Principal Issues: Whether the CRA's long-standing position that losses should be reflected in a corporation's safe income on hand when incurred and not when deducted for tax purposes should be applicable in a context where a corporation is carrying on a construction business and computing its income following the position stated in Interpretation Bulletin IT-92R2.
Position: Yes, we are of the opinion that the long-standing position is reasonable in the circumstances.
Reasons: Wording of the Act and previous positions.
XXXXXXXXXX Canada Revenue Agency Audit Division 2011-039953 XXXXXXXXXX Tax Services Office U. Chalupa XXXXXXXXXX (613) 957-2124
May 9, 2011
Dear Madam,
Subject: XXXXXXXXXX - Calculation of safe income
This is in response to your XXXXXXXXXX note, in which you requested our opinion with respect to the computation of the safe income on hand of XXXXXXXXXX ("Opco"). More specifically, it is necessary to determine in which taxation year a non-capital loss (“NCL") sustained by a corporation carrying on a business in the construction industry in the United States is to be taken into account in the course of calculating its safe income on hand.
Unless otherwise indicated, any reference herein to a legislative provision constitutes a reference to a provision of the Income Tax Act (the "Act").
Context
During a reorganization put in place to allow the withdrawal of XXXXXXXXXX as well as its holding corporation XXXXXXXXXX ("Portco") from the corporate group, XXXXXXXXXX ("Holdco") repurchased, on XXXXXXXXXX, XXXXXXXXXX class "XXXXXXXXXX" shares (participating shares) in its capital stock held by Portco for the amount of $XXXXXXXXXX.
The relevant facts in this case may be summarized as follows:
- Prior to XXXXXXXXXX, Portco held XXXXXXXXXX% of the participating shares of the capital stock of Holdco;
- Holdco’s fiscal year ends on XXXXXXXXXX ;
- Holdco, for its part, holds all of the issued and outstanding shares of the capital stock of Opco and XXXXXXXXXX;
- Opco carries on a business in the construction industry and its fiscal period ends on XXXXXXXXXX;
- Opco's pre-tax net income for the XXXXXXXXXX to XXXXXXXXXX taxation years was: $XXXXXXXXXX;
- Opco's net taxable profits or losses for the XXXXXXXXXX to XXXXXXXXXX taxation years were: $XXXXXXXXXX;
- The NCL sustained by Opco in its XXXXXXXXXX taxation year has been carried forward to Opco's taxation years ending on XXXXXXXXXX as to $XXXXXXXXXX and on XXXXXXXXXX as to $XXXXXXXXXX.
The computation of the safe income on hand of Holdco was made on a "consolidated" basis so as to include the safe income on hand of its subsidiaries. Generally speaking, you accept the computations for safe income on hand for all corporations in the corporate group, except for a particular issue respecting the computation of Opco's safe income on hand. In particular, you query the timing of the deduction, in computing Opco's safe income on hand, of the NCL incurred in XXXXXXXXXX.
Issue
The NCL sustained in XXXXXXXXXX by Opco was deducted in computing Opco's safe income on hand in the taxation years to which it was carried forward, in XXXXXXXXXX and XXXXXXXXXX.
The timing of the NCL deduction in this file is significant for the XXXXXXXXXX taxation year. In particular, since the redemption of the shares of the capital stock of Holdco held by Portco took place before the end of Holdco’s taxation year, a proportional computation was then carried out by the representatives of the taxpayer in order to take into consideration the safe income on hand of the corporation for the "stub" period from XXXXXXXXXX to XXXXXXXXXX. In other words, the safe income on hand computed for Holdco’s XXXXXXXXXX taxation year was determined based on the number of days the shares of the capital stock of Holdco were held by Portco over 365 days. Thus, in computing the safe income on hand in XXXXXXXXXX, only a portion of Opco's loss of $XXXXXXXXXX and carried forward from the XXXXXXXXXX taxation year, i.e., $XXXXXXXXXX, decreased the corporate group's safe income on hand.
Your Position
Under your position, the NCL sustained by Opco in XXXXXXXXXX should be taken into consideration in computing Opco's safe income on hand in the year in which it was sustained, being the taxation year ending on XXXXXXXXXX. As a result, Opco's safe income on hand should be reduced by an amount of $XXXXXXXXXX to reflect the full amount of the NCL sustained by Opco in XXXXXXXXXX. This would increase the deemed capital gain realized by Portco as a result of the application of subsection 55(2) by $XXXXXXXXXX, being XXXXXXXXXX% of $XXXXXXXXXX.
You submit that the safe income of a corporation is its net income for tax purposes in accordance with the computation in section 3. In your opinion, the NCL in the amount of $XXXXXXXXXX sustained in XXXXXXXXXX was computed in accordance with the Act. You also refer to Income Tax Technical News, No. 37, which states that an amount would generally only be included in a corporation's safe income to the extent that it is included in the determination of its net income for tax purposes or is an adjustment specifically set out in paragraph 55(5)(b) or (c). You stated that after computing the safe income, the safe income on hand of the corporation must be determined next. Referring to Income Tax Technical News, No. 37, you emphasized that, to do this, the safe income must be adjusted by certain amounts that do not affect the corporation's net income such as, for example, dividends, taxes payable or receivable, and non-deductible expenses. Your understanding of Income Tax Technical News No. 37 is that those adjustments are necessary to reflect the impact of cash outflows on safe income. In your opinion, in the file under review, the safe income on hand is supported by the fair market value ("FMV") of the net assets of the corporation even if that safe income on hand is computed taking into account the tax loss in the year in which it is sustained.
