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:
1. How are upfront fees to be treated for Part I.3 tax when Taxpayer amortizes them into income for accounting but they are included in income in year of receipt for income tax purposes?
2. Are unamortized premiums, which are amortized into income for accounting purposes but are included as income in the year of receipt for income tax purposes, an advance or are they an “other surplus” for purposes of subparagraph 181.3(3)(a)(ii)?
3. Does an adjustment to the residual value of a XXXXXXXXXX represents a depreciation charge for accounting purposes?
4. How are deferred subvention payments to be treated by Taxpayer for purposes of Part I.3?
5. Are advance payments on leasing contracts advances for purposes of Part I.3 or “other surplus” for purposes of subparagraph 181.3(3)(a)(ii)?
6. Are customers’ rental security deposits advances for purposes of Part I.3?
7. Are cash-down payments surplus for purposes of Part I.3?
Position:
1. The upfront fees constitute surplus for purposes of subparagraph 181.3(3)(a)(ii).
2. The unamortized premiums are not advances but constitute surplus.
3. The adjustment constitutes a “reserve” for purposes of subparagraph 181.3(3)(a)(iii).
4. Included in capital.
5. They constitute advances. They may constitute a reserve as well.
6. Yes.
7. Yes.
Reasons:
1. The upfront fees are legally earned. They do not constitute advances.
2. They do not constitute advances. The unamortized premiums are legally earned.
3. Taxpayer has not provided authority or basis under generally accepted accounting principles for characterizing this adjustment as depreciation.
4. On the assumption that the income is legally earned in year 1 the deferred subvention payments would constitute surplus and therefore be included in capital under 181.3(3)(a)(ii).
5. The payments are unearned. No amount to be included in the capital of Taxpayer to the extent a reserve of an equivalent amount has been deducted in computing income under Part I.
6. They will have to be refunded to the customers at the end of the lease.
7. They have the legal nature of earned income.
March 25, 1999
XXXXXXXXXX TSO HEADQUARTERS
XXXXXXXXXX Michèle Trotier
(613) 957-3494
Attention: XXXXXXXXXX
982857
XXXXXXXXXX (“Taxpayer”)
XXXXXXXXXX (“PayerCo”)
XXXXXXXXXX Taxation Years - Part I.3 Tax Issues
This is in reply to your memorandum dated October 29, 1998 wherein you requested our views on a number of issues relating to Part I.3 tax. Following telephone conversations between XXXXXXXXXX of your Office and Michele Trotier of our Directorate it is our understanding that the following issues raised initially in your October 29, 1998 memorandum do not require our written comments:
a. Allowance for credit losses/Retail lease XXXXXXXXXX
b. A/R Sundry-XXXXXXXXXX Operating Lease Payments (XXXXXXXXXX)
c. Deferred Loan Origination Costs (XXXXXXXXXX)
d. Miscellaneous deposits and safekeeping fees (XXXXXXXXX )
We will provide you with our comments with respect to the other issues in the same order you have raised them in your memorandum.
All references to statute are to the Income Tax Act unless otherwise specified.
Statement of Facts
Taxpayer is a resident corporation which is a financial institution for purposes of section 181.
PayerCo is a resident corporation which is not a financial institution for purposes of section 181.
Taxpayer is a wholly-owned subsidiary of a U.S. corporation which is also a wholly-owned subsidiary of a U.S. corporation. PayerCo is a wholly-owned subsidiary of the same U.S. corporation.
Issues
1. Upfront fees- Swaps
Taxpayer receives upfront fees on certain interest/currency swaps. Prior to XXXXXXXXXX Taxpayer amortized these fees to income over the term of the debt issue for accounting purposes. Revenue Canada (“RC”) has reassessed these amounts as income in the year of receipt under section 9 with respect to the XXXXXXXXXX taxation years. You have advised that Taxpayer has concurred with this reassessment and has reported these amounts as income in the year of receipt for tax purposes under section 9 for the XXXXXXXXXX taxation years.
You have asked our opinion as to whether the upfront fees would be included in the capital of Taxpayer as an “other surplus” for purposes of subparagraph 181.3(3)(a)(ii). Taxpayer has been arguing that these upfront fees represent “advances” and are not included in its capital. Taxpayer is a financial institution for purposes of section 181 and “advances” do not form part of the capital of a financial institution.
We are of the view that these upfront fees are not advances since they do not have to be repaid nor are they received before they are due. Advances usually represent payments made before their due dates or money advances to be repaid. An advance is usually defined as simply “pay” or “pay money before it is due”. In TransCanada Pipelines Ltd decision [1992 - Ont. C.A.] (“TransCanada”), “advance” was referred to “in the sense of a payment on account”. The court quoted from the Dictionary of Business and Finance (1957), p.9, which defines an “advance” as “any payment made before it is due, or before the completion of an obligation for which it is to be paid. Examples include money paid to a contractor at the beginning of a contract, to aid him in undertaking the work, or money paid to the consignee of a shipment to enable him to meet expenses, and to be repaid upon sale of the shipment.” The definition in the Oxford English Dictionary, Second Edition (1989), of an “advance” was also quoted in this decision as a “Payment beforehand or in anticipation; payment on security of future reimbursement. Hence, a sum of money so furnished, a loan.” This decision also refers to a number of other definitions of “advance” which go along the same lines as the ones above. TransCanada decision also referred to another decision, Rose v Hickey (1878), 3.A.R. 309, 329, Patterson, J.A., which says: “’Advance’... is a word usually employed to denote money paid which is to be repaid.”
The Oerlikon Aerospatiale Inc decision (97 DTC 962) also refers to the TransCanada decision with respect to the definition of what constitutes an “advance”.
Black’s Law Dictionary (Six Edition) defines an “advance” as “...To pay money or render other value before it is due;...”. It also defines “advances” as “Moneys paid before or in advance of the proper time of payment; money or commodities furnished on credit; a loan or gift, or money advanced to be repaid conditionally.”
These upfront fees are amortized for accounting purposes over the term of the instrument to which they relate and therefore a deferred revenue amount would appear on the balance sheet of Taxpayer. Since these upfront fees do not have to be repaid by Taxpayer nor are they received before they are due, in our view the upfront fees would not constitute “advances”.
The issue then is whether the upfront fees, which as noted are deferred for accounting purposes, would be included in the calculation of capital pursuant to subparagraph 181.3(3)(a)(ii) as an “other surplus”. It is our view that the terminology used in Part I.3 is based on legal principles, a view which was endorsed by the Court in Autobus Thomas Inc., 1999 DTC 259, T.C.C., when the judge, on page 265, indicated that he “considered it necessary to take the analysis further, since the title given to a particular item in financial statements is not necessarily determinative of the legal nature of what it is supposed to represent.” Nevertheless we recognize that consideration must be given to accounting terminology.
Section 3250 of the Handbook of the Canadian Institute of Chartered Accountants (“CICA”) addresses the concept of surplus for purposes of Canadian generally accepted accounting principles. Included in the discussion of surplus in this section are the following comments:
- In accounting, “surplus” has long been used to designate the excess of net assets over the total paid-in par value or stated value of the shares of a corporation. This usage is firmly established in company law and finance, and is not likely to be discontinued;
- An adequate view of a company’s affairs requires information as to the source of any surplus shown in the balance sheet. A basic distinction exists between amounts received by way of contributions and amounts earned in the conduct of business (these being the only sources of realized surplus), and the difference should be recognized by classification in the balance sheet.
- Items of surplus should be segregated so as to distinguish between those derived from earnings and those derived from contributions. This may be accomplished by setting out the surplus item under two main headings, “Retained earnings” and “Contributed surplus” or in some circumstances by way of note.
- In recent years, more descriptive phrases have replaced terms which include the word surplus; for example, “retained earnings” is used as an alternative to “earned surplus”.
- Retained earnings represent the accumulated balance of income less losses arising from the operation of a business, after taking into account dividends, refundable taxes and other amounts that may be properly charged or credited thereto.
The comments in section 3250 of the Handbook indicate that accounting terminology is subject to change which is a reason why it was intended that the legal nature or character be relevant in determining what an amount on the balance sheet represents. Earned surplus or retained earnings for accounting purposes include amounts that have been included in the income statement which would be income that is considered to have been earned for accounting purposes. For accounting purposes the concept of the term surplus appears to be limited in application to retained earnings and contributed surplus.
Accordingly since “other surplus” for purposes of subparagraph 181.3(3)(a)(ii) has no apparent meaning for accounting purposes its meaning is to be ascertained solely on the basis of legal or general principles.
Black’s Law Dictionary, Sixth Edition, (“Black’s”) defines “surplus” as “A general term in corporate accounting that usually refers to either the excess of assets over liabilities or that amount further reduced by the stated capital represented by issued shares. Surplus has a more definite meaning when combined with a descriptive adjective from par value statutes, e.g. earned surplus, capital surplus or reduction surplus.” It defines “earned surplus” as “The portion of the surplus of a corporation equal to the balance of its net profits, income, gains and losses from the date of incorporation.”
The above, not unexpectantly, suggests that while accounting may utilize different descriptive terminology the concept of surplus is similar for legal and accounting purposes. With regard to the upfront fees Taxpayer does not consider these amounts to be earned for accounting purposes and therefore rather than being included in income and retained earnings these amounts are described on the balance sheet as deferred income. “Deferred income” is defined in Black’s as “income received but not yet earned”. While we express no opinion as the basis for treating the upfront fees as unearned for accounting purposes we note that as Taxpayer is not required to provide any further services or deliver any goods these fees have been legally earned. The fact that Taxpayer has not objected to the inclusion of the upfront fees in income for tax purposes pursuant to section 9 in the year of receipt and is therefore not entitled to claim a reserve under paragraph 20(1)(m) would tend to support the position that the upfront fees are earned. Accordingly it is our view that as the upfront fees are legally earned they constitute surplus of the taxpayer for purposes of subparagraph 181.3(3)(a)(ii).
2. Unamortized Premium
Taxpayer issues debt obligations to arm’s length purchasers at an interest rate that exceeds current market rates. It receives a premium on those obligations at the time of issuance. Prior to XXXXXXXXXX, for accounting purposes, Taxpayer included these premiums in income on an amortized basis over the period of the debt obligation. RC has reassessed these amounts as income in the year of receipt under section 9 with respect to the XXXXXXXXXX taxation years. You have advised that Taxpayer has concurred with this reassessment and has reported these amounts as income in the year of receipt under section 9 for the XXXXXXXXXX taxation years.
You have asked our opinion as to whether the premium would be included in the capital of Taxpayer as an “other surplus” for purposes of subparagraph 181.3(3)(a)(ii). Taxpayer has been arguing that these premiums represent “advances” and are not included in its capital since it is a financial institution for purposes of section 181 and “advances” do not form part of the capital of a financial institution.
For the same reasons set out under caption #1 above with respect to the upfront fees, we are of the view that the unamortized premiums would not constitute “advances” but would constitute surplus of Taxpayer for purposes of subparagraph 181.3(3)(a)(ii).
3. XXXXXXXXXX Residual Value Reserve
XXXXXXXXXX
RC has reassessed this amount as a contingent reserve pursuant to paragraph 18(1)(e) for Part I purposes. You have advised that Taxpayer has concurred with your reassessment.
