25 March 2010 Internal T.I. 2010-0353081I7 - Part VI - Preferred Shares Liabilities

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: Whether preferred shares that are not retractable within the five years of the date of issue that are classified as a liability on the financial institution's balance sheet are included in capital for Part VI purposes.

Position: Yes.

Reasons: The shares are long-term debt within the meaning of subsection 181(1).

								March 25, 2010

	Toronto North TSO					HEADQUARTERS
	Large Case File Manager				Income Tax Rulings
			   					Directorate
	Attention : Mr. Seow Prashad			Terry Young
			(613) 948-5273

								2010-035308

Preferred Shares Liabilities

This is in response to your inquiry in respect of the treatment of preferred shares reported on the financial statements of the XXXXXXXXXX (the "Taxpayer") for purposes of Part VI of the Income Tax Act ("the Act").

The issue involves two classes of preferred shares (the "Shares") that were outstanding on XXXXXXXXXX :

• XXXXXXXXXX ; and
• XXXXXXXXXX .

Both series were Class A preferred shares with a fixed rate, non-cumulative dividend.

The Taxpayer's tax return originally included the $XXXXXXXXXX of Shares in capital (as capital stock) for the purposes of Part VI of the Act, but later the Taxpayer filed a Taxpayer Request to amend its return to remove the Shares from capital.

The Taxpayer's position is that the Shares are no different than those dealt with in AGC v Ford Credit Canada Limited, 2007 FCA 225, 2006 TCC441 ("Ford Credit"). In Ford Credit, the preferred shares in question were reported on the financial statements as liabilities in accordance with Generally Accepted Accounting Principles ("GAAP") and thus were not included in capital as capital stock. Further, it was agreed that the shares were not long-term debt as defined in subsection 181(1) of the Act. As a result, the shares were not included in the taxpayer's capital for purposes of Part I.3 of the Act.

You agree that the Shares are not capital stock of the Taxpayer for Part VI purposes, but are of the opinion that the Shares are long-term debt and, therefore, must be included in the capital of the Taxpayer.

Our views

In Ford Credit (FCA), the Court stated,

In my view, this Parliamentary action in addressing a perceived deficiency in the GAAP treatment of deferred unrealized foreign exchange gains and losses in relation to LCT, supports the proposition that Parliament intended to defer to GAAP as the principal determinant of capital for the purposes of the LCT except to the extent specifically otherwise provided in Part I.3 of the ITA. (endnote 1)

Unless specific provisions of Part I.3 of the Act provide otherwise, the balance sheet of the taxpayer must be accepted for Part I.3 purposes providing that the balance sheet has been prepared in accordance with GAAP, or in the case of a financial institution, the balance sheet has been accepted by the Office of the Superintendent of Financial Institutions ("OSFI"). Although Ford Credit dealt with Part I.3 of the Act, Part VI Tax is based on Part I.3 and the relevant provisions are worded either identically to or refer directly to the provisions in Part I.3.

The capital of a financial institution is defined in subsection 181.3(3) of the Act. The relevant portions of the subsection state:

181.3(3) Capital of financial institution - The capital of a financial institution for a taxation year is

(a) in the case of a financial institution ..., the amount, if any, by which the total at the end of the year of

(i) the amount of its long-term debt,
(ii) the amount of its capital stock ..., retained earnings, contributed surplus and any other surpluses, and

In the case at hand, the Taxpayer's balance sheet presents the Shares as Preferred Share Liabilities. Based on the information provided to us, the Shares are in all material respects similar to the preferred shares in Ford Credit, which were found not to be capital stock, except that, unlike the shares in Ford Credit, the Shares are not redeemable or retractable in the first five years after issuance. The significance of the five years is discussed below. Thus, it is clear that the Shares are not capital stock of the Taxpayer for purposes of subsection 181.3(3).

