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: Are the transactions designed by XXXXXXXXXX subject to 12(1)(x)
Position: YES
Reasons: Transactions entered only for the purpose of satisfying the minority interest.
JURISPRUDENCE:
April 6, 2009
Toronto Centre Tax Services Office HEADQUARTERS
Large Files Claude Tremblay
(819) 281-6906
(613) 957-8979
Attention: Sandra Mallory
2008-028928XXXXXXXXXX ("Parent") BN XXXXXXXXXX
This is in reply to your request asking for our assistance with respect to a payment made by Parent to XXXXXXXXXX . ("Subsidiary") to compensate for the use of its tax pools in the year-ended XXXXXXXXXX and whether such payment should be included in taxable income under subsection 9(1) or paragraph 12(1)(x) of the Act. The legal form of the payment received by Subsidiary was a contribution of capital from Parent, who in turn had received a contribution of capital from XXXXXXXXXX . ("Ultimate Parent"), who ultimately benefited from the use of the tax losses.
The facts as we understand them are as follows:
1. In XXXXXXXXXX , Ultimate Parent, a publicly traded corporation, directly and indirectly owned shares representing XXXXXXXXXX % of the total equity and XXXXXXXXXX % of the voting rights of Parent.
2. Parent was a publicly traded corporation and held XXXXXXXXXX % of the common shares of Subsidiary. Subsidiary carries on a XXXXXXXXXX business of providing XXXXXXXXXX services such as XXXXXXXXXX .
3. XXXXXXXXXX . ("UPSub") is a wholly-owned subsidiary of Ultimate Parent.
4. As at XXXXXXXXXX , Subsidiary had $XXXXXXXXXX of tax losses available to it and, based on Subsidiary's forecast, $XXXXXXXXXX would expire unutilized over the next XXXXXXXXXX years. $XXXXXXXXXX of the XXXXXXXXXX tax year losses were to expire at the end of XXXXXXXXXX .
5. In addition, Subsidiary had $XXXXXXXXXX of allowable capital losses generated as a result of its debt repurchase program.
6. In XXXXXXXXXX , Ultimate Parent approached Subsidiary with a view of permitting Subsidiary to utilize certain of its tax losses prior to their expiry. In XXXXXXXXXX , Ultimate Parent negotiated and agreed with Subsidiary to make a contribution of capital of approximately $XXXXXXXXXX , which amounts to XXXXXXXXXX % of the losses to be utilized (estimated to be $XXXXXXXXXX ) (further described in 11 below).
7. In accordance with the agreements, Ultimate Parent sold XXXXXXXXXX deposit receipts and XXXXXXXXXX shares to Subsidiary on XXXXXXXXXX . They jointly elected under subsection 85(1) of the Act and Ultimate Parent received Class B Subsidiary preferred shares redeemable for $XXXXXXXXXX .
Investment Transferred # securities ACB Agreed Price FMV
XXXXX Deposit Receipts XXXXX $XXXXX $XXXXX $XXXXX
XXXXX shares XXXXX $XXXXX $XXXXX $XXXXX
$XXXXX $XXXXX $XXXXX
8. Subsidiary then sold the property (deposit receipts and shares in 7 above) to UPSub for FMV of $XXXXXXXXXX . As payment for the property, Subsidiary received a promissory note of $XXXXXXXXXX issued by UPSub.
9. On the transaction in 8 above, Subsidiary reported a capital gain of $XXXXXXXXXX and a taxable capital gain of $XXXXXXXXXX . Subsidiary sheltered this taxable capital gain by claiming the following:
Charitable donations $ XXXXXXXXXX
Net capital loss created in the year XXXXXXXXXX
Current year non-capital operating loss XXXXXXXXXX
Other years' non-capital losses carry forward XXXXXXXXXX
10. Subsidiary redeemed the Class B preferred shares held by Ultimate Parent for $XXXXXXXXXX . As consideration, Subsidiary assigned to Ultimate Parent the promissory note from UPSub.
11. In accordance with the agreement to compensate Subsidiary for the use of its losses, Ultimate Parent agreed to make a capital contribution to Parent equal to XXXXXXXXXX % of the amount of losses utilized by Subsidiary to shelter the capital gain arising on the sale of the purchased securities, namely $XXXXXXXXXX . Parent, in turn, agreed to make a contribution of capital in the same amount to Subsidiary or, in the alternative, at Subsidiary's option, a subscription for common shares of Subsidiary in the same amount. There is no evidence that common shares were issued. It appears that the payment was considered a contribution of capital by Parent to Subsidiary.
12. Ultimate Parent entered into a Canadian Tax Indemnity Agreement with Parent and Subsidiary. Ultimate Parent agreed to indemnify Parent or Subsidiary against any taxes that may be assessed with respect to the transactions to utilize Subsidiary's losses, including the payment of $XXXXXXXXXX .
