2015-0606291I7 Surplus Appropriations - Part VI Capital Tax

Principal Issues: Whether discretionary surplus appropriations form part of capital for purposes of calculating Part VI tax.

Position: Yes.

Reasons: Previous position. It remains our view that such amounts form part of “retained earnings, contributed surplus or any other surpluses” under subparagraph 190.13(b)(ii).

Author: Danis, Sylvie
Section: Part VI, 190.13

                                                                                                             December 4, 2015

Large Business Audit Division                                                             HEADQUARTERS
Compliance Programs Branch                                                             Income Tax Rulings Directorate
Attention: James Atkinson                                                                   Sylvie Danis
Coordinator, Industry Specialist Services                                            (613) 670-9047

                                                                                                              2015-060629

Surplus Appropriations & Part VI Tax

We are writing in response to your September 2, 2015 request for our views with regard to the treatment of discretionary surplus appropriations for Part VI tax purposes. We acknowledge receipt of a copy of your letter to the XXXXXXXXXX dated November 20, 2014, as well as a copy of the XXXXXXXXXX response thereto dated XXXXXXXXXX.

Issue

At issue is whether appropriations of surplus must be included in the capital tax base of a Canadian resident life insurer as retained earnings or surpluses pursuant to subparagraph 190.13(b)(ii) of the Income Tax Act (the “Act”), in light of the repeal of subparagraph 190.11(b)(ii) of the Act effective for taxation years beginning after September 2006. As you noted, this issue has been the subject of discussion between the industry and the CRA for many years.

Background

In the notes to the financial statements prepared for the Office of the Superintendent of Financial Institutions (OSFI), certain life insurers report as appropriated retained earnings specific amounts that generally include cash surrender value deficiencies, negative actuarial liabilities, reserves required for foreign jurisdictions or transitional solvency provisions. It is our understanding that OSFI does not require that notes be prepared for these amounts and that the amount of retained earnings reflected in the balance sheet is not adjusted for these amounts.

In Rulings document 2001-0081267, we stated that we were of the view that discretionary appropriations (those not required to be made by OSFI) have the dual character of reserves and retained earnings for purposes of calculating capital for Part I.3 of the Act. Our position was based on the fact that the amounts were "reflected in the balance sheet" as retained earnings and were reported in the notes to the financial statements as appropriations. It was noted that absent subsection 181(4) of the Act, the amount of an appropriation of surplus would be included in the capital of the life insurer both as a reserve and as retained earnings. Accordingly, the insurer was permitted to choose between the two characterizations for Part I.3 purposes. We also stated that where appropriations were required by OSFI, it was our view that such amounts constituted reserves. This same view applied with respect to Part VI tax.

With the repeal of subparagraph 190.11(b)(ii) of the Act, the Compliance Programs Branch considered the impact of this legislative change to the CRA’s position (as set out in Rulings document 2001-0081267). It was concluded that as a result of this legislative change, for taxation years beginning after September 2006, the taxable capital employed in Canada for a Canadian resident life insurer no longer includes the amount by which the life insurer’s reserves for a year in respect of its insurance business carried on in Canada exceeds the amount of its reserves that is deducted or deductible in computing income under Part 1 for the year. However, since surplus appropriations of Canadian resident life insurers are included in retained earnings on their balance sheet, they must be included in their amount of capital stock, retained earnings, contributed surplus and any other surpluses for capital tax purposes. This view was expressed in your November 20, 2014 letter to the XXXXXXXXXX.

XXXXXXXXXX Position

In its XXXXXXXXXX letter to you, the XXXXXXXXXX requests that the CRA reconsider what it believes is a recent change in assessing position with respect to the treatment of discretionary surplus appropriations for capital tax purposes as being retained earnings or surpluses.

The XXXXXXXXXX has always maintained that surplus appropriations are reserves and not retained earnings or surpluses and refers to the choice in characterization permitted to life insurers (Rulings document 2001-0081267) as acceptance by the CRA that surplus appropriations are reserves. They note that the legislative change was prompted by a change to insurance policy reserves (and not by any change to surplus appropriations) and the legislative change does not, in fact, make it clearer that surplus appropriations were intended to be included in the capital tax base. Since in the XXXXXXXXXX view, surplus appropriations are reserves, the elimination of the reserve adjustment in subparagraph 190.11(b)(ii) of the Act has the effect of eliminating, from a life insurer’s capital tax base, all reserves established by insurers (including surplus appropriations and, for example, doubtful debt reserves and other such reserves).

Finally, the XXXXXXXXXX raises issues of fairness and consistency which will not be addressed in this memorandum.

