5 April 2011 External T.I. 2011-0395701E5 - Calculation of SIOH - Capital Loss

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: Clarification requested in respect of the calculation of safe income on hand ("SIOH") where a capital loss on the disposition of a loan receivable would be realized subsequent to the relevant "safe income determination time" ("SIDT").

Position: Based on the particular facts and circumstances of the hypothetical situation described, we are of the opinion that the SIOH attributable to the shares of the capital stock of Xco before the relevant SIDT should be reduced by an amount equal to the anticipated loss related to the loan receivable. It is our position that the SIOH could not reasonably be considered to be fully reflected in the inherent gain in the shares of the capital stock of Xco as the funds loaned by Xco to the related person would be considered to have been "expended" by Xco and would not be "on hand" before the relevant SIDT. In our view, this approach is consistent with the decision of the Federal Court of Appeal in The Queen v. Kruco Inc., 2003 DTC 5506 (FCA). Furthermore, the decision in VIH Logging Ltd. v. The Queen, 2005 DTC 5095 (FCA) can be distinguished as the "loss" that arose from the seismic data deduction in that case, was not a loss that resulted in a reduction in the inherent value of the company before the relevant SIDT.

Reasons: In accordance with the Act, jurisprudence and our previous positions.

XXXXXXXXXX
							2011-039570
							S. Snell
							(613) 946-3261

April 5, 2011

Dear XXXXXXXXXX :

RE: Calculation of Safe Income on Hand Where Capital Loss Realized Subsequent to Relevant "Safe Income Determination Time"
__________________

We are writing in response to your query whereby you have requested our comments in respect of the calculation of "safe income on hand" ("SIOH") pursuant to section 55 of the Income Tax Act ("Act") and the potential implications of the realization of a capital loss subsequent to the relevant "safe income determination time" ("SIDT").

Unless otherwise stated, every reference herein to a part, section, subsection, paragraph or a subparagraph is a reference to the relevant provision of the Act.

1) Facts and Assumptions

Our understanding of the facts and assumptions is as follows:

1. All of the issued and outstanding common shares of the capital stock of Xco, a Canadian-controlled private corporation as defined in subsection 125(7), would be held by Holdco since the incorporation of Xco in 2000.

2. Xco would have a loan receivable that is a capital asset which would be written down for accounting purposes in prior years to a nominal amount. The loan receivable would have an adjusted cost base ("ACB") of $1000 for tax purposes.

3. Holdco would arrange for the sale of Xco to an unrelated purchaser ("Purchaser").

4. Prior to its sale and during the course of Xco's current taxation year, Xco would pay a dividend to Holdco of an amount not to exceed the SIOH attributable to the shares of its capital stock before the SIDT for the transaction or series of transactions. Immediately after, Xco would also pay a dividend in kind, being the loan receivable, to Holdco. The fair market value ("FMV") of the loan receivable at the time of the payment of the dividend in kind would be nominal. The dividends would be deductible by Holdco in computing its taxable income under subsection 112(1).

5. Upon payment of the dividend in kind, Xco would realize a capital loss on the disposition of the loan receivable in accordance with subsection 52(2). This capital loss would be denied pursuant to paragraph 40(2)(e.1).

6. Finally, all of the issued and outstanding shares of the capital stock of Xco would be sold to Purchaser.

2) Your Views

You state that subsection 55(2) will generally apply to recharacterize the dividends as proceeds of disposition of the shares of the capital stock of Xco where the capital gain, that would have otherwise been realized on a disposition at FMV of the shares of the capital stock of Xco immediately before the dividends, could reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971 ("safe income") and before the relevant SIDT.

Consequently, you submit that the SIOH attributable to the shares of the capital stock of Xco held by Holdco must be calculated for the period that Holdco owned the particular shares ("holding period"). In your view, the holding period in this situation would commence in 2000 and would end, pursuant to subsection 55(2), at the time that is immediately before the relevant SIDT, being the time that is immediately before the time that the dividends are paid, in accordance with the definition of "safe income determination time" in subsection 55(1). You have also suggested that the timing of the payment of the dividends relative to Xco's taxation year would create a partial taxation year ("stub period") in respect of the calculation of SIOH immediately prior to the relevant SIDT.

You further submit that the capital loss realized by Xco on the disposition of the loan receivable, which would be denied pursuant to paragraph 40(2)(e.1), would occur upon payment of the dividend in kind. Finally, you state that the capital loss would occur subsequent to the relevant SIDT for purposes of the determination of the SIOH attributable to the shares of the capital stock of Xco held by Holdco. Consequently, you contend that the amount of the capital loss realized by Xco on the disposition of the loan receivable should not reduce the SIOH of Holdco in respect of the shares of the capital stock of Xco for the holding period.

You have requested our comments, in the context of the hypothetical situation described above, with respect to whether or not the capital loss realized on the disposition of the loan receivable would negatively impact the calculation of the SIOH attributable to the shares of the capital stock of Xco held by Holdco.

3) Our comments

Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, Advance Income Tax Rulings, dated May 17, 2002. The particular situation outlined in your letter appears to be a factual one, involving specific taxpayers and completed transactions. Accordingly, you should submit all relevant facts and documentation to the appropriate Tax Services Office for their views. However, we offer the following general comments.