In addition, you referred to the general rule established by John R. Robertson in 1981 that the loss sustained by a corporation must be taken into account in computing the safe income on hand in the year in which it was incurred. You stated that you have not found any literature indicating that this general rule should not apply to a corporation carrying on a business in the construction industry.
In this respect, you summarized the tax peculiarities of this sector as follows: the closing balances of the work in progress, the unapproved work and the construction holdbacks ("WIP”) are not to be included in the income of a construction contractor, because they are not considered as accounts receivable. Furthermore, the costs incurred in carrying out this work in progress are deducted in computing the net income of the year in which they are incurred even if a portion of the revenue from the work performed is not included in income until the invoices generate accounts receivable. The result is that the corporation reduces its taxable income by the expenses incurred for work in progress even though it is not taxable. In light of the above, you wonder whether the loss sustained by the corporation could in fact be described as an "artificial" loss.
Finally, you indicated that safe income on hand, like safe income, is a tax and not an accounting concept.
Taxpayer's Position
Under the position of the taxpayer's representatives, the NCL sustained by Opco in XXXXXXXXXX should be taken into account in computing the safe income on hand for the years to which the loss was carried forward, namely, the years ending XXXXXXXXXX and XXXXXXXXXX respectively.
The taxpayer's representatives submit that the particular facts of this case support this view. In their opinion, the tax loss realized in XXXXXXXXXX by Opco is a notional loss, as demonstrated by the corporation's financial statements for the taxation year in question, where a pre-tax accounting profit of $XXXXXXXXXX was recorded. Leaving aside the deduction for the WIP, the corporation did not realize any losses, but instead a profit. According to the taxpayer's representatives, it is incorrect to consider that the tax loss of XXXXXXXXXX reduces the safe income on hand for that year, because it is equally possible to claim that work in progress at that date, although not taxed immediately under the tax laws, increases the same safe income on hand.
In addition, based on Income Tax Technical News No. 37, the taxpayer's representatives are of the view that the addition or deduction in calculating a corporation's net income of amounts constituting WIP increases or reduces the safe income on hand of the corporation, but that such increase or reduction would not be supported by a change in the FMV of the same during the same period. Thus, according to them, it is wrong to reduce the corporation’s safe income on hand for NCLs sustained because of fluctuations in the reserves for WIP.
The taxpayer's representatives further argue that if the CRA does not include the WIP of XXXXXXXXXX in computing the safe income on hand for that taxation year because it is not yet taxed, it cannot reduce the computation of the safe income on hand by the amount of the losses sustained at that time as they were not yet used and were created in a notional manner and without regard to the market value of the corporation. According to them, the adoption of a contrary treatment does not reflect economic reality.
Representatives of the taxpayer add that it is unfair for a shareholder who departs from a corporation to bear the entire loss from the WIP reserves during the holding period of the shares, even though the shareholder cannot benefit from the reversal of certain reserves which will increase the safe income on hand relating to its shares on the ground that such reserves have not yet been taxed.
Our Comments
We agree with your conclusion that Opco's NCL in XXXXXXXXXX should be taken into account in computing Opco's safe income on hand in the year in which it was sustained, i.e., for the taxation year ending on XXXXXXXXXX. This treatment of the NCL lends itself to a computation of the safe income on hand attributable to the shares of the capital stock of Holdco held by Portco that is reasonable in the circumstances. Our conclusion is based on the following observations.
At the outset, it should be recalled that the determination of safe income on hand attributable to shares of a corporation requires a review of all facts and circumstances pertaining to a particular situation.
That said, subsection 55(2) will apply where a corporation resident in Canada has received a taxable dividend as part of a series of transactions one of the purposes of which (or, in a share buyback context, one of the results of which) was to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on a disposition at FMV of any share immediately before the dividend and that could be reasonably considered to be attributable to something other than safe income on hand prior to the determination of the relevant safe income. Recall that in Canada v. Nassau Walnut Investments Inc., [1997] 2 FC 279 and Canada v. Brelco Drilling Ltd., [1999] 4 FC 35, the Federal Court of Appeal recognized that in the face of two reasonable methods that can be used to evaluate and attribute safe income to a share, the Courts are inclined to adopt the approach of the CRA (see also 2009-0330201C6).
The income "earned or realized" by a corporation referred to in subsection 55(2) is its net income computed for the purposes of the Act taking into account the adjustments referred to in paragraphs 55(5)(b) to (d). However, it must be "on hand" to be able to contribute to an unrealized capital gain on a share (see Robert J. L. Read, Section 55: A Review of Current Issues, 1988 Conference Report). For example, if the income has been used or set aside as a reserve to pay expenses that are non-deductible for the purposes of the Act, to pay dividends or to pay taxes, it can no longer be considered on hand to finance the payment of a dividend (see Income Tax Technical News No. 37). In our view, this principle applies regardless of whether the corporation has unrealized income that could potentially absorb those disbursements.
