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.
Principal Issues: What amount of partnership income is to be included in determining the amount of a corporate partner's retained earnings for the purpose of the thin capitalization rules?
Position: Whichever basis of accounting is established by Canadian GAAP as being appropriate for a corporation's investment in a partnership would govern the determination of that corporation's retained earnings for the purposes of the thin capitalization rules.
Reasons: CRA's position that Canadian GAAP governs in determining a corporation's retained earnings for the purpose of the thin capitalization rules extends to the impact a corporation's interest in a partnership has on its retained earnings.
December 24, 2013
XXXXXXXXXX TSO HEADQUARTERS
Income Tax Rulings
Directorate
L. Carruthers CPA, CA
(613) 957-2113
Attention: XXXXXXXXXX
2013-051255
Impact of partnership income on determination of the amount of retained earnings for the purpose of the thin capitalization rules
We are writing in response to your email dated November 20, 2013, in which you asked for our views regarding the amount of partnership income to be included in determining the amount of a corporate partner's retained earnings for the purpose of the thin capitalization rules.
Facts
Our understanding of the facts relevant to your question is as follows:
- ULC is a taxable Canadian corporation with a XXXXXXXXXX year-end;
- ULC has a XXXXXXXXXX% interest in Partnership and ULC II, a wholly owned subsidiary of ULC, has the remaining XXXXXXXXXX% interest;
- Partnership commenced operations on XXXXXXXXXX, and has a XXXXXXXXXX year-end;
- Partnership's only distribution to ULC during the period XXXXXXXXXX to XXXXXXXXXX was made in XXXXXXXXXX;
- No amounts were included on lines 205 or 305 (Book loss, or income, of partnership, respectively) on ULC's T2SCH1 for its taxation years ended XXXXXXXXXX;
- An amount equal to the XXXXXXXXXX distribution from Partnership to ULC was included on line 305 (Book income of partnership) on ULC's T2SCH1 for its taxation year ended XXXXXXXXXX;
In accordance with subsection 96(1) of the Act, ULC's proportionate share of Partnership's income was reported by ULC in its taxable income for its years ended XXXXXXXXXX. More specifically, no amount of partnership income was included in ULC's taxable income for its taxation year ended XXXXXXXXXX, and ULC's proportionate share of Partnership's income for:
- the period XXXXXXXXXX to XXXXXXXXXX was included in ULC's taxable income for its taxation year ended XXXXXXXXXX, and
- the period XXXXXXXXXX to XXXXXXXXXX, was included in ULC's taxable income for its taxation year ended XXXXXXXXXX; and
- At some point in its XXXXXXXXXX taxation year, ULC had "outstanding debts to specified non-residents" as that term is defined in subsection 18(5) of the Act.
Given the above facts, you asked what amount of Partnership's income is to be included in determining the amount of ULC's retained earnings as at XXXXXXXXXX, for the purpose of clause 18(4)(a)(ii)(A) of the Act as it then applied. More specifically, you asked whether the references to section 96 of the Act in Advanced Income Tax Ruling 2007-0248961R3 indicate that it is our view that section 96 informs the determination of the amount of partnership income to be included in determining the amount of a corporate partner's retained earnings for the purpose of the thin capitalization rules.
The Representative's View
The taxpayer's representative included in its calculation of ULC's retained earnings as at XXXXXXXXXX, for the purpose of clause 18(4)(a)(ii)(A) of the Act as it then applied, ULC's proportionate share of Partnership's income for the period XXXXXXXXXX to XXXXXXXXXX. The representative cited Advance Income Tax Ruling 2007-0248961R3 as the basis for his calculations. (As discussed further below, in our view, Advance Income Tax Ruling 2007-0248961R3 does not, in and of itself, inform the conclusion that ULC's proportionate share of Partnership's income since Partnership's last fiscal period (i.e., since XXXXXXXXXX) is to be included in the calculation.)
Your View
It is your view that only ULC's proportionate share of Partnership's income for the period XXXXXXXXXX to XXXXXXXXXX is to be included in ULC's retained earnings as at XXXXXXXXXX for the purpose of clause 18(4)(a)(ii)(A) of the Act as it then applied. You are of this view because, in accordance with subsection 96(1) of the Act, that amount of income had been included in ULC's taxable income as at XXXXXXXXXX, whereas income of Partnership for the period XXXXXXXXXX to XXXXXXXXXX had not been.
Subsections 18(4) through 18(8) of the Act contain the thin capitalization rules which generally apply such that a Canadian corporation may only deduct interest on debt to specified non-residents to the extent that such debt does not exceed 1.5 times (XXXXXXXXXX) the amount of equity contributed (i.e., surplus contributed and paid-up capital of shares owned) by such non-residents plus retained earnings of the corporation. Clause 18(4)(a)(ii)(A) of the Act (which applies to taxation years that begin before 2014) and subparagraph (a)(i) of the definition of "equity amount" in subsection 18(5) of the Act (which applies to taxation years that begin after 2013) specifically refers to the "retained earnings" of a corporation at the beginning of the year. The Act, however, does not contain a definition for the term "retained earnings".
It has been CRA's longstanding position (as noted in paragraph 8 of Interpretation Bulletin IT-59R3, Interest on Debts Owing to Specified Non-Residents) that, for purposes of subsection 18(4) of the Act, a corporation's contributed surplus and retained earnings are to be determined in accordance with generally accepted accounting principles ("GAAP") but may not include unrealized appraisal surpluses. This position continues to be our view and was recently discussed in our external interpretations 2012-0445891E5 and 2010-0384001E5 which address certain implications that a corporation's transition to International Financial Reporting Standards ("IFRS") would have on its contributed surplus and retained earnings, respectively, for the purposes of the thin capitalization rules.
CRA's position that Canadian GAAP governs in determining a corporation's retained earnings for the purpose of the thin capitalization rules extends to the impact a corporation's interest in a partnership has on its retained earnings. More specifically, in our view, whichever basis of accounting (e.g., consolidation method, equity method, or cost method) is established by Canadian GAAP as being appropriate for a corporation's investment in a partnership would govern the determination of that corporation's retained earnings for the purposes of the thin capitalization rules. While it could have been worded more clearly in this respect, the ruling issued in Advance Income Tax Ruling 2007-0248961R3 is consistent with this view.
In the specific circumstances of it being pursuant to GAAP that a corporate partner's consolidated retained earnings include the exact same amount of the net income of a partnership as was included in its income pursuant to section 96 of the Act (see paragraph 20 of 2007-0248961R3), we ruled that in computing that corporation's retained earnings for the purpose of clause 18(4)(a)(ii)(A) of the Act, subsection 248(24) of the Act would not apply to exclude its share of the net income of the partnership that was included in its income pursuant to section 96 of the Act irrespective of whether the partnership had distributed such income to the corporation. In other words, we ruled that when partnership income is included in a corporation's consolidated retained earnings pursuant to GAAP, subsection 248(24) would not apply to back out that partnership income when determining that corporation's retained earnings for the purpose of clause 18(4)(a)(ii)(A) of the Act. This ruling was relevant because if it had been determined that subsection 248(24) of the Act did apply to the specific circumstances described in of 2007-0248961R3, the consolidation method of accounting would not have been applicable in determining the corporation's retained earnings for the purpose of clause 18(4)(a)(ii)(A) of the Act and, therefore, the net income of the partnership included in the corporate partner's consolidated retained earnings pursuant to GAAP would have had to have been backed out for the purpose of clause 18(4)(a)(ii)(A) of the Act.
The specific circumstances present in 2007-0248961R3 are not present in the facts relevant to your question. Firstly, in 2007-0248961R3, the corporate partner and the partnership had the same year ends; and, secondly, the amount of partnership income included in the corporate partner's consolidated retained earnings pursuant to GAAP and the amount of partnership income included in the corporate partner's taxable income pursuant to section 96 of the Act were the same. Whereas, the facts relevant to your question, as we understand them to be, are that: firstly, Partnership's year-end is XXXXXXXXXX while ULC's year-end is XXXXXXXXXX; and, secondly, the amount of partnership income included in ULC's retained earnings pursuant to GAAP and the amount of partnership income included in ULC's taxable income pursuant to section 96 of the Act were not the same as evidenced by the manner in which ULC filed its T2SCH1.
With respect to the facts relevant to your question, we do not concur with your view that ULC's proportionate share of Partnership's income for the period XXXXXXXXXX to XXXXXXXXXX is to be included in ULC's retained earnings as at XXXXXXXXXX for the purpose of clause 18(4)(a)(ii)(A) of the Act. You cited ULC's taxable income inclusion in accordance with subsection 96(1) of the Act as the basis for your view. However, as discussed above, Canadian GAAP governs in determining a corporation's retained earnings for the purpose of the thin capitalization rules not section 96 of the Act.
That being said, we are not in position to concur with the taxpayer's representative's view that ULC's proportionate share of Partnership's income for the period XXXXXXXXXX to XXXXXXXXXX is to be included in ULC's retained earnings as at XXXXXXXXXX for the purpose of clause 18(4)(a)(ii)(A) of the Act. We are unable to make this assessment because we do not have sufficient facts to determine which basis of accounting (e.g., consolidation method, equity method, or cost method) is established by Canadian GAAP as being appropriate for ULC's investment in Partnership. In fact, given the manner in which ULC filed its T2SCH1s, it is our current understanding that ULC used the cost method of accounting to account for its investment in Partnership. To the extent this method is an appropriate basis of accounting for ULC's investment in Partnership as established by Canadian GAAP, in our view, no amount of Partnership's income could be included in determining ULC's retained earnings as at XXXXXXXXXX, for the purpose of clause 18(4)(a)(ii)(A) of the Act because, as reflected on lines 205 and 305 of ULC's T2SCH1s for its taxation years ended XXXXXXXXXX, no partnership income had been reported for financial statement purposes.
In order to determine the amount of partnership income to be included in ULC's retained earnings for the purpose of clause 18(4)(a)(ii)(A) of the Act, we would recommend that you request that the taxpayer make a submission as to which basis of accounting (e.g., consolidation method, equity method, or cost method) is established by Canadian GAAP as being appropriate for ULC's investment in Partnership. Furthermore, if that basis of accounting is not in accordance with its T2SCH1s as filed, we would recommend that you request that the taxpayer make a submission as to why it is not.
For your information a copy of this memorandum may be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. Such a severed copy would also be distributed to the commercial tax publishers for inclusion in their databases. The severing process would 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 could be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Ms. Celine Charbonneau at (613) 952-1361. A copy would be sent to you for delivery to the client.
Olli Laurikainen CPA, CA
for Director
International Section II
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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