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: Can 78(1)(a) be invoked to include in a taxpayer's income unpaid management fees in taxation years for which the taxpayer previously reported non-capital losses and for which the normal reassessment period has expired?
Position: Generally yes provided that the income inclusion does not result in an assessment of taxes payable. However 78(1)(a) will generally not be invoked by CRA where two non-arm's length taxpayers both account for income on an accrual basis unless the unpaid amounts appear to be part of a tax avoidance scheme. However, in such a situation, it is our view that the taxpayer may choose to apply 78(1) and file amended returns for any taxation year which is not statute-barred.
Reasons: Previous positions taken and CRA policy.
September 7, 2011
XXXXXXXXXX
Technical Advisor Income Tax Rulings Directorate
XXXXXXXXXX Tax Services Office Andrea Boyle, CGA
Canada Revenue Agency
XXXXXXXXXX
2011-040124
Add-back of Unpaid Management Fees
I am replying to your email dated April 1, 2011 in which you asked for our views on whether unpaid management fees can be included in a taxpayer's income in taxation years which previously reported non-capital losses in the circumstances described below. We apologise for the delay in our response.
All statutory references in this letter are references to the provisions of the Income Tax Act, R.S.C. 1985 (5th supp.) c. 1, as amended ("the Act").
THE FACT SITUATION
You have provided the following fact situation:
1. A non-resident corporation ("the Corporation") was incorporated in 1992.
2. The Corporation has a permanent establishment in Canada and has carried on a business in Canada since its incorporation.
3. The Minister issued notifications that no tax was payable by the Corporation for the taxation years 1992 to 2008.
4. In each of these taxation years the Corporation accrued, and deducted in computing its business income for each year, management fees to its U.S. parent corporation ("the Parent Corp."). The Parent Corp. reported the receipt of these amounts on an accrual basis.
5. Due to reoccurring losses and related cash flow issues, these accrued management fees have remained unpaid by the Corporation for all of these taxation years.
6. None of these unpaid amounts were previously included in computing the Corporation's income for the third taxation year following the taxation year in which the outlay or expense was incurred as might be required under paragraph 78(1)(a). Previous audits have not disallowed any portion of the management fee expenses under section 67 on the basis that they were considered unreasonable in the circumstances.
7. The Corporation and the Parent Corp. have not filed an agreement in prescribed form as per paragraph 78(1)(b).
8. The corporation has never withheld and remitted Part XIII tax with respect to these management fees. The management fees, if paid, would be exempt from Part XIII tax by virtue of paragraph 212(4)(b) as they were on account of "a specific expense incurred by the non-resident person for the performance of a service that was for the benefit of the payer."
9. The Corporation has requested adjustments to the business income for taxation years 1995 to 2007 to apply paragraph 78(1)(a) and thereby include unpaid management fees in computing the Corporation's income or loss for the third taxation year following the taxation year in which the unpaid management fee expenses were incurred.
10. For some of these taxation years, the Corporation then wishes to deduct non-capital losses under paragraph 111(1)(a) in computing its taxable income in order to offset taxable income which would otherwise result from the inclusion of the unpaid management fees in business income.
YOUR QUESTIONS
You have asked whether the CRA should accept the corporation's requests to amend its returns for the relevant taxation years to add back unpaid management fees under paragraph 78(1)(a).
Additionally you have asked whether taxation years for which the Minister issued notifications that no tax was payable are open for reassessment indefinitely, or if there is some time limitation. You have also asked whether the application of non-capital losses can be changed in years that are otherwise normally statute-barred as long as this does not result in an assessment of taxes payable.
Finally, you have asked if taxpayer requested adjustments are made, whether the taxpayer can request a determination of losses for these years.
Application of Paragraph 78(1)(a)
Generally under paragraph 78(1)(a) where an amount is unpaid between two persons not dealing at arm's length at the end of the second taxation year following the year in which the expense was incurred, the unpaid amount is included in the debtor's income for the third succeeding year. The effect of paragraph 78(1)(a) can be reduced if both the creditor and the debtor file an agreement, in a prescribed form, on or before a prescribed date.
Section 78 operates as a penalty provision. Where an amount is included in income under 78(1)(a), this is not a "cancellation" of the deduction, it is an income inclusion; this distinction means that, as indicated in paragraph 5 of Interpretation Bulletin IT-109R2 Unpaid Amounts, if an unpaid amount is included in a taxpayer's income under paragraph 78(1)(a), there is no provision in the Act which allows the taxpayer to claim a deduction if or when the amount is subsequently paid. The inclusion of an unpaid amount in income under paragraph 78(1)(a) in no way alters the legality of the transaction and the amount would still be considered to be unpaid and owing to the creditor, nor does it change the fact that the taxpayer has already been allowed a deduction for income tax purposes.
IT-109R2 also discusses our policy with regards to debtors and creditors who are not dealing at arm's length where both of the taxpayers account for income on an accrual basis. Paragraph 15 of the bulletin indicates that subsection 78(1) will not be invoked in such a situation unless the unpaid amount in question appears to be part of a "tax avoidance scheme" which may involve transactions which, for example, are designed to defer tax under Part XIII of the Act where the creditor is a non-resident.
Therefore in the fact situation outlined the CRA would not generally apply subsection 78(1) unless we determined that the unpaid amounts were part of a tax avoidance scheme. We understand that this is not the case in the present situation.
However, even if CRA would not generally invoke subsection 78(1) in a given situation, this would not necessarily preclude a taxpayer from choosing to apply subsection 78(1) in filing its tax return for a specific taxation year or from requesting adjustments to previously filed returns for non-statute-barred taxation years. For this reason, we are of the view that the CRA can accept the taxpayer's request to include the management fees in its income by virtue of subsection 78(1)(a) in the present situation.
It appears that the taxpayer's possible motivation for requesting the subsection 78(1) adjustments could be an attempt to refresh the corporation's non-capital losses that have expired or are about to expire. The taxpayer may erroneously believe that the corporation can claim a deduction in later taxation years when the management fees are eventually paid. It should therefore be made clear to the taxpayer that, as indicated above, no deduction would be available if or when the unpaid management fees are subsequently paid to the Parent Corp.
Calculation of a Non-capital Loss for a Specific Taxation Year
The calculation of a taxpayer's non-capital loss for a given year is determined pursuant to the formula provided in the definition in subsection 111(8). Item (a) of variable "E" of this formula indicates that a non-capital loss includes, among other things, the taxpayer's loss from the year from a business.
A taxpayer's loss from the year from a business is determined in subdivision b of Division B of the Act and this loss is calculated subject to the rules relating to the computation of income provided in subdivision f (including the subsection 78(1) income inclusion for unpaid amounts).
An income inclusion for unpaid amounts under 78(1) would automatically impact the calculation of the loss from the year from a business, which in turn would automatically affect the calculation of a taxpayer's non-capital loss for a specific taxation year. It is a well-established principle that the Minister can recalculate a loss realized by a corporation in a given taxation year (beyond the "normal reassessment period" for that year) in any subsequent taxation year in which the loss is claimed, pursuant to paragraph 111(1)(a), provided the loss was reported in the corporation's tax return for the year in which it was realized.
Therefore, even if a taxation year would otherwise be statute-barred, if an unpaid amount should have been include in the taxpayer's income in that taxation year, the CRA would be able to adjust the non-capital loss balance for that year.
Normal Reassessment Period
Subsection 152(3.1) defines a "normal reassessment period" and indicates, among other things, that it would be the period which ends three or four years after the day of sending an original notification that no tax is payable by the taxpayer for the year. Subsection 152(4) indicates that the Minister may "at any time" notify a taxpayer that no tax is payable. (In contrast, the Minister can only make an "assessment, reassessment or additional assessment" at any time before the taxpayer's normal reassessment period except in certain circumstances outlined in subsection 152(4).)
In other words, where the Minister issued a notification that no tax was payable, the year will be statute-barred for the purposes of assessing taxes payable for that year but not for the purposes of processing taxpayer-requested adjustments to that year which do not result in taxes payable (unless, of course, there is a subsequent loss determination for that year under subsection 152(1.1)).
Therefore, taxpayer-requested adjustments can be made to taxation years for which the taxpayer received a notification that no taxes were payable as long as the adjustments do not result in any assessment of income taxes.
Offsetting Application of Losses
It is our view that where offsetting adjustments are made to years in which a notification that no tax is payable, and those offsetting adjustments do not result in an assessment of tax payable, such adjustments may be made, except where a notice of determination has been issued by the CRA under subsection 152(1.1).
Therefore in this case, the taxpayer can request that unpaid management fees be included in income in the relevant taxation years, in conjunction with offsetting applications of non-capital losses, as long as the effect of the offsetting adjustments results in no assessment of income taxes payable.
Loss Determinations
In the Canadian Tax Court decision Inco Limited v. HMQ, 2004 DTC 2847, the court confirmed that three steps are required for a loss determination:
[13] ....On the other hand, subsection 152(1.1) of the Act clearly contemplates and establishes a procedure involving sequential steps or events that must take place in order for there to be a valid loss determination. These steps are: (a) the Minister ascertains the amount of a taxpayer's non-capital loss for a taxation year in an amount that differs from the one reported in the taxpayer's income tax return; (b) the taxpayer requests that the Minister determine the amount of the loss; (c) the Minister thereupon determines the amount of the loss and issues a notice of loss determination to the taxpayer.
Paragraph 4 of Interpretation Bulletin IT-512 Determination and redetermination of losses also clarifies the CRA's position on the requirements for a loss determination to be issued:
4. Where at the initial assessing stage or as a consequence of a reassessment arising from an audit or other investigative action by the Department the Minister ascertains a loss in an amount other than that reported by the taxpayer, a notice of assessment or reassessment (including a notice of "nil" assessment or reassessment) will be issued with an explanation of the changes. As well, the notice will inform the taxpayer that upon request the Minister will make a determination of the loss so ascertained and issue a notice of determination/redetermination. In this context, the Minister will not be considered to have ascertained that the amount of a loss differs from an amount reported by the taxpayer where the difference fully reflects a change requested by the taxpayer as a result of amended or new information.
Therefore, where the difference in the amount of a loss for the year reflects an amendment by the taxpayer, this is not considered to be "ascertained" by the Minister, and therefore, on its own, does not meet the requirements for subsection 152(1.1) loss determination. Therefore, in this case, because the taxpayer is requesting the changes and the Minister would not be "ascertaining" the amount of the loss, the taxpayer can not request a loss determination.
For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the CRA's electronic library. 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 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 Mrs. Céline Charbonneau at (613) 957-2137. A copy will be sent to you for delivery to the client.
We trust that these comments will be of assistance.
Yours truly,
Guy Goulet CA, M.Fisc.
Manager
for Director
Ontario Corporate Tax Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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