In addition, according to the CRA's long-standing position (refer to the rules set out by Mr. John R. Robertson in 1981 and Technical Interpretation 2011-0395701E5), NCLs generally reduce the safe income on hand when they are sustained and not when deducted in computing the taxable income of the corporation. The rationale for this rule is that losses incurred by a corporation represent amounts expended at the time the expenses were incurred by that corporation. Consequently, those amounts spent are no longer on hand to contribute to the capital gain inherent in a share of the particular corporation.
That rule must be applied in the light of Brelco, supra, and The Queen v. Kruco Inc., 2003 DTC 5506 (FCA). Thus, the nature of the loss must be analyzed to determine whether it has reduced the amount of safe income on hand of a corporation, that is, if an amount of safe income on hand has been expended such that the income no longer contributes to the unrealized capital gain attached to a share. It should also be noted that, according to Brelco, supra, the losses of a foreign affiliate may have an effect on the computation of the safe income on hand of its parent corporation. In 2001-0093385, the CRA clarified that this principle also applies in a domestic context and that when calculating safe income on hand attributable to shares of the capital stock of a corporation, account must be taken of losses of a subsidiary of the corporation where such loss results in a reduction of the FMV of the shares of the corporation.
In this case, we are of the view that, contrary to the representations of the taxpayer's representatives, the tax loss sustained by Opco in XXXXXXXXXX is not fictitious. That loss instead results from the application of the Act and reflects expenses actually incurred by Opco. Indeed, the fact that an item of revenue recognized at the accounting level can be deducted when calculating the net taxable income of a corporation operating in the construction sector does not detract from the fact that the expenses that create that tax loss have actually been incurred by the corporation. The peculiarity here instead lies in the fact that part of the income invoiced by the corporation will be included in the computation of the net income of the corporation at a later date and cannot therefore be part of the "realized or earned" income of the corporation until that later time.
Furthermore, it seems to us that, contrary to the submissions of the taxpayer's representatives, the fact that the corporation's FMV does not fluctuate with the addition or deduction of the WIP reserves does not necessarily have any influence on the adjustments to be made to the computation of the safe income on hand. In our view, it must be determined whether an amount of the safe income on hand was expended so that such income can no longer contribute to the unrealized capital gain on a share. In other words, it is necessary to determine what portion of the unrealized capital gain on the shares is attributable to the safe income on hand and what portion is attributable to income or taxable gains not yet realized.
In addition, we believe that the passage from Income Tax Technical News No. 37 to which the taxpayer's representatives refer merely illustrates the fact that not deducting from safe income on hand items that are otherwise included in a corporation's net income but are no longer on hand or available (such as non-deductible expenses), could have the effect of permitting a "safe" income dividend attributable to unrealized income.
In light of the foregoing, it appears to us that the NCL of Opco sustained in XXXXXXXXXX should reduce the safe income on hand of the corporation in the year in which the loss was incurred. Indeed, in our opinion, this loss is not fictitious, but results from the application of the Act and reflects expenses actually incurred by the corporation. In this case, it is necessary to determine whether a portion of the safe income on hand was expended so that that income can no longer contribute to the unrealized capital gain on a share. In our view, the CRA's longstanding position for the deduction of a loss in the year in which it is incurred, on the ground that the loss was financed by income earned or otherwise realized, must prevail in the current file. This accords with the terms of subsection 55(2), as well as with the purpose underlying that statutory provision. The peculiarities in this file do not make that position unreasonable and do not justify departing from it.
Accepting the position of the taxpayer's representatives in this case would be tantamount to accepting that the expenditures made by Opco in XXXXXXXXXX that generated the tax loss were financed from unrealized assets for tax purposes (such as, for example, WIP) and not from Opco's pre-XXXXXXXXXX safe income on hand. The CRA's longstanding position is instead to reduce the safe income on hand by every dollar of expenses that contributed to the loss sustained by the corporation on the grounds that such income is no longer on hand to contribute to the unrealized capital gain on a share. We do not believe that the application of this general rule advanced by Mr. John R. Robertson in 1981 to the facts of this case is unreasonable or inconsistent with the purpose of subsection 55(2). Thus, as long as an income item (such as WIP) is not "earned or realized" (that is, it is not included in computing the net income of the corporation for the purposes of the Act), it should not be considered, even indirectly, in the computation of the safe income on hand of a corporation. This position is supported by the wording of paragraph 55(5)(a), which provides that the portion of a capital gain attributable to any income expected to be earned or realized by a corporation after the safe-income determination time for the transaction, event or series is deemed to be a portion of a capital gain attributable to anything other than income.
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We hope that these comments are of assistance.
Best regards,
Stéphane Prud'Homme, Notary, M. Fisc.
Manager
Mergers and Acquisitions Section
Corporate Reorganizations and Resource Industry Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch