insurer?
Industry Representations
You have provided us with a submission XXXXXXXXXX with respect to the treatment of these items for purposes of Parts I.3 and VI. They are of the view that these items are “reserves” as defined in subsection 181(1) and are therefore excluded from the life insurer’s surplus amounts. They disagree with Revenue Canada’s (“RC”) proposed position that these items can be characterized both as “reserves” as defined in subsection 181(1) and as surplus for purposes of subparagraph 181.3(3)(b)(ii).
You have advised that at least one multinational life insurer does not agree with XXXXXXXXXX position as set out above. In this regard, you provided us with a letter from this life insurer to RC wherein it was stated that with respect to cash surrender value deficiencies:
XXXXXXXXXX .”
You also provided us with an internal memorandum of this same life insurer again dealing with appropriations of surplus wherein it was stated that “The correct treatment is that they are part of retained earnings and not reserves.”
Discussion with OSFI
OSFI indicated that prior to 1993, OSFI looked to “appropriations” of surplus for solvency purposes. Starting in 1993 OSFI has been looking to generally accepted accounting principles (“GAAP”) for solvency purposes and no longer requires “appropriations” of surplus. OSFI advised that there are no “appropriations” of surplus reflected on the balance sheet prepared in the annual returns for OSFI nor does it require that such “appropriations” of surplus be done. OSFI does not require that any notes to the annual returns be prepared with respect to these items which are described above. We were advised that even if insurers were to identify items as “appropriations” of surplus in notes to the annual returns prepared for OSFI, OSFI would nevertheless consider that these items continue to form part of the surplus. While OSFI does require that these items be identified in an Exhibit entitled Supplementary Actuarial Exhibit strictly for information purposes, they do not consider that these items are “appropriations” or “reserves”. OSFI wants information for the Minimum Continuing Capital and Surplus Requirements (“MCCSR”). MCCSR is used by OSFI for solvency purposes to indicate to them the capital which is available to an insurer to meet its obligations. We were advised by OSFI that the vast majority of life insurers have sufficient capital to support their obligations and therefore there is no restriction on the amount of dividends they can distribute either from their retained earnings or from their participating accounts.
We have considered the above submission and the arguments therein which were raised by XXXXXXXXXX. However, these arguments have not persuaded us to change our views expressed in our earlier memorandum dated October 23, 1997.
Before we provide our comments with respect to the specific questions posed by you it would be useful to illustrate by way of example the implications of a recharacterization by an insurer of part of the surplus as reserves for purposes of the Income Tax Act.
Assume that a stock life insurance company has $1 billion in retained earnings. The insurer is carrying on its insurance businesses both in Canada and outside of Canada. The Canadian reserve liabilities (“CRL”) and Total reserve liabilities (“TRL”) have the meanings as prescribed under the Income Tax Regulations for purposes of Part I.3 tax pursuant to subsection 181(2). It has a CRL/TRL ratio of 50%. In a note to the financial statements prepared for OSFI the insurer “appropriates” $400 million of its retained earnings with respect to the four items referred to above. The insurer may argue that it can treat these items as “reserves” for purposes of Part I.3 tax and exclude them from its retained earnings. Out of the $400 million disclosed in the note 90% relates to the insurance business carried on outside of Canada.
The insurer may argue that only $600 million of the $1 billion constitutes retained earnings and therefore given that the CRL/TRL ratio is 50% $300 million should be included in capital for purposes of Part I.3 tax pursuant to subparagraph 181.3(1)(c)(ii). Out of the $400 million characterized as “reserves” only 10% (i.e. $40 million) would be included as reserves for purposes of subclause 181.3(1)(c)(ii)(B)(I) given that only reserves which have been established in respect of an insurance business carried on in Canada are included.
In addition, in the above example, if the amounts reflected in the note constitute reserves for OSFI purposes this will have an impact on the CRL/TRL ratio which is relevant for purposes of Parts I, I.3 and VI. In the above example the CRL would be increased by $40 million whereas the TRL would be increased by $400 million which will result in a decrease in the CRL/TRL ratio which may be significant depending on the circumstances. As noted below, it is our view that as the amounts reflected in the note do not constitute appropriations or reserves for OSFI purposes they, therefore, would not impact on the CRL/TRL ratio.
Ignoring the potential implications of a change to the CRL/TRL ratio the position taken by the XXXXXXXXXX with regard to this example is that $340 million would be included in capital for purposes of Parts I.3 and VI as opposed to $500 million had the appropriations not been made.
It has been and continues to be our view that the term “reserve” as defined in subsection 181(1) is broad, and is not limited to and does not necessarily include amounts simply because they are identified as reserves for accounting purposes. It is the legal nature of an amount that determines its characterization for purposes of Part I.3 although we recognize that generally accepted accounting principles must be given consideration and in some cases are and of themselves determinative. Where the taxpayer is a financial institution in determining the legal nature of a particular amount it is our opinion that the requirements of OSFI should be taken into account.
Pursuant to section 3260 of the Canadian Institute of Chartered Accountants (“CICA”) Handbook (“Handbook”), an “appropriation” of retained earnings is made where there is a condition restricting or affecting the distribution of retained earnings. Where this is the case, the Handbook requires that the details be disclosed. A few examples of “appropriations” which can be made at the discretion of management are given in section 3260 of the Handbook with respect to “appropriations” such as a reserve for future decline in inventory values, a reserve for general contingencies and a reserve for future plant extension.
