31 August 1993 Internal T.I. 9305667 F - Effects of Tax Credits on Safe Income

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.

LAVAL DISTRICT OFFICE Corporate Reorganizations III Technical Services and Specialized Audit Section

Impact of Share Purchase Tax Credit and Investment Tax Credit on Income Earned or Realized after 1971 ("Safe Income")

This is in reply to your memorandum of February 18, 1993 wherein you requested our opinion regarding the effect that a share-purchase tax credit ("SPTC"), within the meaning assigned by paragraph 127.2(6)(a) of the Income Tax Act (the "Act"), an investment tax credit ("ITC"), within the meaning of subsection 127(9) of the Act, and Part VII taxes, have on the calculation of Safe Income of one or more corporations within a corporate group.

The facts of the particular situation are as follows:

1.     In each of XXXXXXXXXX a parent corporation ("Parent") acquired additional shares of its subsidiary ("Subco1"). The aggregate value of the shares acquired over the years by Parent was $XXXXXXXXXX In each case, Subco1 designated an amount pursuant to subsection 192(4) of the Act and Parent claimed a deduction for the resultant SPTC pursuant to subsection 127.2(1) of the Act to reduce its Part I tax otherwise payable. In consequence of the designation, Subco1 became liable for Part VII tax pursuant to subsection 192(1) of the Act.

2.     Immediately after each issuance of its shares to Parent, Subco1 acquired additional shares of its subsidiary ("Subco2"). In each case, Subco2 also designated an amount pursuant to subsection 192(4) of the Act and Subco1 claimed a deduction for the resultant SPTC to reduce its Part VII tax payable pursuant to subparagraph 192(2)(a)(i) of the Act. Consequently, Subco2 became liable for Part VII tax pursuant to subsection 192(1) of the Act.

3.     Subco2, which had previously acquired a qualified property described under subsection 127(9) of the Act, then applied the resultant ITC to reduce its Part VII tax payable pursuant to subparagraph 192(2)(a)(ii) of the Act.

4.     In XXXXXXXXXX, Subco1 and Subco2 were amalgamated pursuant to the provisions of section 87 of the Act and immediately thereafter the amalgamated corporation was wound up into Parent. In XXXXXXXXXX, Parent redeemed a number of its shares held by one of its corporate shareholders.

You have requested our views regarding the effects of the SPTC and the ITC on the calculation of Safe Income attributable to the shares of each of the corporations described herein, which would become Safe Income of Parent as a result of the amalgamation and wind-up referred to in paragraph 4 above.

Our Comments:

In order to determine the effects of any particular tax credit on the Safe Income with respect to a share of a corporation, we would have to look at the nature of the tax credit itself and how it would attribute to the gain that would be realized on a disposition at fair market value of the share. In this regard, it is necessary to consider the effect of other items which would limit the ability of a corporation to pay a dividend out of Safe Income.

In the Department's paper "Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55" that was published in the 1981 Conference Report (the "1981 Paper" and the "1981 Conference Report", respectively), guidelines were given for computing Safe Income, and as explained on page 83 of the 1981 Conference Report, it is only that portion of Safe Income that remains on hand immediately before a dividend is paid that can contribute to a gain realized on the disposition of a share. In addition, we also took the position that undistributed retained taxed earnings only attribute to the value of a share of a corporation on a dollar for dollar basis, and that any balance of the gain is attributable to something other than "income earned or realized".

Thus, it is possible that a computation of Safe Income could result in an amount greater than that which could be paid as a safe dividend. For example, the 1981 Paper mentioned that items that are non- deductible for income tax purposes (see pages 90 and 104 of the 1981 Conference Report) will reduce the amount of post-1971 income to which a capital gain could be attributed, and this gives rise to the concept of "Safe Income on Hand", as referred to on page 18:4 of the Department's paper "Section 55: A Review of Current Issues", which has been published in the 1988 Conference Report (the "1988 Paper").

