Originally published in Blakes Bulletin on Tax, June 2007
In a decision released on June 11, 2007 (Attorney General of Canada v. Ford Credit Canada Limited, 2007 FCA 225), the Federal Court of Appeal held that retractable preferred shares (shares that oblige the issuer to redeem them at the request of the holder) are not "capital" for purposes of the Large Corporations Tax (LCT) that was imposed by Part I.3 of the Income Tax Act (the Act) for years prior to 2006. Although LCT was effectively repealed as of January 1, 2006, corporations and financial institutions that had issued retractable preferred shares before that date should consider challenging any assessment or reassessment that included the amount of those retractable preferred shares in capital for LCT purposes.
In this decision, the Federal Court of Appeal rejected the longstanding policy of the Canada Revenue Agency that Generally Accepted Accounting Principles (GAAP) do not displace the legal meaning of terms used in Part I.3 of the Act. This policy has been reiterated on numerous occasions by officials of the Minister of National Revenue (the Minister) and is clearly reflected in Interpretation Bulletin IT-532:
11. . . . the balance sheet nomenclature used to describe or characterize a particular balance sheet item may be based upon its accounting substance rather than its legal form. It is the CCRA's position that the legal nature governs irrespective of the accounting treatment or nomenclature used to describe or characterize a particular transaction or event. The reporting of certain leases as sales or financing transactions (CICA Handbook, Section 3065) and the reporting of certain preferred shares with various debt characteristics as debt (CICA Handbook, Section 3860) are but two examples where the accounting characterizations may not reflect the legal nature of the transactions.
12. Preferred shares that have been characterized as liabilities and reflected on the balance sheet in an amount equal to the redemption amount of the shares would, for the purposes of Part I.3, be considered to retain their legal character as shares of the capital stock of a corporation. . . .
By way of background, the Canada Revenue Agency reassessed Ford Credit for its 2001 to 2003 taxation years on the basis that CAD 1.17 billion of retractable preferred shares should be included in its capital for purposes of Part I.3 tax. In allowing Ford Credit’s appeals, the Tax Court of Canada concluded that subsection 181(3) provided that GAAP was to be used to determine amounts under Part I.3. Accordingly, the amount of the retractable preferred shares was not to be included in the amount of Ford Credit’s capital stock under subparagraph 181.3(3)(a)(ii) of the Act as the retractable preferred shares were characterized on the financial statements as liabilities rather than equity and that characterization was in accordance with GAAP. The Minister appealed to the Federal Court of Appeal.
The Minister argued that many components of capital of corporations and financial institutions, for LCT purposes, originate in accounting principles (e.g., reserves, surpluses and retained earnings) and that where a component of capital derives its meaning primarily from GAAP, the accounting meaning ascribed to that component must prevail. However, according to the Minister, where a component of capital has an ordinary legal meaning, that meaning must be given precedence.
The Federal Court of Appeal dismissed the Minister’s arguments. Justice Ryer, writing for himself and the other members of the panel (Justice Décary and Justice Evans), rejected the dichotomy suggested by the Minister as the language of subsection 181(3) of the Act "does not contemplate a distinction between terms with ordinary legal meanings and terms with primarily accounting meanings." The Court reviewed the history of the LCT and characterized that tax as a deficit reduction measure that was intended to be temporary in nature. As such, Parliament simply adopted a method of computing capital that was already well known to large corporations, namely GAAP, as the principal determinant of the capital tax base for large corporations and financial institutions. Where Parliament wished to depart from GAAP for LCT purposes, it did so expressly. Accordingly, the retractable preferred shares at issue were properly characterized as liabilities under GAAP and the amount of the retractable preferred shares was not required to be included in the capital of Ford Credit for LCT purposes for 2001, 2002 or 2003.
To the extent that taxation years before 2006 remain open, large corporations and financial institutions should consider filing Notices of Objection challenging the Minister’s longstanding administrative policy that has now effectively been overturned. For years after 2005, LCT remains relevant in several contexts including the computation of unused surtax credits and their carry back. In addition, capital taxes continue to be imposed by several provinces and, depending on the relevant legislative framework, it may be possible to file Notices of Objection with the provincial tax authorities on the same basis.
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