Principal Issues: Whether amounts added to retained earnings from fair value adjustments under Section 1500 of CICA Handbook (Part II - Accounting Standards for Private Enterprises) should be included in accumulated profits for the purpose of determining the deductibility of interest on borrowed money used to pay a dividend?
Position: No
Reasons: Previous positions.
FEDERAL TAX ROUNDTABLE 7 OCTOBER 2011
2011 APFF CONFERENCE
Question 15
Deductibility of interest in the context of the concept of filling the hole
Background
In December 2009, the Canadian Accounting Standards Board released a new set of accounting standards for Canadian private enterprises. The initial application of those new standards (Section 1500 of the CICA Handbook) allows a corporation to revalue its property, plant and equipment at fair value at the date of the accounting standards transition and to use that fair value as the deemed cost to the business on that date. In doing so, the gain recognized at that time will increase the opening balance of the retained earnings ("RE") of the corporation.
For its part, the concept of filling the hole, being an exception to the test of the direct use of borrowed money, permits the deduction of interest where a loan is incurred by a person in replacement of the capital used for eligible purposes. The capital can be determined by adding the amount of capital contributed by the shareholders to the amount of the accumulated profits for the shares. According to paragraph 23 of Interpretation Bulletin IT-533 of the CRA:
Accumulated profits would generally be the retained earnings of the corporation computed on an unconsolidated basis with investments accounted for on a cost basis. [Your underlining]
Take the following example:
A closely-held corporation performed a revaluation of its property, plant and equipment under Section 1500 of the CICA Handbook on January 1, 2010. The balance of its RE was increased as a result of the revaluation. During its 2011 fiscal year, the corporation received a loan to pay a dividend to its shareholders. The amount of the loan and the dividend equalled the balance of its RE immediately after the revaluation of its property, plant and equipment. The RE balance before the application of Section 1500 of the CICA Handbook consisted exclusively of accumulated profits realized in the ordinary course of the activities of its business.
Question
Would the amount of the revaluation that affected the corporation's RE in the example described above be part of the corporation’s eligible accumulated profits for the purposes of the exception provided for in paragraph 23 of Interpretation Bulletin IT-533?
CRA Response
No. Furthermore, the CRA has already stated several times (in the context of technical interpretation letters and in response to Roundtable questions) in the past that the accumulated profits do not include revaluation surpluses.
Robert Gagnon
(613) 957-9768
2011-041204