Parent's Safe Income

Generally, a corporation's annual Safe Income consists of its net income for tax purposes as adjusted by paragraph 55(5)(b), (c) or (d), as the case may be. Certain deductions in computing taxable income (e.g. charitable donations), income taxes and the non-deductible items referred to above are then deducted in computing Safe Income on Hand. In determining Parent's Safe Income on Hand, the application of the SPTC in reducing its Part I tax otherwise payable initially results in an increase in its Safe Income on Hand. However, it is our view that the amount required by subsection 127.2(8) to be deducted in computing the cost to Parent of the shares of Subco1 will reduce Parent's Safe Income on Hand, since this cost reduction represents what Parent paid out to obtain the SPTC. Although the Department stated in the 1981 Paper on page 90 of the 1981 Conference Report that Safe Income on Hand is not reduced by a disbursement made in respect of the acquisition of property, it is our view that the portion of the share purchase price which could reasonably be regarded as consideration for the SPTC is not a disbursement made for the acquisition of the shares. In this regard, subsection 127.2(11) only applies for purposes of section 127.2 and Part VII of the Act.

Therefore, Parent's Safe Income on Hand for each year in which it deducted an SPTC would be equal to the income earned in that particular year net of its tax liability after the reduction resulting from the SPTC claimed for that particular year, but taking into consideration the outlay in respect of the cost reduction referred to herein. This assumes no other amount is relevant in determining Parent's Safe Income on Hand, i.e. no dividends were paid or no other non-deductible expenditures were incurred.

Subco1's Safe Income

In each year that Subco1 designated an amount under subsection 192(4) of the Act in respect of Parent, it would have a Part VII tax liability for that year. Consequently, the Part VII tax liability would initially decrease Subco1's Safe Income on Hand. However, assuming that in each such year, Subco1 would also have an SPTC as a result of the designation made by Subco2, then Subco1 would have a Part VII refund by virtue of subparagraph 192(2)(a)(i) of the Act. In such a case, Subco1's Part VII tax liability would be offset by its Part VII tax refund, and consequently, its Safe Income on Hand, otherwise determined, would neither be decreased nor increased by the Part VII tax liability and the offsetting refund. However, as explained above with respect to Parent, the amount required by subsection 127.2(8) to be deducted by Subco1 in computing the cost of its shares of Subco2 would reduce Safe Income on Hand of Subco1, but this reduction would be offset by that portion of the share contribution received from Parent that represents the consideration paid by Parent for the SPTC.

Subco2's Safe Income

In each year that Subco2 designated an amount under subsection 192(4) of the Act in respect of Subco1, it would have a Part VII tax liability for that year. As in the case of Subco1, we are of the view that the Part VII tax liability would decrease Subco2's Safe Income on Hand. However, for the reasons given below, the Part VII tax refund resulting from the utilization of any ITC, pursuant to subparagraph 192(2)(a)(ii) of the Act, would not offset Subco2's reduction in Safe Income on Hand resulting from the Part VII tax liability. The Department's views regarding the recognition of an ITC in the computation of Safe Income (and, impliedly, Safe Income on Hand) were explained in a paper presented by Mr. M. Hiltz of our Directorate at the 43rd Tax Conference of the Canadian Tax Foundation held in Toronto in 1991 (the "1991 Paper"), and may be found in chapter 15 of the 1991 Conference Report. On page 15:16 of the 1991 Conference Report, we stated that:

"The income earned or realized of a corporation in a year that acquired a depreciable property in that year will not be affected by reason of the deduction in the year of an amount in respect of such property under subsection 127(5). In other words, the tax credit deducted is not included in income earned or realized. In the following year, however, the capital cost of the property will be reduced by reason of the application of paragraph 13(7.1)(e). As a result, the income and, therefore, the income earned or realized of the corporation will increase in the following and subsequent years."

For example, if Subco2 reduced a Part VII tax liability in XXXXXXXXXX by applying an ITC in the manner set out under subparagraph 192(2)(a)(ii) of the Act, then pursuant to paragraph 13(7.1)(e) and subparagraph 13(21)(f)(vii) of the Act, the cost and undepreciated capital cost of the property would be reduced in XXXXXXXXXX by the amount of the Part VII refund claimed by Subco2 in XXXXXXXXXX. In this regard, we would point out that for the purposes of paragraph 13(7.1)(e) and subparagraph 13(21)(f)(vii) of the Act, an amount claimed under subparagraph 192(2)(a)(ii) is deemed by subsection 192(10) of the Act to have been deducted under subsection 127(5) of the Act.