XXXXXXXXXX
You have asked our opinion as to whether this additional $XXXXXXXXXX adjustment to the residual value represents a “reserve” which should be included in the Taxpayer’s capital pursuant to 181.3(3)(a)(iii). It appears that Taxpayer is not disputing that this additional adjustment represents a “reserve” since Taxpayer is arguing that this additional adjustment relates to the cost of the XXXXXXXXXX and is equivalent to a provision in respect of depreciation and as such would be excluded from the definition of “reserves” in subsection 181(1).
It has to be determined whether or not this $XXXXXXXXXX adjustment in fact represents depreciation for accounting purposes. In their July 3, 1998 letter to your Tax Services Office, Taxpayer indicated that such an adjustment to the residual value “relates to the cost of XXXXXXXXXX and is equivalent to a provision in respect of depreciation.” Taxpayer has not given any argument to why this $XXXXXXXXXX adjustment should be considered to be a depreciation charge. We were advised that RC does not think that Taxpayer will make any further submission on this issue.
We note that had Taxpayer recorded the residual value at the $XXXXXXXXXX amount instead of the $XXXXXXXXXX in the first place, there would not have been any adjustment made to the retained earnings and there would not have been any depreciation charge, since the initial entry recording this residual value of $XXXXXXXXXX is not recorded as a depreciation charge. It appears to us somewhat dubious that the further reduction of the initial residual value from $XXXXXXXXXX to $XXXXXXXXXX could then represent a depreciation charge.
Unless Taxpayer provides an authority or basis under generally accepted accounting principles for characterizing as depreciation this adjustment to the residual value, which is charged to income, it is our view that such an amount would constitute a “reserve” that is not an allowance in respect of depreciation. As noted above this amount is not deductible for income tax purposes and therefore would be included in computing the capital of Taxpayer pursuant to subparagraph 181.3(3)(a)(iii).
4. Deferred Subvention Income
We will briefly summarize what the above item represents since it has been the subject of a number of memoranda from our Directorate and your Office over the years for purposes of Part I tax. It is our understanding that the taxation years XXXXXXXXXX are presently under review by our Appeals Division.
These subvention income payments represent amounts received by Taxpayer from PayerCo in respect of financing contracts provided to purchasers of vehicles at rates of interest which are lower than market rates. The payment is made to Taxpayer to induce it to acquire these contracts by compensating it for the fact that the interest rates are below market.
It is our understanding that Taxpayer includes these subvention income payments in its income on a monthly basis as it receives the cash from PayerCo. However, PayerCo expenses these payments up front for tax purposes and not over the length of the contracts with respect to which PayerCo is paying the subvention income payments.
It is difficult for us to envisage how PayerCo can claim a deduction for income tax purposes and for accounting purposes on the basis that is has an enforceable liability to Taxpayer with respect to these subvention income payments and yet Taxpayer can conversely take the position that it has no enforceable right to such income and therefore records no such subvention income payments until such time as it receives the cash from PayerCo. The two parties should be treating these subvention income payments on a similar basis for accounting and for income tax purposes. For purposes of Part I Taxpayer has been assessed on the basis that the entire amount of the subvention payments are income in the year they are earned (i.e. year 1).
Based on the premise that PayerCo does have an enforceable liability to Taxpayer with respect to the subvention income payments we are of the view that these amounts should be reflected on a balance sheet prepared in accordance with generally accepted accounting principles pursuant to subparagraph 181(3)(b)(i). To the extent that this amount is reported as income it would be included in the capital of Taxpayer pursuant to subparagraph 181.3(3)(a)(ii) as “retained earnings”. To the extent it is reported as a deferred amount, we are of the view that it would be included in the capital of Taxpayer as surplus for purposes of subparagraph 181.3(3)(a)(ii) since the payments would be considered to be legally earned income and would therefore meet the definition of surplus as it is understood under legal and general principles as discussed under “Upfront fees - Swaps” above. With respect to this issue it would be appropriate to request a submission from Taxpayer as to the basis for their not reflecting the subvention payments in the balance sheet.
5. XXXXXXXXXX Advance Payments (XXXXXXXXXX)
These payments represent amounts which have been received by Taxpayer in respect of leasing contracts in advance of these amounts being owed by the customers under the leasing contract. You have advised that where a customer pays in advance the leasing payments under the leasing contract Taxpayer will charge a lower interest rate when computing the leasing payments as an incentive for the customers to pay in advance their leasing payments. It is our understanding that Taxpayer is reporting these payments as deferred items in the liability accounts for accounting purposes. Taxpayer brings into income these payments over the term of the leasing contracts to which they relate for both accounting and tax purposes. You have advised that RC has not reassessed with respect to these leasing advance payments. These amounts represent approximately XXXXXXXXXX.
You have requested our opinion as to whether these advance payments constitute “other surplus” of Taxpayer for purposes of subparagraph 181.3(3)(a)(ii). Taxpayer is of the view that these amount represent “advances”.
Taxpayer has advised in a letter dated January 28, 1999, to your Tax Services Office, that
“XXXXXXXXXX.”
As indicated under caption #1 above, the term “advance” often means simply “pay” or “pay money before it is due” and therefore has a broad scope.
In this case, it appears that the advance payments are legally advances. RC considers that these payments are included in income pursuant to paragraph 12(1)(a) and Taxpayer has been allowed to claim a reserve under paragraph 20(1)(m) which in this case is equal to the amount Taxpayer has deferred for accounting purposes. The fact that RC has not reassessed with respect to these advance payments is consistent with a finding that the payments are legally advances.
We note that the XXXXXXXXXX advance payments could also be considered to constitute a “reserve”, however, no amount would be included in capital under subparagraph 181.3(3)(a)(iii) given that an equivalent amount has been deducted in computing income under Part I.
6. Miscellaneous Deposit - XXXXXXXXXX LS Rent (XXXXXXXXXX)
You have advised that the balance in this account represents rental security deposits paid to Taxpayer by the customer at commencement of a lease, which are to be paid back to the customer upon termination of the lease. These deposits represent approximately XXXXXXXXXX. It is our understanding that Taxpayer is reporting these amounts as liabilities for accounting purposes. You have advised that Taxpayer is not reporting these amounts for income tax purposes since they represent liabilities of Taxpayer.
You have asked our opinion as to whether or not these rental security deposits could be considered to be “advances”.
We are of the opinion that customer deposits which have to be refunded to the customers represent “advances” for purposes of Part I.3 tax. Please refer to our comments as to what may constitute “advances” under caption #1 above for further discussion on this point. We are of the view that the rental security deposits represent “advances” made to Taxpayer by the customers since they will have to be refunded by Taxpayer at the end of the lease. Taxpayer, being a financial institution for purposes of Part I.3 tax, does not include “advances” in calculating its capital.
7. Cash-down Payments
You have advised that cash-down payments which may be received by Taxpayer from customers when XXXXXXXXXX contracts are signed do not form part of the APP referred to in Caption #5 above. You have also advised that these amounts are amortized for accounting purposes but are included by Taxpayer in income for tax purposes in the year of receipt under section 9.
You have asked our opinion as to whether these cash-down payments would be included in the capital of Taxpayer as an “other surplus” for purposes of subparagraph 181.3(3(a)(ii).
Since such amounts were included in income under section 9 on the basis that they have been earned by Taxpayer this would suggest that these payments would have the legal nature of earned income and as such would be included in capital as surplus for purposes of subparagraph 181.3(3)(a)(ii).
In closing, for your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department’s mainframe computer. 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 the disclosure including information that could disclose the identity of the taxpayer. Should your client requests a copy of this memorandum, they can be provided with the LAD version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Jackie Page at 613-957-0682. The severed copy will be sent to you for delivery to the client.
We trust the above comments will be of assistance.
F.Lee Workman
Section Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and Interpretations Directorate
Policy and Legislation Branch
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