19 January 2005 External T.I. 2004-0081001E5 F - Réserve de valorisation d'une coopérative
Principal Issues: [TaxInterpretations translation] What are the tax consequences of the creation of an enhancement reserve, and the subsequent payment of this reserve, to a cooperative and its beneficiaries?
Position: The creation of the reserve is not deductible under Part I but may constitute a reserve for the purposes of Part I.3. The payment of the patronage dividend may be taxed as an allocation in proportion to patronage or otherwise depending on the circumstances.
Reasons: Question of fact. Text of the Act.
XXXXXXXXXX 2004-008100 Michel Lambert January 19, 2005
Dear Madam,
Subject: Valuation reserve
This is in response to your letter of June 3, 2004, requesting clarification of the taxation of the enhancement reserve provided for in section 149.1 of the Quebec Cooperatives Act (R.S.Q. c. C 67.2).
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (the "Act"). In addition, our analysis assumes that the cooperative that establishes an enhancement reserve is a cooperative within the meaning of subsection 136(2).
As stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, it is our practice not to issue written opinions on proposed transactions otherwise than by way of advance rulings. Furthermore, when it comes to determining whether a completed transaction has received appropriate tax treatment, that determination is made first by our Tax Services Offices as a result of their review of all facts and documents, which is usually performed as part of an audit engagement. However, we can offer the following general comments that we hope may be helpful to you. These comments may not, however, apply to your particular situation in certain circumstances.
According to section 149.1 of the Cooperatives Act, certain cooperatives will be able to set up a reserve, called an enhancement reserve, to value the use of the cooperative's services.
Section 149.2 of the Cooperatives Act provides that a by-law of the cooperative may provide that the sums making up the enhancement reserve may be allotted in the form of rebates to the persons or partnerships who ceased to be members or auxiliary members of the cooperative following their resignation or otherwise. The by-laws may also provide that, should there be a winding-up of the cooperative, the sums making up the enhancement reserve will be remitted in the manner and under the conditions set out in section 185 of the Cooperatives Act.
In addition, section 149.4 of the Cooperatives Act provides as follows:
Where the by-laws of the cooperative contain provisions for the purposes of the first paragraph of section 149.2, the board of directors may, as part of a policy it establishes, allot a rebate to the persons or partnerships referred to in that section.
The rebate shall be allotted in proportion to the business done by those persons or partnerships with the cooperative or with a business corporation or partnership in which the cooperative holds shares or other securities during the period determined by the by-laws.
The allotment of the rebate is subject to the conditions set out in section 38, with the necessary modifications.
Section 185 of the Cooperatives Act reads in part as follows:
Where the by-laws of a producers cooperative, a work cooperative or a shareholding workers cooperative contain provisions for the purposes of the second paragraph of section 149.2, the balance remaining in the enhancement reserve, if any, shall be paid to the persons or partnerships that were members or auxiliary members of the cooperative during the period covering the five fiscal years preceding the year the winding-up was voted, in proportion to the business done with the cooperative or with a business corporation or partnership in which the cooperative held shares or other securities during the period determined by the cooperative’s by-laws by those persons or partnerships.
The balance remaining in the enhancement reserve mentioned in the preceding paragraph is the balance appearing on the balance sheet of the cooperative established by the liquidator, minus the net loss from the disposal of the cooperative’s assets.
In the case of a cooperative to which section 149.5 applies, the balance includes, as the case may be, the portion of any profit earned on the disposal of the shares of the cooperative that may be paid into the enhancement reserve.
In our view, the cooperative cannot deduct in computing its income the amount allocated to the enhancement reserve. Paragraph 18(1)(e) provides that a taxpayer may not deduct in computing income from a business or property an amount in respect of a reserve, a contingent liability or amount or a sinking fund except as expressly permitted. There is no provision in the Act that permits such a deduction.
You asked whether a cooperative may deduct amounts it pays as patronage dividends pursuant to sections 149.2 and 149.4 of the Cooperatives Act. Subsections 135(1) and (2) provide that a taxpayer may deduct in computing income for a taxation year the total of the payments made, pursuant to “allocations in proportion to patronage” by the taxpayer. This deduction is subject to certain conditions. For more details on the requirements of subsection 135(1), see Interpretation Bulletin IT-362R. An electronic version of this Bulletin is available on the Canada Revenue Agency's (the Agency's) Web site at http://www.cra-arc.gc.ca/E/pub/tp/it362r/READ-ME.htm. Where a patronage dividend is paid to a former member or auxiliary member, we are of the view that the amount paid must be, inter alia, a payment in accordance with allocations in proportion to patronage in order for the co-operative to be able to deduct the amount as a patronage dividend.
Section 135(4) defines what constitutes an allocation in proportion to patronage. The definition reads as follows:
allocation in proportion to patronage for a taxation year means an amount credited by a taxpayer to a customer of that year on terms that the customer is entitled to or will receive payment thereof, computed at a rate in relation to the quantity, quality or value of the goods or products acquired, marketed, handled, dealt in or sold, or services rendered by the taxpayer from, on behalf of or to the customer, whether as principal or as agent of the customer or otherwise, with appropriate differences in the rate for different classes, grades or qualities thereof, if
(a) the amount was credited
(i) within the year or within 12 months thereafter, and
(ii) at the same rate in relation to quantity, quality or value aforesaid as the rate at which amounts were similarly credited to all other customers of that year who were members or to all other customers of that year, as the case may be, with appropriate differences aforesaid for different classes, grades or qualities, and
(b) the prospect that amounts would be so credited was held out by the taxpayer to the taxpayer’s customers of that year who were members or non-member customers of that year, as the case may be;
Subsection 135(7) provides that where a payment pursuant to an allocation in proportion to patronage (other than an allocation in respect of consumer goods or services) has been received by a taxpayer, the amount of the payment shall be included in computing the recipient’s income for the taxation year in which the payment was received. The term "consumer goods or services" is defined in subsection 135(4) as goods or services the cost of which was not deductible by the taxpayer in computing income from a business or property.
The question of whether an amount paid under section 149.2 or 185 of the Cooperatives Act is a payment made in accordance with an allocation in proportion to patronage can only be resolved after considering all the relevant facts.
If the payment received under section 149.2 or 185 of the Cooperatives Act is not a payment made in accordance with an apportionment in proportion to patronage, it may be taxed as something else depending on the circumstances.
A cooperative that has paid an amount pursuant to section 149.2 or 185 of the Cooperatives Act and wishes assistance in determining the nature of the amount can contact its Tax Services Office. If it is a proposed transaction, the cooperative can request an advance income tax ruling before making the payment. How to request an advance income tax ruling is explained in Information Circular 70-6R5. This circular is available on our website at http://www.cra-arc.gc.ca/E/pub/tp/ic70-6r5/READ-ME.html.
You stated that when a workers’ cooperative disposes of its investment in the business, a portion of the realized capital gain may go to the enhancement reserve and you asked what the impact is on the cooperative. In our view, the gain on the disposition of the shares will be subject to the general capital gains tax rules if the shares are capital property. In general, property held as an investment is capital property. In addition, the allocation of a portion of the capital gain to the enhancement reserve does not affect the calculation of the capital gain on the disposition of the investment. The subsequent payment of a patronage dividend will follow the rules outlined above.
With respect to the large corporations tax, often referred to as the capital tax, paragraph 181.1(3)(f) provides that no capital tax under Part I.3 is payable for a taxation year by a corporation that was throughout the year a corporation described in subsection 136(2) [a cooperative corporation] the principal business of which was marketing natural products belonging to or acquired from its members or customers.
For other cooperative corporations, the amount of an enhancement reserve could be taken into account in calculating capital for the purposes of Part I.3. Paragraph 181.2(3)(b) provides that the capital of a corporation, other than a financial institution, for a taxation year includes the amount of its reserves for the year, except to the extent that they were deducted in computing its income for the year under Part I. It should be noted that the enhancement reserve does not give rise to a deduction in computing income under Part I.
We are of the view that where an expression in Part I.3 is derived primarily from the accounting nomenclature, the accounting treatment of the item in question will be used to decide whether the item is included in the calculation of capital. Otherwise, it is the legal character of an item that takes precedence. The question of whether the enhancement reserve is a reserve for the purposes of Part I.3 must be resolved in light of this commentary. However, it is our view that an amount credited by a cooperative as an enhancement reserve would constitute a reserve for the purposes of Part I.3.
Where a corporation is subject to tax under Part I.3, it must pay a tax on its taxable capital employed in Canada that exceeds its capital deduction for the year. Generally, subsection 181.5 sets the capital deduction at $50 million unless the corporation is related to another corporation at any time in the year. In such a case, its capital deduction is nil unless an election is filed with the Minister in prescribed form to provide for the allocation of the $50 million among the corporations in the related group.
As stated in Information Circular 70-6R5, this opinion is not an advance income tax ruling and is not binding.
Best regards,
Section Manager
for the Director of the Directorate
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch