23 November 2016 Internal T.I. 2015-0618511I7 - Thin Capitalization - Retained Earnings

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: 1. Whether a taxpayer can adopt accounting standards in the unconsolidated financial statements prepared for the purpose of filing the taxpayer’s tax returns that are different from the consolidated financial statements prepared by the taxpayer for the financial reporting purposes. 2. Whether partnership income reported by the taxpayer under subsection 96(1) of the Act can be added to the accounting retained earnings when determining the “equity amount” for thin capitalization purposes.

Position: 1. No. 2. No.

Reasons: 1. The accounting standards must be applied consistently between the consolidated and unconsolidated financial statements. 2. The Act does not permit a taxpayer to add the amount included in a taxpayer's income under subsection 96(1) to the retained earnings for thin capitalization purposes.

								November 23, 2016

XXXXXXXXXX							HEADQUARTERS
XXXXXXXXXX TSO 						Income Tax Rulings
								  Directorate
								Judy Ho

								2015-061851

Re: Thin-Capitalization – Retained Earnings

This letter is in reply to your correspondence wherein you requested our views in respect of the issues described below. The following is a brief summary of the relevant facts:

• A Canadian resident corporation (the “Taxpayer”) adopted the International Financial Reporting Standards (“IFRS”) for the Taxpayer’s consolidated financial statements used for financial reporting purposes (“consolidated financial statements”) for all relevant years (XXXXXXXXXX). The Taxpayer also prepared unconsolidated financial statements using IFRS for the purpose of filing of the Taxpayer’s tax returns (“unconsolidated financial statements”) for the relevant years.
• In XXXXXXXXXX, for purposes of the unconsolidated financial statements, the Taxpayer adopted a particular standard, IFRS 9, effective XXXXXXXXXX (i.e., retroactively). However, the Taxpayer did not adopt IFRS 9 for its consolidated financial statements for the relevant years.
• The Taxpayer filed its income tax return for the XXXXXXXXXX taxation year based on the unconsolidated financial statements that used IFRS 9. The Taxpayer also amended and filed its XXXXXXXXXX and XXXXXXXXXX tax returns based on the revised unconsolidated financial statements that used IFRS 9.
• The adoption of IFRS 9 for unconsolidated financial statements resulted in an increase in the opening retained earnings balance of the Taxpayer for the XXXXXXXXXX fiscal period. This increase in the retained earnings resulted from the change in the fair market value (“FMV”) of the Taxpayer’s direct and indirect interests in certain partnerships and corporations (“Subsidiaries”). The FMV of the investments in Subsidiaries was approximated through increasing/decreasing the previously reported balance by net income/loss incurred by each of the Subsidiaries in each relevant period. Any income/loss incurred by the Subsidiaries was not previously included in the retained earnings balance of the Taxpayer.

You have requested our assistance in respect of the following questions:

1. Can the Taxpayer use the unconsolidated financial statements which adopt a different standard (IFRS 9) than the consolidated financial statements, for the purpose of filing its income tax returns prospectively and for the purpose of amending the Taxpayer’s previously filed tax returns for the XXXXXXXXXX and XXXXXXXXXX taxation years?

2. If the Taxpayer is unable to adjust the retained earnings resulting from the adoption of IFRS 9 in the unconsolidated financial statements, can the Taxpayer’s proportionate share of partnership income reported by the Taxpayer under subsection 96(1) of the Income Tax Act (the “Act”) be added to the retained earnings when determining the “equity amount” for thin capitalization purposes?

Our Comments

We are not expressing any opinion in respect of the Taxpayer’s accounting policies, including whether the amounts of retained earnings reported by the Taxpayer are in accordance with IFRS, whether it is permissible under IFRS to adopt IFRS 9 in the Taxpayer’s unconsolidated financial statements but not in the consolidated financial statements, or whether the financial statements can be amended retroactively.

1. Adoption of IFRS 9 in the unconsolidated financial statements

The CRA stated in Income Tax Technical News No. 42, May 31, 2010 (“ITTN 42”) that when a taxpayer files under IFRS, the retained earnings should be computed using IFRS. ITTN No. 42 also states that taxpayers should apply IFRS on a consistent basis to all calculations in order to determine income tax. Even though ITTN No. 42 does not specifically address the consistency between the consolidated financial statements and unconsolidated financial statements, such consistency is expected from the taxpayers to avoid the use of financial statements as a tax planning tool. It is our view that the computation of retained earnings for thin capitalization purposes should be based on the same accounting policies as those in the consolidated statements that were presented to the shareholders, with the exception that the unconsolidated financial statements would eliminate the consolidation aspects of the consolidated financial statements.

This is consistent with our position in the context of the now repealed large corporations tax (Part I.3 of the Act). Please see document E9406995, where we concluded that a corporation was not permitted to use a different accounting policy (acceptable under GAAP) in financial statements prepared for purposes of Part I.3 tax, where consolidated financial statements were prepared for shareholder presentation.

As a result, it is our view that the Taxpayer should not be able to adopt IFRS 9 in the unconsolidated financial statements prepared for the purpose of filing the tax returns until the time the Taxpayer adopts the same standard in its consolidated financial statements. This would apply both to the prospective tax returns (i.e., for the XXXXXXXXXX and subsequent taxation years) and to the previously filed tax returns (i.e., for the XXXXXXXXXX and XXXXXXXXXX taxation years).

2. Inclusion of partnership income in the “equity amount”

It is our understanding that for the purposes of determination of the “equity amount” under subsection 18(5) of the Act, as an alternative to restating the unconsolidated financial statements, the Taxpayer would like to add to the retained earnings balance any income allocated to the Taxpayer from various partnerships under subsection 96(1) of the Act. The Taxpayer relied on document 2007-0248961R3 as a support for such approach.

In document 2007-0248961R3, among other things, we ruled that:

In computing ULC’s retained earnings for the purpose of clause 18(4)(a)(ii)(A), subsection 248(24) will 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 whether or not the Partnership has distributed such income to ULC.

However, as can be seen from the facts of document 2007-0248961R3, the consolidated retained earnings of ULC already included its share of the net income of the Partnership under GAAP, and such income was also included in ULC’s income pursuant to section 96 of the Act for tax purposes, as further explained in document 2013-0512551I7.

It is our view that the amount of income included into a corporation’s income under section 96 of the Act cannot be an amount that is added to the retained earnings for the purposes of the thin capitalization calculations and there is nothing in the Act that would allow such an addition. However, if income of a partnership in which such corporation is a member is already included in the retained earnings of the corporation under IFRS (or other accounting standards, as applicable), there is no provision in the Act that would exclude such income from the retained earnings of the corporation for thin capitalization purposes, as indicated in the above referenced documents.

As such, the Taxpayer is not permitted to add its proportionate share of partnership income allocated to the Taxpayer under subsection 96(1) of the Act to the retained earnings balance when determining the “equity amount” for thin capitalization purposes. Partnership income is only included in the “equity amount”, as defined in subsection 18(5), if such income is included in the retained earnings of the corporation under the applicable accounting standards.

We trust our comments will be of assistance.

Yours truly,

Section Manager
For Division Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

c: Leslie Bafia