DATE July 31, 1987
TO - Audit Applications Division Industry Studies Section
FROM - Financial Institutions Section Douglas Watson (613) 957-8960 Attention Bruce Kuber
RE MTAR and Reserve for Interest Guarantees
In response to your memorandum of June 17, 1987 we offer our comments on the query sent to you by the Ottawa District office regarding the reserve, claimed by the XXXX for liabilities under deposit administration fund policies which included a reserve for interest guarantees. Based on the assumption that future interest rates will decline the reserve represents an estimate (on a discounted basis) of the additional future liability of the insurer under these policies.
In accordance with paragraph 18(1)(e) of the Income Tax Act ("Act"), reserves are not deductible unless specifically provided for by legislation. For purposes of subparagraph 138(3)(a)(i) of the Act paragraph 1401(1)(a) of the Income Tax Regulations ("Regulations") allows a reserve for deposit administration fund policies which is limited to the lesser of a "... reasonable amount in respect of the aggregate of the insurer's liabilities under the policies as at the end of the year..." or "... the aggregate of the insurer's liabilities under those policies calculated in the manner required for the purposes of the insurer's annual report for the year..." filed with the Department of Insurance ("DOI").
In our opinion, a reasonable reserve in respect of the aggregate of the liabilities under the policies as at the year end does not include a reserve which is contingent on a decrease in interest rates over the next few years. Paragraph 1401(1)(d) of the Regulations does allow a reserve for additional risks or guarantees associated with certain insurance policies. The fact that the policies described in paragraph (a) are specifically excluded from this provision would appear to support the view that paragraph (a) is limited in scope to actual liabilities at a year end.
In order to satisfy the requirement that the reserve was not in excess of the statutory limit, the auditor contacted the DOI. In their response of May 25, 1987, the DOI gave the opinion that it was acceptable for XXXX to include a reserve for interest guarantees for statutory purposes. It is interesting to note that the DOI is also of the opinion that such a reserve is not reasonable within the meaning of paragraph 1401(1)(a) of the Regulations.
For its part, XXXX appears to be arguing that the reserve is reasonable regardless of the method of calculation. If XXXX submits a revised calculation of the reserve, the auditor will have to test it for reasonableness. The issue may not end with the proposal of this adjustment.
for Director Financial Industries Division Rulings Directorate Legislative and Intergovernmental Affairs Branch