| Special Audits Division | Specialty Rulings |
| Specialized Industries Section | Directorate |
| O. Laurikainen | |
| Shaukat Lakhani | 957-2125 |
| File No. 7-4509 |
24(1)
Subject: Subsection 5907(2) of the Regulations Exempt Surplus Calculation
This is in response to your memorandum of November 8, 1989 wherein you requested that we review the comments in a memorandum dated October 13, 1989 from the Vancouver District Office (the "follow-up memo") which was to follow up an opinion we previously gave on the application of subsection 5907(2) of the Regulations.
In our original memorandum dated September 8, 1989, we stated that in our view the revenue, income, or profit derived by a foreign affiliate from an active business that is exempt from tax in the foreign jurisdiction, as dealt with in paragraph 5907(2)(f) of the Regulations, is generally the net accounting income from such business. The follow up memo has raised the concerns that this approach may be inconsistent with the provisions of subsection 5907(2.1) of the Regulations where the taxpayer has not made an election thereunder and may result in unjust deductions from earnings if the exempt business segment subsequently becomes taxable in the foreign jurisdiction.
The approach suggested in our memorandum of September 8, 1989 can be followed independent of whether or not the taxpayer has elected under subsection 5907(2.1) of the Regulations without any inappropriate tax consequences t the taxpayer where the exempt business segment subsequently becomes taxable and without reducing the advantage available to it if such an election is made. This appears to be in accordance with the intent of subsection 5907(2.1) of the Regulations which in our view is a relieving provision that permits a taxpayer to increase the "adjusted earnings amount" where depreciation in respect of certain assets has been claimed for tax purposes and the amount claimed differs from accounting depreciation in respect of those same assets. If the approach suggested in the follow up memo is taken, the result would be an unintended reduction the advantage that is otherwise available as the result of making an election under those provision. This is because the amount of accounting depreciation in respect of assets used to earn exempt income would be included only in the amount computed under subparagraph 5907(2.1)(a)(ii) of the Regulations and not subparagraph (a)(i). Therefore, the result would be a reduction of the amount otherwise computed under paragraph 5907(2.1)(a) of the Regulations.
If the accounting net income from the exempt business is included in the earnings amount under paragraph 5907(2)(f) of the Regulations, the accounting depreciation in respect of assets used in the exempt business will have been deducted from the resulting adjusted earnings amount for that year. Therefore, should an election be made pursuant to subsection 5907(2.1) of the Regulations such an amount of accounting depreciation would be included in both the amount computed under subparagraph 5907(2.1)(a)(i) and subparagraph (a)(ii) of the Regulations and the taxpayer would receive the full advantage of the election with respect to assets used to earn taxable income. In addition, for the purposes of computing the earnings amount in a subsequent taxation year if tax depreciation on assets previously used to earn exempt income should be taken in that year (e.g. where the income earned is no longer exempt), the provisions of paragraph 5907(2)(b) of the Regulations would apply to ensure that the aggregate of the accounting depreciation deductions and tax depreciation deductions in respect of a particular capital asset made by the affiliate in computing earnings for the purpose of section 5907 of the Regulations for the current and preceding taxation years does not exceed the affiliate's cost of that asset. If this procedure is followed there will be no need to adjust prior years earnings amounts for any notional deduction made for foreign tax purposes from the cost of such assets when the income earned by them is no longer exempt.
In summary our views remain as they were in our memorandum of September 8, 1989.
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