There are a number of accounting texts which state that “appropriations” of retained earnings remain part of the retained earnings. You have provided us with a number of excerpts from various accounting texts. We have listed a number of them below:
Page 743 “Appropriations (also called reserves) of retained earnings are nothing more than segregations of retained earnings, temporarily or perhaps even permanently established for a given purpose. The consequence of an appropriation is to indicate to shareholders that a portion of retained earnings is not available for dividend distributions. An appropriation of retained earnings in no way results in the existence of any cash fund for reasons related to the appropriation....”
Page 744 “The appropriation is recorded as a debit to Retained Earnings and a credit to an appropriately named account that itself is really a subdivision of Retained Earnings.”
Page 152 “The amounts of retained earnings appropriated are transferred to Appropriated Retained Earnings. The Retained Earnings section may therefore report two separate amounts - retained earnings free (unrestricted) and retained earnings appropriated (restricted). The total of these two amounts equals the total retained earnings balance.”
Intermediate Accounting, Sixth Canadian Edition, Thomas R. Dyckman, Roland E. Dukes, Charles J. Davis, Morton Nelson, Michael Zin, Joan E.D. Conrod, Irwin.
Pages 1044 and 1045 “From time to time, retained earnings may be appropriated as a result of management action or restricted by contract or law. Appropriated retained earnings and restricted retained earnings involve a constraint on a specified portion of accumulated earnings for a specific purpose. Such specific appropriations and restrictions nevertheless represent a part of total retained earnings.” “The appropriation or restriction of retained earnings by transferring an amount from retained earnings to an appropriated retained earnings account has no effect on assets, liabilities or total shareholders’ equity. An appropriation is a clerical identification for information purposes only.”
Pages 1046 and 1047 “The primary purpose of appropriations is communication to financial statement user by removing specific amounts from availability to be paid as current dividends.” An example of a note to a statement of retained earnings is shown on page 1047 and is as follows:
Note 5. Appropriations and restrictions:
Appropriation for investment in plant $ 15,000
Restriction for bond sinking fund 25,000
Unappropriated retained earnings 126,000
Total retained earnings 166,000
A 1997 survey of annual reports of 200 Canadian public companies for 1995 and 1996 was prepared by Clarence Byrd and Ida Chen entitled Financial Reporting in Canada, Twenty-second Edition, and was published by the CICA. This report stated that “Section 3260 makes a number of Recommendations for dealing with surplus or retained earnings reserves. However, in our survey of 200 companies we did not find a single instance of a company using retained earnings reserves in their financial statements. This is similar to the findings of previous editions of Financial Reporting in Canada and suggests that the use of such reserves is a dying practice.”
We have also reviewed an earlier edition of Canadian Financial Reporting, by Byrd and Chen, wherein it was indicated that an “appropriation” of retained earnings is for information purposes only and this is why this information is now almost exclusively included in a note to the financial statements.
Even if it could be substantiated that for accounting purposes “appropriations” would constitute reserves, it appears that such amounts would nevertheless continue to constitute retained earnings or surplus. Amounts which are “appropriations” of retained earnings remain part of retained earnings and the “appropriation” is there only for information purposes which is to advise the shareholders that “appropriated” retained earnings are not available to be distributed as dividends. Consequently, even though an amount may be an “appropriation” of retained earnings, that amount continues to be part of the total retained earnings.
As noted above, OSFI does not require nor do they recognize the amounts reported in the notes to the financial statements prepared for OSFI, including Form 20.55, as appropriations of surplus or reserves. In our view this supports that, independent of whether such amounts constitute reserves for accounting purposes, the legal characterization of such amounts for purposes of Part I.3 is that they are retained earnings. It is also relevant to note that CRL and TRL as defined in subsection 2405(3) of the Income Tax Regulations are amounts as determined for purposes of OSFI or as would be determined if required by OSFI. Accordingly for the reasons noted above such amounts would not constitute CRL or TRL for purposes of either Part I or Parts I.3 and VI. As noted above, OSFI has advised that there are no restrictions on the distribution of these amounts to the shareholders or policyholders of the life insurers. This in our opinion is further support for the view that such amounts do not constitute reserves for purposes of Part I.3 and VI (or Part I) but rather are properly characterized as retained earnings.
While it is our opinion that such amounts do not constitute reserves if this matter is litigated the following alternative or fall-back assessing position should be advanced. If the Court was persuaded that such amounts constitute reserves, it is our opinion, based on the accounting authorities cited above and the views of OSFI, that such amounts would nevertheless still have the characterization of retained earnings. Subsection 181(4) prevents an amount from being included in the calculation capital twice. On the assumption that appropriated amounts (a characterization as noted above with which we do not agree) constitute reserves only that portion that relates to an insurer’s insurance business in Canada would be included in the calculation of its capital pursuant to subclause 181.3(1)(c)(ii)(B)(I). Therefore the remaining amount of the “reserve” would nevertheless be included in capital as retained earnings pursuant to subparagraph 181.3(3)(b)(ii). The end result is that 100% of the appropriated and unappropriated surplus would be reflected in the calculation of capital; part as a reserve and part as retained earnings.
With regard to the example referred to earlier in this memorandum $40 million would be included in capital pursuant to subclause 181.3(1)(c)(ii)(B)(I) and $460 million pursuant to subparagraph 181.3(1)(c)(ii) or alternatively $500 million under subparagraph 181.3(1)(c)(ii).
If you have any further questions or comments with respect to this issue do not hesitate to contact Michele Trotier or F. Lee Workman.
Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and Interpretations Directorate
Policy and Legislation Branch
6
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