12 March 1998 External T.I. 9731035 - SAFE INCOME - ACCOUNTING RESERVES

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

do accounting reserves set up prior to an acquisition of control reduce the safe income on hand earned after the change of control when the amounts are expended and deducted for tax purposes

Position: No

Reasons: see response

973103
XXXXXXXXXX T. Lanzer
(613) 957-2129

Attention:XXXXXXXXXX

March 11, 1998

Dear Sirs:

Re: Computation of Safe Income on Hand – Accounting Reserves

We are writing in response to your letter of November 21, 1997 wherein you requested our comments concerning the treatment of accounting reserves in the computation of safe income on hand.

In your situation, a corporation recorded accounting reserves for warranty, pension and severance accruals that remained unpaid and undeducted for tax purposes prior to the acquisition of the shares of the corporation by a new shareholder in an arm’s length transaction at fair market value. Subsequent to the acquisition, the corporation made cash payments in satisfaction of the accounting reserves and claimed a tax deduction for the amounts expended.

It is your view that while the safe income earned by the corporation (i.e., the income earned or realized) subsequent to the acquisition would be reduced by the deduction claimed for tax purposes in respect of the drawdown of the accounting reserves, the safe income on hand would not be reduced by these expenditures. In this regard, you have noted that the existence of these accounting reserves has reduced the fair market value of the company’s shares at the time they were recorded and would therefore reduce any capital gain inherent in its shares. The subsequent payout of these reserves would not, in your view, reduce the portion of the capital gain inherent in the company’s shares after the acquisition of control which is attributable to the safe income earned by the corporation after the acquisition of control.

In support of your position, you refer to Access Document Number 9231575 wherein Revenue Canada considered the treatment of amounts actually expended but not deducted, and cite the following therefrom:“Since the amounts have been expended, regardless whether they were deductible or not for tax purposes, they are no longer on hand to contribute to the fair market value of , or the gain inherent in, a share. Consequently, they do not form part of the safe income on hand attributable to that share. When these amounts are deducted for tax purposes in the future, they will reduce safe income but will not, generally, affect safe income on hand.”

The issue to be determined is whether a dividend paid by the corporation to the new shareholder prior to a subsequent sale of the shares could be recharacterized as proceeds of disposition pursuant to the provisions of subsection 55(2) of the Income Tax Act (the “Act”).

Our Comments

It appears that your request for an opinion involves both a specific taxpayer and a completed transaction. Since the responsibility for determining the tax consequences arising from completed transactions rests with the tax services offices, the appropriate office may, upon disclosure of all the relevant facts, be able to assist you in clarifying the tax consequences affecting this situation.

Although we cannot comment directly on your situation, we are able to provide you with the following general comments on the effect that deferred deductions have on the determination of safe income on hand of a corporation at a particular time.

Subsection 55(2) of the Act is an anti-avoidance provision designed to prevent the use of the inter-corporate dividend exemption to unduly reduce a capital gain on a sale of shares. It treats the dividend in these situations either as proceeds from the sale of the shares or as a capital gain and not as a dividend received by the corporation.

Subsection 55(2) does not apply to the portion of a capital gain that can be attributed to a corporation’s income earned or realized during the relevant holding period – referred to as “safe income”. Safe income is protected from the application of subsection 55(2) because this income has been subject to corporate income tax and should therefore be allowed to be paid as a tax-free dividend to other Canadian corporations.

It is the Department’s position that in order to contribute to the capital gain that would be realized on a disposition of a share at fair market value, the safe income must also be on hand, in the sense that it is available for distribution to the corporation’s shareholders. Consequently, a dividend will escape subsection 55(2) only if it has been paid out of the corporation’s “safe income on hand”.

Since the starting point in the calculation of “safe income” is net income as otherwise determined for purposes of the Act, certain accounting provisions, such as reserves, that are not currently deductible for income tax purposes will not generally reduce a corporation’s safe income. However, since such amounts will not contribute to the gain inherent in a corporation’s shares, they will have to be taken into account as a reduction in determining the corporation’s safe income on hand at the time the provisions are recorded. The subsequent deduction claimed for payments in respect of the drawdown of such accounting provisions would generally have no further effect on the computation of safe income on hand. Thus, safe income on hand earned subsequent to the time such reserves were set up would not be reduced a second time by a deduction claimed under the provisions of the Act. In accordance with paragraph 22 of Information Circular 70-6R3, the opinions expressed in this letter are not income tax rulings and are therefore not binding on the Department.

Yours truly,

for Director
Reorganizations and International Division
Income Tax Rulings and Interpretations Directorate
Policy and Legislation Branch

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