Therefore, the ITC will be included in Subco2's Safe Income (and Safe Income on Hand) over the period that the income tax effects of the particular ITC will be realized through Subco2's operations. In this regard, you have not informed us when Subco2 acquired the qualified property referred to in 3 above. However, whether Subco2 acquired a qualified property in each of XXXXXXXXXX in one of those years, or in two of those years, it is our position that, as indicated above, the resultant ITC which may be applied by Subco2 as a Part VII refund pursuant to subparagraph 192(2)(a)(ii) of the Act against its Part VII tax liability for the particular year would not increase its Safe Income on Hand otherwise determined for that year. Therefore, although the Part VII tax liability would reduce Safe Income on Hand for the year in which it arose, the Part VII refund provisions of subparagraph 192(2)(a)(ii) of the Act would not offset Part VII tax payable. Rather, Safe Income on Hand of Subco2 would only benefit from the ITC in the following and subsequent years. However, the negative effect of the Part VII tax would be offset by that portion of the share contribution received from Subco1 that represents the consideration paid by Subco1 for the SPTC.

Summary

As can be seen from the foregoing analysis, the SPTC claimed by Parent and by Subco1 is neutral in determining their Safe Income on Hand, and the ITC claimed by Subco2 only benefits its Safe Income on Hand in taxation years subsequent to the taxation year in which it is claimed. It may also be noted that although the Part VII tax payable by Subco2 is not reduced by the Part VII refund generated by the ITC, the Part VII tax is neutralized by the share contribution made by Subco1, and we consider that this is so notwithstanding that Subco1 used the share contribution to acquire the property which generated the ITC.

In substance, the overall result is appropriate, since it is only Safe Income on Hand of Subco2 that should benefit in the years that the income tax effects of the ITC are realized. Furthermore, the Safe Income on Hand of Parent and Subco1 should be neutral in terms of the tax effects of the flow of funds down to Subco2, and this too is appropriate, since Safe Income on Hand of these corporations should not be duplicated by what amounts to the same expenditure that generated the ITC claimed by Subco2.

One further point to bear in mind is that Safe Income on Hand can never be greater than Safe Income, and in numerous cases, will be less. It is also important to note that liquid funds may not always increase Safe Income on Hand. For example, if funds are borrowed from a bank in order to pay a safe dividend, and if the safe dividend is payable out of Safe Income on Hand of a corporation as determined in accordance with the guidelines given the 1981 Paper and the 1988 Paper, then that is acceptable. However, if the borrowed funds would exceed a safe dividend that could be paid out of Safe Income on Hand, it is likely that the borrowing represents an encumbrance on an unrealized gain in one or more properties of the corporation, and as such, would be subject to the provisions of subsection 55(2) of the Act.

The attached appendix illustrates the effects of the SPTC, the Part VII tax and Part VII refund, and the ITC, in determining Safe Income on Hand in respect of Parent, Subco1 and Subco2.

Amalgamation and Wind-up

As stated in the 1981 Paper and reaffirmed in the 1988 Paper and the 1991 Paper, Safe Income of a parent corporation is calculated on a consolidated basis. Consequently, Parent's Safe Income immediately after the amalgamation and wind-up referred to above will include its interest in the Safe Income of Subco1 and Subco2. However, the ability of Parent to pay a dividend out of its Safe Income so determined will be limited to its Safe Income on Hand.

Therefore, Safe Income on Hand of Parent in respect of the redemption of its shares held by the corporate shareholder referred to above should be determined in accordance with our comments given above.

We trust that the foregoing comments will be of assistance to you.

Chief Corporate Reorganizations III Section Reorganizations and Foreign DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch

APPENDIX

Assuming that the ITC claimed by Subco2 is $100, the following analysis sets out the effect of the ITC, the SPTC, the Part VII tax and the Part VII refund, and the outlay reflected by the cost reduction required by subsection 127.2(8) of the Act, on Safe Income on Hand in respect of each of Parent, Subco1 and Subco2 in the year ("Year 1") in which Subco2 claims the ITC.

Safe Income on Hand

Parent

SPTC  $100 127.2(8) cost reduction (100)

Net effect on Safe Income on Hand Subco1

Part VII tax liability $(100) SPTC 100 127.2(8) cost reduction (100) Consideration received by Subco1 for the SPTC issued to Parent

•      Subco2

ITC 0 Part VII tax liability $(100) Consideration received by Subco2 for the SPTC issued to Subco1

•      Subco2

ITC (Year 2 and subsequent 4 years) $ 20 *

*Assumes that the tax effect of the capital cost allowance is realized over a period of five years.