13. For accounting purposes, Subsidiary recorded the contribution of capital as a reduction of its income tax expenses.
14. In the unaudited financial statements for Parent, the receipt of $XXXXXXXXXX was not recorded. According to a letter dated April 24, 2006, this omission in the financial statements was an oversight. In the consolidated financial statements, the receipt was recorded as a credit to contributed surplus while the contribution to Subsidiary was recorded as a debit to Investments in Subsidiary.
15. A waiver has been obtained for Subsidiary but not for Parent.
16. On XXXXXXXXXX , Ultimate Parent, Parent and Subsidiary amalgamated.
17. In XXXXXXXXXX , UPSub was amalgamated with XXXXXXXXXX ("UPSub1"). In XXXXXXXXXX , UPSub1 was wound up into Ultimate Parent.
18. Because of the amalgamation in XXXXXXXXXX , the indemnification agreement has become irrelevant.
Audit's Position:
It is your view that the amounts were received in the course of earning income from a business and would meet the conditions in subparagraphs 12(1)(x)(i) and (iii) of the Act. Further, in your view, the wording of paragraph 12(1)(x) of the Act does not exclude contributions of capital from being included in income under this paragraph. Your reasons are as follows:
A. Paragraph 12(1)(x) of the Act addresses payments such as inducements, reimbursements, etc. The payment under discussion is an inducement or reimbursement. Although the legal form of the payment is a contribution of capital, this payment was made to compensate Subsidiary for the use of tax losses in the amount of $XXXXXXXXXX . The amount of this inducement is calculated based on the losses utilized and the compensating payment would not have been made without the use of the losses. This payment is therefore addressed by paragraph 12(1)(x) of the Act.
B. The preamble to paragraph 12(1)(x) of the Act. The contribution of capital was a payment to induce the use or to compensate for the use of Subsidiary's losses. Subsidiary carried on a XXXXXXXXXX business. It was the normal business of Subsidiary that generated the losses. The preamble therefore does not exclude the compensation payment from being included in income under this subsection.
Clause 12(1)(x)(i)(B) of the Act. As per the share agreement between Subsidiary and UPSub, Ultimate Parent makes a payment of $XXXXXXXXXX to Parent and Parent in turn makes a contribution of capital to Subsidiary. As a result of this series of transactions utilizing Subsidiary's losses, Ultimate Parent obtains the benefit of sheltering the difference between the original ACB and FMV of the investments transferred. In effect, the ACB of Ultimate Parent's investments have increased from $XXXXXXXXXX to $XXXXXXXXXX with the capital gain sheltered by Subsidiary's losses. If we consider Parent as the payer, clause 12(1)(x)(i)(B) of the Act applies as Parent does not deal at arm's length with Ultimate Parent. Alternatively, if Ultimate Parent is considered the payer, again this clause applies as Ultimate Parent is the person obtaining the benefit.
C. Subparagraph 12(1)(x)(iii) of the Act. The contribution of capital is a "compensation" payment tied directly to the use of the losses. It has been calculated based on the tax benefits no longer available to Subsidiary and indirectly the minority shareholders of Parent. Without the use of the losses by Ultimate Parent, this "contribution of capital" would not have been made, thus, the payment was an inducement to allow Ultimate Parent to utilize the tax losses.
Alternatively, the contribution of capital can be included in income under section 9 of the Act. Subsidiary carried on a XXXXXXXXXX business that resulted in significant non-capital losses. It also incurred capital losses on the disposition of capital properties. Subsidiary is clearly being compensated for the use of its non-capital and capital losses (see the agreement) created in the normal course of business. Therefore, it is your view that the compensating payment is received as part of Subsidiary's XXXXXXXXXX business.
Taxpayer's Position
Subsidiary does not believe that the contribution of capital should be included in income under paragraph 12(1)(x) of the Act because, in their view, such amount cannot reasonably be considered to have been received by Subsidiary in the course of earning income from a business or property. In addition, the taxpayer's representative refers to CRA documents 2004-0076801R3, 2004-0070491R3, 2004-0100991R3 and 2003-0181283. In the representative's view, these examples demonstrate CRA's acceptance that the compensatory payments for losses utilized within an affiliated group are not offensive and should not give rise to taxable income and that the capital contributions are not subject to paragraph 12(1)(x) of the Act.
We agree with you that the contribution should be included in the income of Subsidiary under paragraph 12(1)(x) of the Act.
