Principal Issues:
(1) If M Co invests $60,000 in shares in its subsidiary Prod Co, is it reasonable to regard this additional outlay as a payment made on account of M Co's acquisition of an interest in Prod Co in the form of shares, within the meaning of subparagraph 12(1)(x)(viii) of the Act?
(2) Can M Co's equity investment be treated as an amount of assistance that would reduce Prod Co's "qualified labour expenditure" for the purposes of section 125.4?
(3) If M Co converts its loan into shares at the end of production, will this be treated as an aid amount?
Position:
(1) Yes.
(2) No.
(3) No.
Reasons:
(1) It appears to us that each share issued to a person by a corporation, out of one of the classes of shares of its capital stock, has particular rights. In our view, when Prod Co issues shares to M Co, M Co acquires rights in its subsidiary within the meaning of subparagraph 12(1)(x)(viii).
(2) The definition of "assistance” in subsection 125.4(1) refers to amounts that would, inter alia, be included under paragraph 12(1)(x) in computing a taxpayer’s income if that paragraph were read without reference to subparagraph to 12(1)(x)(vii).
(3) Assuming that paragraph 12(1)(x) did not apply at the time the loan was made, the loan could be subject to section 80 at the time it is settled or extinguished without payment or by payment of less than the principal. Application of paragraphs 80(2)(g) and (g.1). The debt settlement would not constitute assistance for the purposes of section 125.4.
May 16, 2005
International Tax Directorate Headquarters
6th floor, Canada Building Danielle Bouffard
(613) 957-8953
Attention: Mr. Pierre Mercier
2005-011906Producer's capital outlay - section 125.4 of the Income Tax Act
This letter is in response to your email of March 2, 2005 in which you requested our opinion on the above subject. We have taken into account the additional information that you sent us by email on March 30, 2005 and during our telephone conversations (Mercier/Bouffard).
As part of your request, you submitted a hypothetical situation that was proposed by Mr. Jacques Morneau of the Montreal Tax Services Office.
Situation
1. Prod Co is a wholly owned subsidiary of M Co.
2. Prod Co is a "qualified corporation" as that term is defined in subsection 125.4(1) of the Income Tax Act (the "Act"). Prod Co was incorporated to limit the liability of M Co and its directors and to ensure that its principal activity will be to produce a film that is a Canadian film or video production ("CFVP").
3. Prod Co will produce a CFVP at a cost of $1,900,000, that is eligible for the tax credit provided under subsection 125.4(3). The film will be made in only 6 months.
4. After this film, Prod Co will become inactive. Prod Co will not produce any other film or engage in any other commercial activity.
5. The financial structure of the PCMC is as follows:
Provincial tax credit: $300,000
Federal tax credit: $240,000
Licence for commercial exploitation: $900,000
Participation of XXXXXXXXXX: $300,000
XXXXXXXXXX: $100,000
Equity investment by M Co: $60,000
Total: $1,900,000
6. The useful life of the film is approximately 10 years. It is impossible to assess the value of the film after this period. In fact, it is impossible in practice to know the value of a film until it has been shown to the public.
7. The equity investment, made by M Co in Prod Co, is in the form of a loan. This loan will be used to finance part of the production. The loan will only be repaid if the production generates revenue. No security can be given other than the film. M Co does not anticipate that Prod Co will generate sufficient income to repay the loan.
8. M Co will charge some $350,000 in fees to its subsidiary.
In a similar situation that was analyzed during an audit, the Canada Revenue Agency ("CRA") treated a loan, as described above, as assistance for the purposes of paragraph 12(1)(x) and as an amount of "assistance," as that term is defined in subsection 125.4(1), reducing Prod Co's "labour expenditure" and tax credit under subsection 125.4(3).
Questions
(1) Instead of making a loan, as described above, if M Co invests $60,000 in shares of Prod Co, is it reasonable to regard this outlay as a payment made on account of the acquisition by the payer (M Co) of an interest in the taxpayer (Prod Co) in the form of shares, within the meaning of subparagraph 12(1)(x)(viii)?
(2) Can M Co's funding in the form of shares be treated as an amount of assistance that would reduce Prod Co's "qualified labour expenditure" for the purposes of section 125.4?
(3) If M Co converts its loan into shares at the end of the production, will this conversion be treated as an amount of assistance?
Your Comments
In the scenario where, instead of making a loan as described above, M Co subscribes to shares in Prod Co, your interpretation is that M Co is seeking to avoid the application of paragraph 12(1)(x), thereby avoiding a reduction in its labour expenditure.
Our Comments
For the purposes of this letter, you asked us to assume that Prod Co carries on a business that is a Canadian film or video production business, despite the fact that it produces only one production and that it is unlikely that the production will generate sufficient revenues to permit its future repayment of its obligations or redemption of the shares held by M Co.
In addition, you requested that we assume that Prod Co has legal and beneficial ownership of the copyright in the CFVP (the film). In this regard, applying the CRA's position set out in paragraph 4 of Interpretation Bulletin IT-441, a third party (e.g., a distributor) could be considered to have acquired all beneficial ownership rights in the copyright in a production, if the production company grants to that third party all of the revenues from the distribution or the right to distribute or otherwise exploit the film in markets representing most or all of the exploitable value of the film. Such an acquisition would also take place if the producer transferred the entire exploitable value of the production during the foreseeable commercial life of the production and the rights subsequently reverted to the producer. If this were the case, the production would be an "excluded production" as that term is defined in proposed subsection 1106(1) of the Income Tax Regulations.
Finally, whether the capital outlay by M Co is in the form of a loan or shares, we have assumed that the conditions of subparagraph 12(1)(x)(i) are satisfied.
12(1)(x)(viii) acquisition of rights in Prod Co
Subparagraph 12(1)(x)(viii) refers to a payment made in respect of the acquisition by the payer of an interest in the taxpayer or the taxpayer’s business or property. As you know, there is very little jurisprudence discussing the scope of the terms used by Parliament for the purposes of this subparagraph.
As stated in Question 19 of the 1991 Canadian Tax Foundation Roundtable, whether a shareholder's contribution to the capital of a corporation can reasonably be considered to have been made for the purpose of acquiring a right is a question of fact that can only be determined after an examination of all relevant facts. To make that determination, it is necessary to analyze the commercial nature of the transaction, including the attributes of any shares acquired.
As stated above, we have assumed that M Co makes an additional investment in Prod Co in the form of shares for the purpose of earning income from a business or property.
You did not specify what the characteristics of the shares issued by Prod Co. would be. Despite this, it appears to us that each share issued to a person by a corporation, from one of the classes of shares of its capital stock, has particular rights. Thus, in the absence of an express contrary provision of the Act or a finding that the transaction at issue is a sham, the legal relationships established by the taxpayers must be respected in tax matters. A recharacterization is only possible where the taxpayer's designation of the transaction does not adequately reflect its true legal effects. Consequently, taking into account the foregoing, if, in order to partially finance a production, Prod Co issues shares of a class of its capital stock to its parent company M Co, the latter acquires, in our opinion, rights in Prod Co through the shares issued to it for the purposes of subparagraph 12(1)(x)(viii).
If M Co pays more for the shares than their fair market value ("FMV"), it would be deemed by paragraph 69(1)(a) to have acquired them at that FMV. In that case, the reduction in the cost to M Co of acquiring the shares under paragraph 69(1)(a) could constitute a capital contribution by M Co for the purposes of paragraph 53(1)(c). For additional comments on this interpretation, we refer you to the answer given to question 33 of the Federal Taxation Roundtable held at the 1993 Annual Conference of the Association de planification fiscale et financière.
Amount of assistance - shares
The term “assistance" is defined in subsection 125.4(1). The definition reads as follows:
“assistance means an amount, other than a prescribed amount or an amount deemed under subsection 125.4(3) to have been paid, that would be included under paragraph 12(1)(x) in computing a taxpayer’s income for any taxation year if that paragraph were read without reference to subparagraphs 12(1)(x)(v) to 12(1)(x)(vii).”
Taking into account our comments under the previous heading to the effect that the shares acquired by M Co constitute the acquisition of rights in its subsidiary within the meaning of subparagraph 12(1)(x)(viii), we are of the view that the acquisition of those shares does not constitute an amount of assistance to Prod Co for the purposes of section 125.4.
Conversion of the loan into shares at the end of the production
If we assume that paragraph 12(1)(x) did not apply at the time the loan was made, the loan could be subject to section 80 at the time it is settled or extinguished without payment or by payment of less than the principal.
Where a corporation issues shares to a person in satisfaction of a debt issued by the corporation and payable to the person, paragraph 80(2)(g) generally provides that the amount paid in satisfaction of the debt by reason of the issuance of shares is deemed to be equal to the FMV of the shares at the time of their issuance. Subject to the possible application of paragraph 80(2)(g.1), there will be a debt settlement if the FMV of the shares is less than the amount of the loan. We are of the view, however, that this debt settlement would not constitute an amount of assistance for the purposes of section 125.4.
In addition, the term "excluded obligation" is defined in subsection 80(1) and refers, inter alia, to a debt issued by a debtor that has been included in computing the debtor's income. Where a loan is included in income under paragraph 12(1)(x), it is generally excluded from the application of subsection 80(2) because the forgiven amount on the loan would be nil.
Since, in your situation, you have assumed that the loan from M Co is assistance that is required to be included in Prod Co's income under paragraph 12(1)(x), the conversion of the loan by M Co into shares of Prod Co at the end of the production would not engage the application of subsection 80(2).
Additional comment - Invoicing of fees by M Co
In this hypothetical situation, you stated that M Co will charge Prod Co fees in the amount of $350,000. As you know, for an expense to be deductible in computing a taxpayer's income, it must have been made or incurred by the taxpayer for the purpose of gaining or producing income from property or a business. In addition, section 67 prevents the deduction of an otherwise deductible expense except to the extent that the expense is reasonable in the circumstances. Determining the reasonableness of an expense, such as, for example, management fees, is a question of fact that should take into account, among other things, the nature of the services rendered and the time required to render those services; and the fees that could have been paid to obtain similar services from third parties.
We therefore have assumed that M Co will render services to its subsidiary and that the fees charged for such services will be reasonable in light of such services.
We have answered your questions based solely on the information provided, which was not supported by any contract. Whether an amount is included in computing a taxpayer's income for a taxation year under paragraph 12(1)(x) is a question of fact that must be resolved in light of all the circumstances and particulars of each case. It is possible that, as a result of additional information or facts specific to a particular situation, our answers may be different.
We hope you find these comments of assistance. Should you require any additional information regarding the content of this document, please do not hesitate to contact us.
For your information, unless exempted, 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, the electronic library version can be provided. Alternatively, the client 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 Ms. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
Patrick Massicotte, CA, M. Fisc.
For the Director
Business and Partnerships Division
Income Tax Rulings Directorate
Directorate General for Policy and Planning