Our Comments

For Part VI tax purposes, the capital of a life insurance corporation that was resident in Canada is described in paragraph 190.13(b) of the Act and includes “the amount of its capital stock (or, in the case of an insurance corporation incorporated without share capital, the amount of its members’ contributions), retained earnings, contributed surplus and any other surpluses.” The taxable capital employed in Canada of such a corporation is computed in paragraph 190.11(b) of the Act.

Subparagraph 181(3)(b)(ii) of the Act generally provides that for purposes of determining the carrying values of the relevant components under Part I.3, an insurance corporation shall use the amounts that are reflected in the balance sheet as accepted by the Superintendent of Financial Institutions, the superintendent of insurance or a similar provincial authority for regulatory purposes. As stated in AGC v Ford Credit Canada Limited (2007 FCA 225):

[…] In essence, Rothstein J.A. determined that the balance sheet of the taxpayer must be accepted for LCT purposes if it was accepted by the Superintendent of Financial Institutions. In my view, the same logic should apply where the corporation in question is subject to subparagraph 181(3)(b)(i) rather than subparagraph 181(3)(b)(ii). On that basis, provided that the balance sheet in question has been prepared in accordance with GAAP and otherwise complies with the specific provisions of Part I.3, that balance sheet must be accepted for the purposes of the determination of the LCT liability of the corporation. (para 27)

Although Ford Credit dealt with Part I.3 of the Act, Part VI tax is based on Part I.3 and the relevant provisions are worded either identically or refer directly to the provisions in Part I.3. As you note, subsection 181(3) of the Act applies for purposes of Part VI as a result of subsection 190(2) of the Act.

In Rulings document 2001-0081267 dated November 6, 2001, we stated:

… it is our view that the definition of “reserves” in subsection 181(1) would include an “appropriation” of surplus made at the discretion of the life insurer in a note to its financial statements prepared for the OSFI even if not required by the OSFI. It also continues to be our view that such an “appropriation” nevertheless remains as part of the retained earnings of the life insurer where the full amount of the retained earnings is reflected as such on the balance sheet. Consequently, for purposes of Part I.3 tax the amount of an “appropriation” of surplus would be included in the capital of the life insurer both as a reserve and as “retained earnings” absent subsection 181(4).

In its letter, the XXXXXXXXXX refers to the first part of this statement but fails to mention the comments that follow which, in our view, are critical (likely because the XXXXXXXXXX does not view surplus appropriations as retained earnings or surpluses). Notably, the reason that insurers could choose between the two characterizations, for purposes of Part I.3 or Part VI tax, was the result of the application of subsection 181(4) of the Act which ensures that an amount is not included twice in the computation of taxable capital.

The XXXXXXXXXX also asserts that since the scheme of the Act distinguishes between reserves and surplus, the elimination of the reserve adjustment in subparagraph 190.11(b)(ii) of the Act clearly excludes from a life insurer’s capital tax base surplus appropriations. We are unclear as to the basis for this assertion. In its December 28, 2006 news release (2006-091), the Department of Finance stated that the reserve adjustment adds the amount, if any, by which the policy reserves reported on the financial statements exceed the maximum policy reserves reported for tax purposes and is no longer required. In our view, the description of the reserve adjustment does not suggest that surplus appropriations are included in the reserve adjustment.  Also, the statement suggests that the Department of Finance believed that policy reserves reported on the financial statement will no longer exceed the maximum policy reserves reported for tax purposes (or that the excess would be immaterial). There is no indication that surplus appropriations that form part of retained earnings would not be included in computing taxable capital given subparagraph 181(3)(b)(ii) of the Act. If that had been the intent, it seems to us that subparagraph 190.13(b)(ii) of the Act would have been amended to exclude such amounts.

To conclude, it remains our view that discretionary appropriated surplus amounts have the dual character of reserves and retained earnings where the amounts are reflected in the balance sheet as retained earnings and are reported in the notes to the financial statements as appropriations. Prior to the repeal of subparagraph 190.11(b)(ii) of the Act and absent subsection 181(4) of the Act, such amounts could be included in the capital tax base twice, under subparagraphs 190.13(b)(ii) and 190.11(b)(ii) of the Act, respectively. However, following the legislative change, it is our view that subsection 181(4) of the Act has no application since the only remaining inclusion of the amount of the appropriated surplus is as “retained earnings, contributed surplus and any other surpluses” under subparagraph 190.13(b)(ii) of the Act. Accordingly, while our position in Rulings document 2001-0081267 remains the same, the repeal of subparagraph 190.11(b)(ii) of the Act means that a choice pursuant to subsection 181(4) of the Act is no longer available.

We trust the above comments are of assistance.

Yours truly,

Jenie Leigh
for Director
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without the prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5.

© Her Majesty the Queen in Right of Canada, 2016

Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistribuer de l'information, sous quelque forme ou par quelque moyen que ce soit, de façon électronique, mécanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.

© Sa Majesté la Reine du Chef du Canada, 2016