The determination of SIOH for purposes of section 55 is a factual one with regard to the particular facts and circumstances in each situation. It has long been the Canada Revenue Agency's ("CRA's") position that it is only the portion of the safe income that remains on hand immediately before payment of the dividend that can reasonably be consider to contribute to the capital gain on the shares of the capital stock of a corporation. (footnote 1) The Federal Court of Appeal endorses this concept of SIOH in, amongst other decisions (footnote 2) , The Queen v. Kruco Inc., 2003 DTC 5506 ("Kruco") wherein the Court recognizes that the calculation of safe income, which the Court defines as a corporation's net income for tax purposes subject to the adjustments specified in subsection 55(5), is merely a starting point. The Court states that in order to determine the portion of the notional capital gain that can "reasonably be considered to be attributable to anything other than" safe income, there necessarily must be an inquiry as to whether the safe income is on hand or disposable to fund the payment of the dividend. Similarly, the FCA in VIH Logging Ltd. v. The Queen, 2005 DTC 5095 (FCA) ("VIH"), confirmed this approach in paragraph 42 in which the Court states that subsection 55(2) requires a determination as to the source of the hypothetical gain that would have arisen if the share had been sold prior to the dividend.

CRA's general position with respect to losses for income tax purposes is that the loss would be reflected in SIOH when incurred or sustained by the dividend recipient during the particular holding period, and not when deducted for tax purposes. (footnote 3) Furthermore, we have opined that a stub period should reflect anticipated losses where it is reasonable to expect that any of the income earned or realized in the stub period would be offset by losses in the remainder of the year. It is our view in such circumstances, that the income of the corporation used to finance the losses would no longer be on hand and, consequently, such income could not reasonably be considered to be reflected in the inherent gain in the shares. (footnote 4)

The treatment of certain anticipated deductions or losses is the subject of comment by both the TCC and the FCA in VIH (footnote 5) . The primary issue in VIH is the calculation of SIOH pursuant to section 55 and the determination of whether or not partial taxation years known as stub periods should be included in the computation period; however, the TCC also briefly addresses the treatment of certain deductions for property (seismic data) that was acquired by the corporation subsequent to the relevant SIDT. While the Court determined that the seismic deduction was anticipated, the Court acknowledges the Crown's position that the "loss" that arose from the seismic deduction was not a loss that resulted in a reduction in the value of the company and, accordingly, the parties agreed that the seismic deduction did not reduce SIOH. (footnote 6)

In the FCA decision of VIH, the Court comments on the Crown's alternative argument that the SIOH should be reduced by the amount equal to the deduction for the seismic data. Specifically, the Court acknowledges Robert Read's position vis-à-vis anticipated losses, providing additional clarification that the position applies to situations where circumstances exist prior to the commencement of the series of transactions which are likely to generate a loss. (footnote 7)

In our view, the capital loss arising on the disposition of the loan receivable in the hypothetical situation would be an anticipated loss of the type described by Mr. Read and, accordingly, the treatment of the seismic data deduction in VIH would be distinguished from the particular facts and circumstances of the hypothetical situation described above.

It is our position that an examination of the "hypothetical capital gain" that would have resulted from a FMV sale of the shares of the capital stock of Xco immediately before the dividend, is required to determine the source of the gain, as endorsed by the FCA in VIH and Kruco. In the scenario described above, the SIOH of Xco before the relevant SIDT should reflect the anticipated loss related to the loan receivable since that SIOH could not reasonably be considered to be fully reflected in the inherent gain in the shares of the capital stock of Xco. In other words, the funds loaned by Xco to the related person should be considered to have been "expended" by Xco. Consequently, these funds could not be considered to be "on hand" before the relevant SIDT. Furthermore, the gain on the shares of the capital stock of Xco before the dividends should be reduced by the funds "expended" by Xco as a result of the loan.

In our view, this approach is consistent with the Kruco decision. As discussed in our Income Tax Technical News No. 37, dated February 15, 2008, we are of the view that the FCA's decision in Kruco requiring a second stage inquiry in respect of the calculation of a corporation's safe income to determine whether the income earned or realized was kept on hand, supports the notion that SIOH should be reduced to reflect the impact of cash outflows (such as non-deductible expenses). In the hypothetical situation described above, the funds initially loaned by Xco to a related person should be considered to have been expended, and thus, would be similar in nature to cash outflows such as a non-deductible expense.

For these reasons, it is our position that the capital loss described in the hypothetical situation, which would be realized subsequent to the relevant SIDT and denied pursuant to paragraph 40(2)(e.1), would be an anticipated loss that would have the effect of reducing the amount of disposable after-tax income at Xco's level. Consequently, we are of the opinion, based on the particular facts and circumstances of this situation, that the SIOH attributable to the shares of the capital stock of Xco before the relevant SIDT should be reduced accordingly, in order to reflect the impact of the loss associated with the loan receivable.

The above comments represent our general view with respect to the subject matter and are not binding on the CRA, as explained in paragraph 22 of Information Circular 70-6R5. We trust that the foregoing will be of assistance to you.

Yours truly,

Stéphane Prud'Homme, LL.B, M. Fisc.
Manager
for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained
in the original document are shown below instead:

1 See John R. Robertson, F.C.A., "Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55", Report of Proceedings of the Thirty-Third Tax Conference, 1981 Conference Report (Toronto: Canadian Tax Foundation, 1982) 81- 109, at page 84.
2 For example, The Queen v. Placer Dome Inc., 96 DTC 6562 (FCA) and Brelco Drilling Ltd. v. The Queen, 99 DTC 5253 (FCA).
3 Robertson Supra, at page 90. See also Technical Interpretation 2000-0034037(E).
4 Robert J.L. Read, C.A., in "Section 55: A Review of Current Issues", Report of Proceedings of the Fortieth Tax Conference, 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989) 18:1, at 18:5-6.
5 VIH Logging Ltd. v. The Queen, 2004 DTC 2090 (TCC).
6 See paragraph 48 of the TCC decision in VIH.
7 See paragraph 41 of the FCA decision in VIH.