It follows then, that in order for the Shares to be capital of the Taxpayer, they must be long-term debt, which is defined in subsection 181(1). It states, in part:

"long-term debt" means,

(a) in the case of a bank, its subordinated indebtedness (within the meaning assigned by section 2 of the Bank Act) evidenced by obligations issued for a term of not less than 5 years (emphasis added)

In his Tax Court of Canada decision, Chief Justice Bowman, as he was at that time, stated,

Although, as set out below, the accountant treated the Class C shares as "debt" for balance sheet purposes and, as an accounting matter, as long term debt, they are not "long term debt" within the definition of that expression in subsection 181(1). (endnote 2)

While Chief Justice Bowman accepted that the Class C shares were both debt and long-term debt for accounting purposes, he did not specifically indicate why the shares were not "long-term debt" within the meaning of subsection 181(1). However, it seems reasonable to conclude in looking at the terms of the shares, the reason was that the shares were retractable at the option of the holder within five years of issue and, therefore, were not issued "for a term of not less than 5 years".

In the case at hand, the Shares are not retractable within the first five years after the respective dates of issue and thus meet the five-year requirement of the definition.

Turning to the other requirement, section 2 of the Bank Act states:

"subordinated indebtedness" means an instrument evidencing an indebtedness of a bank that by its terms provides that the indebtedness will, in the event of the insolvency or winding-up of the bank, be subordinate in right of payment to all deposit liabilities of the bank and all other liabilities of the bank except those that, by their terms, rank equally with or are subordinate to such indebtedness;

The Supreme Court of Canada has stated that "the words of the Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act, the object of the Act, and the intention of Parliament." (endnote 3)

For a financial institution, subsection 181(3) requires that "...the amounts reflected in the balance sheet accepted by the Superintendent of Financial Institutions..." be used for Part I.3 purposes. Pursuant to subsection 308(4) of the Bank Act (endnote 4) , OSFI reporting is based on GAAP unless the Superintendent of Financial Institutions specifies otherwise. There are no OSFI directives with respect to shares that are classified as liabilities for GAAP financial statement purposes.

With respect to the Shares, while they are not classified as subordinated indebtedness on the Taxpayer's balance sheet, subsection 181(1) provides a specific definition of long-term debt (see above). Therefore, the characterization of the Shares must be determined in accordance with this definition in the context of the financial statements. Starting with the fact that the Shares are considered a liability under GAAP (or as Chief Justice Bowman described it, debt), the Shares fit within the meaning of subordinated indebtedness and are long-term debt of the Taxpayer.

Although the Taxpayer's representative suggested that the Shares are not subordinated indebtedness of the Taxpayer because they are, in fact, capital stock of the Taxpayer, that argument would be inconsistent with the context and purpose of the provisions and of the intentions of Parliament, which is to tax the capital available for use by the Taxpayer. Further, to say that the Shares are not equity because they are debt for purposes of subsection 181.3(3) and then argue that they are not debt because they are equity for the purposes of the same provision of the Act would be inconsistent, to say the least.

Consequently, it is our view that the Shares are long-term debt, within the meaning of subsection 181(1), of the Taxpayer and, are included in the Taxpayer's capital for the purposes of Part VI of the Act.

Lee Workman
Manager
Charitable and Financial Institution Sectors
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

ENDNOTES

1 Paragraph 22.
2 Ford Credit Canada Limited, 2006 TCC 441, paragraph 7.
3 65302 British Columbia Ltd. v. Canada, [1999] 3 S.C.R. 804, paragraph 50 and reaffirmed in Canada Trustco Mortgage Co. v. Canada, [2005] 2 S.C.R. 601, paragraph 10.
4 308(4) of the Bank Act: "The financial statements referred to in subsection (1), paragraph (3)(b) and subsection 310(1) shall, except as otherwise specified by the Superintendent, be prepared in accordance with generally accepted accounting principles, the primary source of which is the Handbook of the Canadian Institute of Chartered Accountants. A reference in any provision of this Act to the accounting principles referred to in this subsection shall be construed as a reference to those generally accepted accounting principles with any specifications so made."