12 February 2004 Internal T.I. 2003-0027201I7 - Swaps and Part I.3 Tax

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 the obligation with regard to principal under swap contracts would be viewed as a "loan or advance" for the purposes of subsections 181.2(3) and 181.2(4) of the Act.

2. Whether a particular credit amount in the taxpayer's records should be included in computing the taxpayer's capital for purposes of Part I.3 of the Act?

Position: 1. No
2. Unable to conclude

Reasons: 1. Consistent with the position taken for purposes of Part I and Part XIII. XXXXXXXXXX

2. Insufficient information to determine how the credit amount arose and how it was treated in the financial statements. The nature of the amount must be determined before the issue of whether it is an amount to be included in the computation of capital can be addressed.

							February 12, 2004

	TORONTO CENTRE TSO					HEADQUARTERS
	Verification and Enforcement  				Alison Campbell
(613) 957-3496
	Attention:  Gordon MacGibbon
								2003-002720

XXXXXXXXXX - Part I.3 Reassessment
Relating to Swaps and Foreign Exchange Translations

We are writing in reply to your memoranda of June, October and November of 2003, requesting our views on the appropriate treatment under Part I.3 of the Income Tax Act (the "Act"), of certain items in the taxpayer's financial statements for the taxation year ended XXXXXXXXXX. We have also considered the submissions made by the taxpayer in respect of the issues, which you provided to us.

You have requested our views on two key issues that have arisen in the course of your audit of the taxpayer's XXXXXXXXXX taxation year.

1) Are the credit balances in the taxpayer's G/L accounts, with respect to its swap liabilities, "loans or advances" for the purposes of paragraph 181.2(3)(c) of the Act, and are the corresponding receivables, "loans and advances" in respect of which an investment allowance may be claimed by virtue of paragraph 181.2(4)(c) of the Act?

2) The taxpayer has requested an adjustment to reduce its capital as computed under Part I.3 of the Act, for its XXXXXXXXXX taxation year. You have questioned whether the adjustment should be granted.

Our first comments are general ones relating to subsection 181(3) of the Act. It is not clear to us that the balance sheet provided has been prepared in accordance with generally accepted accounting principals ("GAAP"). As GAAP balances are required pursuant to paragraph 181(3)(b) of the Act, we recommend that the taxpayer be asked to provide confirmation from their auditors that the balance sheet has, in fact, been prepared in accordance with GAAP.

Subsection 181(3) provides that, for the purposes of determining any amount under Part I.3, the amounts reflected in the balance sheet prepared in accordance with GAAP shall be used. The CRA has confirmed on a number of occasions that an amount must be reflected on the balance sheet (including the notes to the balance sheet) if it is to be included in a corporation's Part I.3 capital. For example, see Rulings opinion E2001-0106227.

Where the balance reflects an aggregation of underlying amounts, the CRA's view is that the balance sheet amount must be disaggregated for capital tax purposes. For example, see section 10 of IT-532. This view was confirmed by the Tax Court of Canada in PCL Construction Management Inc. 2000 DTC 2624 (TCC).

Issue 1: Swap Liabilities - "Loans or Advances"?

After reviewing the ISDA Master Agreements and confirmations that were provided, we have separated the transactions to which your query relates into two categories.

A) Most of the transactions appear to involve notional exchanges of principal amounts. This would include the interest rate swaps and some of the currency swap contracts. We are of the general view that where the principal amount under the swap contract is only notionally exchanged, there is no amount that would constitute a "loan or advance" for purposes of either the computation of "capital" or the "investment allowance" under the provisions of Part I.3 of the Act.

B) As you have noted in your submission, some of the transactions provide for actual exchanges of principal amounts between the parties to the confirmation and related ISDA Master Agreement. You question whether these amounts should be treated as "loans and advances" for purposes of Part I.3 of the Act. It has been the CRA's general position for many years to not treat swap transactions as involving loans or advances for the purposes of Part I and Part XIII of the Act. XXXXXXXXXX it is our view that the current position must be applied uniformly for all purposes of the Act, including Part I.3.

Our final comment on the swap liability issue is that in some cases there may be indebtedness with respect to swap payments as of the time that they become payable under the contracts. However, it is only in those cases where such an amount has remained outstanding for more than 365 days at the end of the taxpayer's fiscal period, that the swap payable will be indebtedness for the purposes of paragraph 181.2(3)(f) of the Act.

Issue 2: Taxpayer's Requested Adjustment to Capital Computation

We understand that the taxpayer has requested an adjustment to the computation of the corporation's capital for the XXXXXXXXXX taxation year. The adjustment would be to remove from capital an amount that had been included in the return filed, as a "deferred unrealized foreign exchange gain". The taxpayer's submissions state their position that the amounts are not "deferred unrealized exchange gains and losses" and that the amounts are "a product of hedge accounting for foreign currency denominated equity investments" or "an anticipated liability to a counter-party under a hedge". Unfortunately, no evidence in support of the true nature of the amounts in question has been provided, nor has there been any explanation of how the amounts were computed, how the amounts were treated for financial statement purposes and what the GAAP basis was for the financial statement presentation. The nomenclature used to describe the item is not sufficient to determine the capital treatment of the item. What the amounts in question actually are, is essential to the determination of whether the amounts are to be included in the computation of capital under subsection 181.2(3). Accordingly, we do not have sufficient information to provide an opinion on the proper treatment of the amounts in the computation of the taxpayer's liability under Part I.3 of the Act.

Other Comments

We do however, have a couple of comments that may assist you in working with the taxpayer to determine the nature of the amounts in question.

First, in your submission you provided that at least a portion of the $XXXXXXXXXX reduced the shareholders' equity section on the balance sheet. Sections 1650.32 to 1650.39 of the CICA Handbook state that an adjustment to shareholders' equity would be appropriate for reporting exchange gains and losses arising from the translation of the financial statements of self-sustaining foreign operations. Combining this fact with the taxpayer's accountant's statement that the adjustment item is "a product of hedge accounting for foreign currency denominated equity investments", suggests to us that at least a portion of the amount in question may relate to a translation adjustment resulting from the translation of equity investments in self-sustaining foreign operations. Subsection 181(3) of the Act, stipulates that the amounts to be used under Part I.3 are the amounts reflected in the financial statements prepared in accordance with GAAP, but for the application of consolidation and equity accounting. It should be determined whether the credit amount included in "Accounts Payable and Accrued Liabilities" and the debit entry to "Shareholders' Equity" are consolidation or equity entries. If this is the case, then both the credit the debit entries should be adjusted for, to remove the impact of the application of consolidation or equity accounting methods. You should have the taxpayer confirm for you whether this is in fact the case before deciding whether or not to agree to the adjustment.

Second, based on the statement by the taxpayer's legal counsel that the adjustment item is "an anticipated liability to a counterparty under a hedge" it is possible that the adjustment item, if not "deferred unrealized foreign exchange gains" is a "provision" for accounting purposes. Accounting provisions are reserves for Part I.3 purposes pursuant to subsection 181(1) of the Act, and are included in the computation of capital by virtue of paragraph 181.2(3)(b) of the Act. In this regard, reference should be made to our memorandum 2003-0002721, which was sent to you in connection with another submission.

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. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

F. Lee Workman
Manager
Financial Institutions Section
Income Tax Rulings Directorate
Policy and Planning Branch