Generally, paragraph 12(1)(x) of the Act provides that certain inducements, reimbursements, contributions, allowances and assistance received by a taxpayer in the course of earning income from a business or property must be included in income "to the extent that" the particular amounts have not otherwise been included in income or reduced the cost of a property or the amount of an outlay or expense. Further, there is a presumption that all activities a corporation is engaged in are in the course of earning income.
Specifically, paragraph 12(1)(x) of the Act provides that any amount (other than a prescribed amount) received by a taxpayer in the year must be included in income from a business or property, if it is received from a person who pays the amount, among other things, in the course of earning income from a business or property or in order to achieve a benefit or advantage for the payer or for persons with whom the payer does not deal at arm's length, where the amount can reasonably be considered to have been received as an inducement, under subparagraph 12(1)(x)(iii), or a refund or reimbursement of an outlay or expense or an amount included in the cost of property, under subparagraph 12(1)(x)(iv), unless one of the exceptions set forth in subparagraphs 12(1)(x)(v) to (viii) of the Act applies.
In our view, a capital contribution payment to compensate Subsidiary for the use of its losses could be considered to have been received as an "inducement, whether as a grant, subsidy, forgivable loan, deduction from tax, allowance or any other form of inducement", as contemplated by the provisions of subparagraph 12(1)(x)(iii) of the Act.
Further, in the case at hand, in our view, none of those exceptions apply.
As to your alternative argument regarding section 9 of the Act, we note that by virtue of subparagraph 12(1)(x)(v) of the Act, paragraph 12(1)(x) of the Act has no application where section 9(1) of the Act applies due to the express wording "was not otherwise included in computing the taxpayer's income". Although, it may be arguable that section 9 of the Act could apply, we are strongly of the view that paragraph 12(1)(x) of the Act applies.
Our position, as reflected below XXXXXXXXXX, is that the amounts being compensated by Ultimate Parent for the use of Subsidiary's losses would be considered to "be received in the course of earning income from a business and would meet the conditions in subparagraph 12(1)(x)(i), (ii) and (iii) of the Act as:
(A) [Ultimate Parent] would have achieved a benefit or advantage from the utilization of the losses of [Subsidiary] and
(B) [Subsidiary] has received an inducement to allow [Ultimate Parent] to utilize its losses or the [Subsidiary] has received a reimbursement, contribution, allowance or assistance in respect of an outlay or expense. The excess of such outlay or expense over income resulted in losses that [Subsidiary] will allow [Ultimate Parent] to utilize."
The documents referred to by the taxpayer are not similar to the current situation. All of the documents referred to involve a wholly-owned group of corporations in a loss consolidation arrangement. The contributions of capital in those documents were made to a special purpose corporation in order for that special purpose corporation to pay its dividends on the preferred shares. In the documents referred to, there are no compensation payments for the use of a lossco's losses.
Generally Accepted Accounting Principles ("GAAP") should apply and the facts in paragraph 13 above indicate that Subsidiary did indeed follow GAAP. However, in this situation, the Subsidiary recorded the contribution as a reduction of income taxes and then deducted the amount on Schedule 1; thus, Subsidiary did not include the amount in income for tax purposes.
At the Federal Court - Trial Division in Woodward Stores [91 DTC 5090] the judge stated:
"..Some persons may take this particular subsection [9(1)] to mean that inducement payments may, even in the absence of paragraph 12(1)(x), be included in income, presumably by section 3 or subsection 9(1) of the Act. This was the case in French Shoes for example. However, insofar as I should also conclude that the generally accepted accounting principles should apply unless there is found some statutory rule to the contrary..."
The Court of Appeal in West Kootenay Power and Light Company Limited [92 DTC 6023] adopted the principle that the method used to report income [by a taxpayer] for tax purposes must be that which provides the "truer picture" of the taxpayer's revenue. In our view, this will generally be the method reflected for financial statement purposes.
We disagree with the representative's statement that the capital contribution cannot be included in the income of the Subsidiary because such amount cannot reasonably be considered to have been received in the course of earning income from a business or property. As has been noted, there is a presumption that income earned by a company, which has been incorporated for certain business purposes, is business income: see Canadian Marconi Co. v. M.N.R. (1986), 70 N.R. 174; 86 DTC 6526 (S.C.C.), especially at 6529. This is reflected in paragraph 5 of Interpretation Bulletin IT-73R4:
"Where a corporation was incorporated to earn income by doing business, there is a general presumption that profits arising from its activities are derived from a business (or from separate businesses as discussed in IT-206R). Thus, from the time the activities are contemplated commence (see IT-364), until they permanently cease, most corporations will be carrying on one or more business ...".
In summary, based on our comments above, we agree with your view that the payment of $XXXXXXXXXX should be included in Subsidiary's income by virtue of paragraph 12(1)(x) of the Act.
For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency'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. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
R. Albert, CA
for Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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