1 September 1989 Income Tax Severed Letter AC58434 - Effect of SR & ED Investment Tax Credits on Calculation of "Safe Income on Hand"

5-8434
             19(1)                           D. Watson
                                             613-957-2121

September 1, 1989

Dear Sirs:

Re: Subsection 55(2), 55(5) and 127(5) of the Income Tax Act (the "Act")

This is in reply to your letter dated July 25, 1989. In that letter you requested our comments on the effect of investment tax credits earned on research and development expenditures, on the calculation of income earned or realized ("safe income on hand") for purposes of subsection 55(2) of the Act.

The Department's view on the calculation of safe income on hand were expressed in Mr. J.R. Robertson's address to the 1981 Canadian Tax Foundation. These views were subsequently updated by Mr. M.A. Hiltz at the 1984 Corporate Management Tax Conference ad Mr. R.J.L. Read at the 1988 Canadian Tax Foundation.

Generally, safe income on hand is made up of taxable income plus certain adjustments less the aggregate of losses incurred, dividends paid and income taxes paid or payable. The effect that various tax credits will have on the safe income on hand of a corporation will depend on the nature of the credit involved, how it is claimed and the facts of the case. For example, assume that in Year 1 a taxpayer has claimed an investment tax credit of $350, which is included in his income in Year 2 pursuant to paragraph 12(1)(t).

Year 1

         Taxable Income                       $3,000
         Tax 40%                              $1,200
         Less ITC                350             850
         Safe income on hand                   2,150

Year 2

         Taxable Income
           Before 12(1)(t)                    $4,000
         Add ITC                                 350
           Total                              $4,350
         Less Tax 40%                          1,740
           After tax income                   $2,610
         Less ITC Income Inclusion               350
           Safe Income on hand                $2,260
         Total safe income on hand
           at end of year 2                   $4,410

In year 2, the taxpayer's taxable income would be increased by $350 pursuant to paragraph 12(1)(t). In the safe income on hand calculation, this $350 "phantom" inclusion would be deducted, resulting in a net inclusion of nil.

This result is consistent with the guidelines established in Mr. Robertson's paper. While the calculation of safe income on hand would reflect the taxed retained earnings of the taxpayer, paragraph (xx) of the guidelines provides for a reduction of amounts which represent phantom income.

As well, in order to pay a "safe dividend" the safe income on hand must be reflected in the gain on the shares. Otherwise, the dividend will reduce the gain which is attributable to something other than safe income on hand.

Our comments represent our interpretation of the guidelines as they apply to the above example. The facts of each case are unique and the principle applied in this example may not be appropriate in every case.

Yours truly,

for Director Reorganizations and Non-Resident Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch