Tax and Estate Planning Blog : Moodys LLP and SNC Law

On January 9, 2012 the Internal Revenue Service (“IRS”) issued a statement that contains two very important announcements for Canadian residents who have US tax and filing obligations: first, it will shortly issue new instructions to bring unfiled returns current for taxpayers who owe no US tax; and second, it indefinitely extends the basic terms of the 2011 Offshore Voluntary Disclosure Initiative (“OVDI” or “IRS amnesty program”), which allowed taxpayers to file delinquent returns and pay a reduced penalty. Thus, it appears Mr. Flaherty’s promise of relief for Canadian residents made on December 2 of last year is coming to fruition.

What this means for Canadian residents is that they now have options for bringing unfiled returns current. The first step is to prepare the past eight years of returns and determine whether any US tax is due. If no tax is due, then it may make sense to participate in the newly announced program (though the details of the program are not yet available). If some tax is owed, it may make sense to participate in the new OVDI. Each case is unique and needs to be evaluated on its own merits, so what may make sense for one person may not for another.

Canadian residents with these filing obligations should act now to bring filings current. The onerous failure to file penalties can be reduced to zero under the doctrine of “reasonable cause.” Reasonable cause can exist when the individual simply did not know about the filing obligations. As media exposure increases on filing requirements it will become increasingly difficult to rely on ignorance as a defense to the imposition of penalties.

Some Background

The US tax code as it applies to those residing outside the US is punishingly complex. Publication 4732, Federal Tax Information for US Taxpayers Living Abroad illustrates this complexity. The publication refers to at least eight other IRS publications and 667 pages of forms for a total of 7,322 pages.

The US requires its citizens and residents to file returns and pay tax on their worldwide income. However, according to statistics released last week, only about 11 percent of those residing outside of the US filed returns. Of those returns that were filed, only nine percent of them showed a US tax obligation.

It is Not the Taxes, it is the Penalties

Tax obligations, however, are only a minor part of the problem for non-filers. The US requires the filing of many other forms on which no tax is due. The failure to file these forms can trigger penalties that can be financially ruinous. For example, the failure to file the Foreign Bank Account Report carries a $10,000 penalty if the failure was not willful, and enhanced monetary and criminal penalties if the failure was willful. There are numerous other forms that carry $10,000 penalties if not filed when due.

“Reasonable Cause” Defense to Penalties

Most of these onerous penalties may be reduced to zero provided the taxpayer can prove reasonable cause for not filing. Reasonable cause is a legal doctrine, the application of which is determined by all of the facts and circumstances surrounding the taxpayer’s failure to file. Particular facts that support its application are found in case law, administrative interpretations, the statutes, and the treasury regulations.

Depending on the particular facts, one of the theories that may support a finding of reasonable cause is that the taxpayer was unaware of his filing obligations. In guidance published in December, the IRS lists facts that the IRS will, apparently, weigh more heavily than others in determining whether being unaware is sufficient to support the reasonable cause argument, including:

• The taxpayer’s education; 
• Whether the taxpayer has previously been subject to the tax for which the return has not been filed;
• Whether the taxpayer has been penalized before; 
• Whether there were recent changes in the tax forms or law the taxpayer could not reasonably be expected to know; and 
• The level of complexity of a tax or compliance issue.

In the same guidance the IRS issued in December, the IRS gave several examples, the facts of which support a finding of reasonable cause, the most telling of which is Example 4. Under Example 4 the IRS concludes that reasonable cause is shown based on the following facts:

• The taxpayer complied with tax filing and payment obligations in his country of residence;
• He was previously unaware of his US filing obligations;
• After discovering his US filing obligations he filed his previously unfiled returns;
• He attached a statement to his returns setting forth his reasonable cause argument;
• He had a legitimate reason for maintaining non-US accounts;
• There was no indication that he had taken efforts to intentionally conceal the reporting of income or assets; and
• There was no additional US tax due.

In making the reasonable cause argument, it is critically important to analyze the facts, support the facts with affidavits or other evidence, and to make sure that the facts are supported by existing law. If the facts are either false or misleading, the IRS could charge the individual with criminal tax evasion.

The good news is that we now have good guidance as to what facts will support reduction of penalties. Further, it appears that the IRS appears to be listening to the impassioned arguments made by Mr. Flaherty and others who have been affected.

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On March 22, 2012 I had the privilege of speaking at the Eighth Annual International Estate Planning Institute in New York City. The conference was sponsored by the New York Bar Association and the Society of Trust and Estate Practitioners (“STEP”) and is one of the best conferences on cross-border tax issues anywhere.

My general topic was US tax and reporting obligations for Canadian residents, in particular tax and reporting obligations under the Foreign Account Tax Compliance Act (“FATCA”), the Report of Foreign Bank and Financial Accounts (“FBAR”) the Offshore Voluntary Compliance Initiative (“OVDI”). All of the presentations are available for download on the New York State Bar Association website.

Since the topic of US tax and FBAR reporting is so important to many of our clients we have made my seminar materials available on our website. The materials are practitioner-focused and as a result they are very detailed and cross-referenced with appropriate statutory and legal support.

Our firm Moodys LLP Tax Advisors has sponsored several presentations on the US tax and filing obligations for Americans residing in Canada. These presentations are less technical and cover additional topics including: FBAR, FATCA, renouncing citizenship, expatriation, and penalty reduction under “reasonable cause.” We have recorded a recent presentation and made it available on our website.

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By Robert R. Worthington LLB, Kim G C Moody CA, TEP and Paul R. LeBreux LL.B., LL.M. (Tax), TEP (of counsel to Moodys Tax Advisors LLP)

St. Michael Trust Corp. v. The Queen is the first appeal where the Supreme Court of Canada has considered the test for residency of a trust for tax purposes. The appeal was heard merely four weeks ago. We were surprised this morning when printing out the Court’s judgment that its pages could be bound by a standard staple, which is exceedingly rare for a complex tax appeal. The importance of residency status is that a Canadian-resident taxpayer, including a trust, is taxable in Canada on worldwide income.

The St. Michael Trust case involved an offshore estate freeze. The plan was to avoid Canadian capital gains tax on the eventual sale of a Canadian corporation, PMPL. To achieve this, a trust was formed in Barbados (the “Fundy Settlement”), which subscribed for shares of a new Canadian holding company, which in turn held shares of PMPL. The trustee of the Fundy Settlement was St. Michael Trust Corp., a Barbadian trust company owned by partners of a large public accounting firm. The beneficiaries of the Fundy Settlement were Mr. Garron and his family. A similar structure, with a holding company and a trust (the “Sommersby Settlement”) was implemented for the other shareholder of PMPL, Mr. Dunin, the beneficiaries of which were Mr. Dunin and his family.

Ultimately, the shares of the holding companies were indeed sold, resulting in capital gains of CAD $217 million for the Fundy Settlement and CAD $240 million for the Sommersby Settlement. Both trusts claimed their respective capital gains were exempt Canadian tax by virtue of the Canada-Barbados tax treaty. The treaty exemption was only available if the trusts were resident in Barbados.

The trustee argued that the appropriate test for residency status of a trust is the residence of the trustees, consistent with previous case law. The Minister of National Revenue (the “Minister”) said the test should be “central management and control”, which is the residency test used for corporations. Before this case, there had been little judicial authority regarding the appropriate test for residency of a trust, so practitioners were hopeful that the Supreme Court would provide some helpful guidance in this critical and uncertain area of tax law.  

As discussed in our past blogs, the Minister was successful at the Tax Court of Canadaand the Federal Court of Appeal. The Minister was also successful at the Supreme Court of Canada, which decided the test for residency of a trust is central management and control. The Court described a trust’s place of central management and control as being the place “where its real business is carried on”. In this case, the Tax Court’s finding was that the beneficiaries of the trusts exercised central management and control from Canada whereas the role of the trustee was limited to administrative services and the trustee had little or no responsibility. Applying the central management and control test to these facts, the Supreme Court upheld the lower courts’ decisions.

The Supreme Court agreed with the Tax Court’s earlier statement that adopting a similar residency test for trusts as for corporations promotes “the important principles of consistency, predictability and fairness in the application of tax law.” Despite these views expressed by thecourts in this case, from a practitioner’s perspective we think this case leaves open a number of issues worthy of comment.

1. The central management and control test is said to be the place “where its real business is carried on”. But what does this mean in the context of a trust? The “business” of a trust is typically to simply hold property, which depending on the situation may involve very little activity. Unlike a corporation, there may not be day-to-day decision making required.
2. The Federal Court of Appeal provided some guidance regarding the central management and control test. In Justice Sharlow’s view, it is acceptable for a beneficiary to make recommendations to trustees, but if beneficiaries exercise the trust powers or trustees’ discretions, then the beneficiaries are controlling the trust.[1] Did the Supreme Court intend to adopt the analysis of the Federal Court of Appeal on a wholesale basis, at least as far as the central management and control test is concerned?[2]
3. If the location of central management and control changes from year to year for whatever reason, does this mean the residence of a trust also changes from year to year?
4. A trustee has a fiduciary duty to manage the trust property. Is the central management and control test predicated on the presumption that a trustee is generally in breach of that duty, at least for purposes of a tax appeal, until the trustee proves otherwise?
5. Further to the above, if central management and control is found to be exercised by someone other than a trustee (for example, a beneficiary or a financial advisor), will that trustee be in breach of the fiduciary duties it owes to the beneficiaries for allowing its control to be subverted?
6. The genesis of the central management and control test was a 1906 decision in De Beers Consolidated Mines, Ltd. v. Howe­.[3] However, business was very different and much more regional in nature than it is today. In 1906, there were no fax machines, no e-mail, no internet, aviation was in its infancy and there was no commercial air travel, and long distance telephone calls were much more expensive and less reliable. Today, it is not uncommon for a board of directors to be comprised of individuals in various jurisdictions making decisions using electronic communication. Arguably, the world has changed sufficiently that it is worthwhile for a court to reconsider the principles in the De Beers case.
7. A trust is fundamentally different from a corporation. For example, a trustee owes fiduciary duties to its beneficiaries, whereas directors of a corporation do not owe fiduciary duties to the shareholders. Instead, they owe a fiduciary duty to act in the best interests of the corporation. Is the central management and control test reconcilable with this difference?
8. Given the above, one could query whether or not this decision will help to achieve the principles of consistency, predictability and fairness in the application of tax law. It seems to us that this case has the potential to do quite the opposite when trying to assert where a trust is resident for tax purposes.

The United States has a codified test to determine whether the trust is domestic or foreign for US purposes.[4] Should Canada adopt a similar model to achieve the consistency, predictability and fairness principles espoused by the Courts?

Stay tuned… much ink will be spilled on this matter in the years to come. In the meantime, trustees will have to be mindful of the central management and control test to ensure that the trust’s residency is in the place that they desire it to be.

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On March 29, 2012, The Honourable Jim Flaherty, Minister of Finance released the 2012 Federal Budget. This blog discusses some of the more important tax proposals that will affect our clients and friends. Our blog of February 21, 2012 had some predictions as to what the Federal Budget would contain and certainly some of our predictions have come true as highlighted below.

1.    Tax Rate Changes

There are no tax rate increases or decreases proposed in Budget 2012. 

2.    Improvements to the Eligible Dividend System

This proposal is a welcome surprise!

Budget 2012 proposes to improve the ability for a company to designate a dividend as an eligible dividend. As discussed in our May 7, 2009 blog, the current law is very strict both in terms of the method and the timing of how eligible dividends are designated as such. Budget 2012 proposes a method which will enable split dividend designations and late designations to occur. Currently, if a Canadian Controlled Private Corporation (“CCPC”) declares a taxable dividend and wishes for the dividend to be treated as an eligible dividend, all of the dividend must be designated as an eligible dividend pursuant to subsection 89(14) of the Income Tax Act (the “Act”). Now, for dividends declared after March 28, 2012, any portion of the taxable dividend may be designated as an eligible dividend. In addition, a late designation of an eligible dividend may be made within a three year period following the day which the designation was first required to be made. Currently, no such provisions are in existence and therefore this should provide great flexibility for CCPCs and their shareholders to designate dividends to be eligible dividends. This is a great move by the Federal Government to provide flexibility.

3.    Employees Profit Sharing Plans (“EPSPs”)

EPSPs are a trust most commonly used by owner-managers of private corporations to allocate income to employees (beneficiaries), which may include members of the owner’s family. Often a private corporation could make a tax deductible contribution to an EPSP and the EPSP would allocate such amounts to its beneficiaries. EPSP allocations are generally included in computing the income of beneficiaries, hence simple income splitting and source withholding avoidance (such as CPP and EI amounts) could be achieved. As the allocations are taxable to the beneficiaries, EPSP trusts are generally not subject to tax.

Budget 2012 targets “excessive EPSP amounts” paid to a specified employee (defined as an employee who has a significant equity interest in the corporation or who does not deal at arm’s length with the corporation). The Budget includes a measure to impose a special tax on the “excessive EPSP amounts” which will consist of a tax levied at the highest federal and provincial marginal rates to be applied on allocations from an EPSP that exceed 20% of the specified employee’s salary from the corporation in the year. 

Although this measure was adumbrated in the prior year budget, the method on how Finance would approach perceived abuses involving EPSPs was of interest to many. The 2012 Budget proposal appears to limit the ability of an owner to income split with family members as a special tax at the highest marginal rate is applied to any “excessive EPSP amounts”.

As mentioned above, owners could often avoid paying CPP and EI by paying themselves a salary of a nominal amount from their corporation and receive the balance of their compensation by having the corporation contribute to an EPSP and receive allocations from it. The 2012 Budget proposal should deter an owner of a business from doing this in the future (assuming they have a significant equity interest in the business) since the excessive amount of the allocation from the EPSP would be subject to the special tax at the highest marginal tax rate.

Bottom line, it would appear that much of the mischief involving EPSPs and owner-manager remuneration planning (income splitting with minor children or other non-arm’s length persons and CPP/EI avoidance) will end and many EPSPs will now likely need to be wound down.

4.    Partnership “Bumps”

Section 88 of the Act contains very complex rules that enable a taxable Canadian corporation (“Parent”) that has acquired control of another corporation (“Sub”) to increase the cost of certain capital assets acquired by the Parent on a vertical amalgamation or on winding up the Sub. Very generally, the section 88 bump recognizes that in such cases the amount paid by the Parent for the shares of the Sub represents the cost of the assets of the Sub and allows the Parent, within limits, to add the amount paid for the shares to the cost of certain capital assets acquired on the amalgamation or winding up. Essentially, only the non-depreciable capital property of the Sub is eligible for the section 88 bump. Examples of such property are land, shares of a corporation or an interest in a partnership. Other assets such as eligible capital property, depreciable property, inventory and resource properties (assets that are generally held on account of income (“income assets”)) are not eligible.

The Government has noticed that partnership structures can be used to achieve a bump in respect of the cost of a partnership interest (which is holding income assets) where the bump would otherwise be denied in respect of the shares of a subsidiary (which is holding income assets). Accordingly, Budget 2012 introduces measures that will result in a denial of a section 88 bump in respect of a partnership interest to the extent that the unrealized gain of the partnership interest is reasonably attributable to the amount by which the fair market value (“FMV”) of income assets exceed their cost amount. This measure will apply to amalgamations that occur and windings-up that begin on or after March 29, 2012.

This is a very targeted measure that will now shut down some otherwise useful planning.

5.    Overseas Employment Tax Credit (“OETC”)

The OETC was introduced over 30 years ago as a measure to maintain the competitiveness of Canadian firms in certain sectors in bidding for overseas contracts. If an employee is eligible for the OETC, they are entitled to a tax credit equal to the federal income tax otherwise payable on 80% of their qualified employment income up to a maximum foreign employment income of $100,000.

Budget 2012 proposes to phase out the OETC over four taxation years beginning with the 2013 taxation year. The Government believes that the conditions in which the OETC was originally introduced have now changed to the point where Canada is just as competitive as many other foreign countries who do not have an OETC comparative credit. Accordingly, Budget 2012 proposes to reduce the 80% factor applied to an employee’s qualifying foreign employment income to the following:

·      2013 – 60%

·      2014 – 40%

·      2015 – 20%

·      2016 –   0%

For employees who work outside of Canada, this will have a dramatic impact on their Canadian taxes otherwise payable. We know of many employees who are eligible for the OETC and this may ultimately impact their desire to work overseas. 

6.    Employee Benefits: Group Sickness or Accident Insurance Plans

In addition to the tax that is withheld on an employee’s salary, tax is generally withheld on all other taxable benefits provided to employees. These include benefits such as the automobile benefit for personal use of a company car, private medical plan premiums and life insurance.

The premiums paid by an employer to a wage loss replacement plan were not included as a taxable benefit at the time premiums were paid but the periodic benefits were taxable to the employee when received. This was generally beneficial as the employee might not ever receive wage loss benefits and if they did, the employee’s wage loss payments were generally subject to a lower rate of tax.

However, if the benefits were not payable on a periodic basis or when there was no loss of employment income, the benefits were not taxable.

Budget 2012 proposes to change this so that in the future, premiums attributable to these non-periodic or other benefits will be taxable benefits to the employee at the time of payment by the employer.

7.    Retirement Compensation Arrangements (“RCAs”)

RCAs are plans which enable an employer to make a deductible contribution to certain retirement plans in respect of select employees with no immediate tax implications to the employee. However, contributions to RCAs require the RCA to remit a tax, which is refundable, equal to 50% of the amount contributed to the RCA. The refundable tax is held by the Canada Revenue Agency (“CRA”) until such time the employee withdraws amounts from the RCA. Such withdrawals create a taxable event for the employee and a proportionate return of the refundable tax to the RCA. These rules were introduced as anti-avoidance measures during the 80’s to prevent inappropriate tax deferral involving employee’s contributions to self-funded plan arrangements.

Over the years, RCAs have been used as planning vehicles for owner-managed companies and their shareholders. For example, consider where OpCo makes a deductible contribution of $100 to an RCA in respect of Mr. Apple, who is an employee (and likely a shareholder) of OpCo. As required, OpCo contributes $100 to the RCA (a trust) and the RCA remits $50 of refundable tax to the CRA. Subsequently, the RCA borrows from a bank against the refundable tax and receives say $45. The RCA then loans the aggregate $95 to OpCo. Presumably, the Government was bothered by the loan from the RCA to OpCo, and obviously had questions about whether the RCA was created for the purpose of funding employee retirement.

In addition, RCAs were allowed a wide range of investment choices in the past and, as illustrated in the above example, the Government does not appear to like some of those choices.

Just as RRSPs and TFSAs are currently subject to penalties for owning “prohibited investments” or conferring “advantages” on a beneficiary, Budget 2012 proposes to adopt such concepts for RCAs, where an RCA has a beneficiary with a significant interest in the employer (generally more than 10% ownership). If applicable, the RCA and the beneficiary will be subject to a 50% tax on the value of the prohibited investments and a 100% tax on the value of any advantage. Further, the refundable tax held by CRA will not be returned to the RCA if a decline in value of property held in trust is reasonably attributable to prohibited investments or advantages. We previously discussed the concept of “advantage” in our blog dated February 1, 2012.

The Budget proposals for RCAs should put a stop to much of the perceived mischief that was occurring with RCAs. Using our example above, the RCA custodian would be liable to a 50% tax on the prohibited investment, the $95 loan receivable to OpCo, resulting in a $45 tax liability. Ouch!

8.    Changes to the Thin Capitalization Rules

In general, the existing thin capitalization rules limit the deductibility of interest paid to non-resident shareholders to the amount that is computed on a 2:1 debt-to-equity ratio for Canadian subsidiaries of non-residents. This requires a non-resident setting up a Canadian subsidiary to provide at least one-third of its financing through equity rather than debt.

Budget 2012 proposes the following changes:

·         Reduction of the debt-to-equity ratio of the Canadian subsidiary to 1.5:1 for taxation years that begin after 2012;

·         The debts of a partnership of which the Canadian resident corporation is a member will now be included in the thin capitalization calculation. Partnership debts were previously excluded from the calculation of thin capitalization. This new rule will apply in respect of debts of a partnership that are outstanding during corporate taxation years that begin on or after March 29, 2012;

·         Disallowed interest under the thin capitalization rules will now be reclassified as dividends, and therefore subject to the appropriate withholding tax requirements; and

·         Interest that is included in the calculation of foreign accrual property income (“FAPI”) of the controlled foreign affiliate will be excluded from the thin capitalization calculation. This measure is proposed to avoid double taxation on these amounts.

Overall, the thin capitalization measures of the 2012 Budget reflect the Government’s efforts to ensure the profits of Canadian corporations are taxed in Canada by limiting the ability of a Canadian company to obtain an interest deduction on “excessive” foreign debt.

9.    Foreign Affiliate Dumping

The Department of Finance has identified certain types of “foreign affiliate dumping” transactions as being rather abusive in respect of Canadian fiscal policy. Such transactions are thought to erode the Canadian tax base without net economic benefits to Canada.

Generally, foreign affiliate dumping transactions involve a foreign parent corporation (“FPCo”) and a Canadian subsidiary (“Canco”), whereby Canco acquires shares of a foreign affiliate (“FACo”) that were previously held by FPCo. The perceived abuse arises when Canco borrows money to acquire the shares of FACo (presumably, the interest is deductible in Canada by Canco) and FACo will likely repatriate its profits to Canco through dividends that are effectively not subject to Canadian taxation.

The Budget proposes to implement measures that will, where certain conditions are met, deem a dividend to be paid by Canco to FPCo to the extent of any non-share consideration that is provided by Canco in respect of the acquisition of the shares of FACo. Further, the deemed dividend will be subject to the Canadian withholding tax regime as reduced by any applicable tax treaty.

10. Scientific Research and Experimental Development Program (“SR&ED”)

The SR&ED program essentially provides two tax incentives for qualified activities and expenditures incurred by a taxpayer by way of (i) a deduction in computing income for tax purposes for current and capital SR&ED expenditures incurred, and (ii) an investment tax credit (“ITC”), either a “general” or “enhanced” rate, on qualified expenditures in the form of a cash refund, a reduction of income taxes payable, or both.

The Budget proposes several changes to SR&ED with the hope that the revised program will be “more focused, cost effective and predictable”. Generally, the Budget proposes to:

• Exclude capital expenditures from SR&ED deductions and ITCs for capital property acquired on or after January 1, 2014;
•  Reduce the “prescribed proxy” amount from a rate of 65% to 60% for 2013, and to 55% after 2013. Note the “prescribed proxy” method (which is in lieu of itemizing detailed overhead expenses) generally allows a taxpayer to include an amount (the prescribed proxy amount) for salary and wages incurred, in the direct conduct of SR&ED in Canada, as qualified expenditures for the purposes of SR&ED deductions and ITCs;
• For ITC purposes, disallow the profit element in arm’s length (third party) SR&ED contract payments from qualified expenditures for amounts incurred on or after January 1, 2013 (for simplicity, it is proposed that the cost of arm’s length SR&ED contract payments will be restricted to 80% of the actual amount incurred, which equates to an imputed profit element of 20%); and
• Reduce the “general rate” ITC from 20% to 15% in respect of taxation years that end after 2013. However, the “enhanced rate” ITC, which is available to eligible CCPCs, will remain unchanged from the current rate of 35% on up to $3 million of qualified SR&ED expenditures.

11. Charitable Organizations

Foreign Charitable Organizations

Generally, donations made by taxpayers to foreign charities are not eligible for a donation tax credit, or deduction, unless the taxpayer also has foreign sourced income. However, in recent years the Government of Canada has graciously made gifts to foreign charitable organizations, which if so desired, enabled the foreign charitable organization to register as a “qualified donee” under the Act.

A registration as a “qualified donee” provides Canadian taxpayers the opportunity to donate to foreign charitable organizations and receive a corresponding donation tax credit or deduction.

The Budget proposes to restrict “qualified donee” status to those foreign charitable organizations that only pursue activities “related to disaster relief or urgent humanitarian aid” or that are “in the national interest of Canada”.   The restrictions apply to those foreign charitable organizations seeking “qualified donee” status on or after January 1, 2013.

Canadian Charitable Organizations

Canadian charitable organizations are required to operate exclusively for charitable purposes, which include “relief of poverty, the advancement of education or religion, and certain other purposes as recognized by the courts”, including engaging in political activities as long as such efforts represent a “limited portion of its resources, are non-partisan, and are ancillary and incidental to its charitable purposes and activities”.

The Budget proposes to implement sanctions against those charities that (i) exceed the limitations imposed in respect of political activities, or (ii) do not comply with the compliance obligations legislated by the Act. If the proposed legislation is passed, the CRA will have the authority to suspend the offending charity’s tax-receipting privileges for a one year period if the charity exceeds the limitations on political activities or suspend such privileges indefinitely until its compliance obligations are met.

12. Tax Shelter Administrative Changes

Section 237.1 of the Act provides rules for the registration and reporting requirements for arrangements that are considered tax shelters (as defined in subsection 237.1(1)). For instance, a promoter of a tax shelter arrangement must obtain an identification number in order for deductions and claims to be allowed by those taxpayers who participated in the tax shelter. Currently, the Act imposes a penalty on any person (usually the promoter) for failure to register or comply with reporting obligations. Also, if the penalty applies, the taxpayer is prohibited from any deduction or claim in respect of the penalized tax shelter.

In an effort to encourage compliance with registration and reporting requirements, the Budget proposes to:

•  In respect of charitable donation tax shelters, increase the current penalty (the greater of $500 and 25% of the consideration received or receivable by the promoter) to the greater of the amount determined under the existing rules and 25% of the amount the taxpayer receives as a charitable donation tax receipt, and
• Increase the failure to file or inaccurate filing penalty from the existing amount (the greater of $100 and $25 multiplied by the number of days a return is outstanding to a maximum of $2,500) to 25% of (i) the unreported tax shelter sales, or (ii) in the case of a charitable donation tax shelter, the greater of 25% of the consideration received or receivable by the promoter and the amount the taxpayer receives as a charitable donation tax receip

The proposed increase in penalties against offending charitable tax shelter organizations are timely as many Canadians have been fleeced by unscrupulous promoters of what initially appears to be a charitable giving arrangement. Our firm welcomes these proposals.

13. Government Commitment to Proceed with Previously Announced Tax and Related Measures
The Government took the opportunity to announce that it is committed to proceed with previously announced tax and related measures, as modified to take into account consultations and deliberations since their original release date. The list was rather lengthy but included the July 16, 2010 Income Tax Technical Amendments which include the restrictive covenant proposals under section 56.4. We have written about these proposals in our July 20, 2010 and April 10, 2008 blogs. 
Stay tuned! It appears that the Government is getting ready to pass a huge back-log of proposed technical tax amendments.

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The Canada Revenue Agency (“CRA”) recently lost in Tax Court against a taxpayer that had structured their operations to minimize Canadian tax. The case, Velcro Canada Inc. v. The Queen, (“Velcro Canada”) is the first case since the FCA decision of Prevost Car Inc. v. The Queen(“Prevost Car”), (see our blog on March 18, 2009)that deals with the concept of “beneficial ownership” in a treaty shopping context. The purpose of this blog is to outline how treaty shopping works and how the CRA has tried to assess against this practice.   

By way of background, treaty shopping is generally a strategy where multinational corporations structure their affairs to minimize their overall global taxes. Some of the planning, as in this case, involves the use of intellectual property. Intellectual property may be “trade secrets” that allows one to manufacture and sell a particular product. As consideration for allowing someone to use their intellectual property, a royalty is often charged which may be based on a percentage of sales or based on the number of products produced. The key to treaty shopping is to ensure the intellectual property is resident in a country with low taxes which has favorable tax treaties with other countries.

In Velcro Canada’s case, the company was subject to a royalty agreement with a corporation that was resident in another country where the royalty payments were not subject to either Canadian corporate or withholding tax. 

As an illustrative example,[1] assume that a fastener is manufactured by a Canadian corporation and can be sold for $100 per unit, the domestic cost to manufacture the fastener is $50 per unit, and the production royalty is $50 per unit. Given this example, the company would have Canadian taxable income of $0 calculated as follows:

If the company was not subject to a royalty payment, the company would have $50 of income that would otherwise have been subject to Canadian corporate tax. This results in the shifting of income that has been earned in Canada to another country. The Canadian Government has domestic tax rules that subjects royalty payments made to non-residents of Canada to a 25 percent withholding tax. However, in the Velcro Canada case the withholding tax rate was reduced to zero percent because of a specific article in the Netherlands/Canada Tax Convention (the “Treaty”) that allows such payments to be exempt from withholding tax. 

If we follow the taxation of this royalty along the international corporate chain, it was paid to a corporation resident in the Netherlands (“Netherlands Holdco”). The Netherlands Holdco was also subject to a royalty agreement such that 90 percent of the royalties that it received from Canada must be paid to yet another corporation (“ParentCo”) that was resident in the Netherlands-Antilles, a jurisdiction with a historical low taxing rate.

In continuing on our example, the royalty payment made to the Netherlands Holdco would report the following income:

If we assume that the Netherlands’ corporate income tax rate is 29.6 percent, it results in $1.48 of Netherlands corporate tax on the above profits. We also note that there is no Netherlands withholding tax on royalty payments between the Netherlands and the Netherlands-Antilles.   

To summarize, the royalty has now been transferred to ParentCo which is resident in the Netherlands-Antilles, a jurisdiction which provides for various participation exemptions and special incentives to royalty companies which may result in a two percent[2] tax rate. Accordingly, the tax paid in the Netherlands-Antilles would be $0.90 using our above-noted example.   

Accordingly, the Velcro Canada royalty would have been taxed as follows: $0 in Canada, $1.48 in the Netherlands and $0.90 in the Netherlands-Antilles for a total tax of $2.38. The effective tax rate would be 4.76 percent[3] ($2.38 of total taxes paid on $50 of royalties). Compare this effective rate with the Canadian corporate or withholding rate of 25 percent and this represents a significant tax saving.

In Velcro Canada, the Treaty prescribed a reduced withholding rate on royalty payments made to a “beneficial owner” resident in the Netherlands.[4] The CRA took offense to the fact that the corporation that received the Canadian royalty payment, the Netherlands Holdco, was under a contractual obligation to pay within 30 days, 90 percent of the royalties received from Velcro Canada to an affiliate corporation in the Netherlands Antilles. The CRA questioned how a corporation could be the beneficial owner if it is obligated to pay 90 percent of the Canadian royalty received to another corporation. They further argued that the Netherlands Holdco was an agent or conduit of ParentCo, which would have enabled the Court to pierce the corporate veil.[5]

The Tax Court refused to pierce the corporate veil in this instance. The Court expanded on the FCA’s decision in Prevost Car regarding beneficial ownership including an analysis of the four elements of beneficial ownership, being “possession,” “use,” “risk” and “control”. The Tax Court found that, notwithstanding Holdco’s obligation to pay 90 percent of the royalty, Holdco exercised the four elements of beneficial ownership, and therefore met the conditions of the Treaty to be eligible for a reduced withholding tax rate. 

It appears that unless there is a change to Canada’s tax treaties clarifying what “beneficial owner” means, the Canadian Courts will respect the form of the structure so long as one can demonstrate that they meet the common law tests for beneficial ownership. However, the OECD is keenly interested in this subject and has released a discussion draft clarifying what the concept of “beneficial owner” means in Articles 10, 11 and 12 of the OECD Model Tax Convention (which is how most of Canada’s tax treaties are modeled). 

Stay tuned… this is a fast moving area of tax law.

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As mentioned in an earlier post, the Federal Budget is usually the place where most tax proposals arise. Accordingly, tax practitioners are keenly interested in the detailed Budget proposals that get released. However, as we have mentioned in earlier posts, there are also many income tax amendments / proposals and comfort letters released by the Department of Finance throughout the year. In addition, there are hundreds of cases released by the Courts every year in Canada that affect the practice of tax. Accordingly, while it has long been the tradition by many of our peers to race to release a Federal Budget summary, our approach at Moodys is purposefully different. We will, of course, release a Budget summary but we instead, strive for thoughtful analysis and the timely release of tax information throughout the year; not just once a year. 

At the moment, the exact date of the 2012 Federal Budget is not known. However, most speculation points to sometime toward the end of March 2012. As most readers know, the content of the Budget is a closely held secret. However, there always appear to be strategically timed "leaks" where one can safely bet that there will be a proposal that deals with the leaks. In addition, Finance Minister Flaherty has been busy in the last little while completing his “Budget consultations”. Whether such consultations will actually amount to any substantive proposals remains to be seen. 

With the above in mind, I will engage in a bit of sport fishing for tax practitioners. It is always fun to guess / speculate what will be in the Federal Budget from a tax perspective. A little caution though....the list below is mine only, is pure speculation and should not be relied upon. I have no inside knowledge whatsoever and, as stated, I am simply speculating.
 

1.        Scientific Research and Experimental Development ("SR&ED") Tax Credit Changes

This guess should be of no surprise to people who follow tax. With the release of the Jenkins Report in October 2011, this should be the impetus for the government to change the existing SR&ED tax credit regime which has long been criticized for being inefficient and overall not being effective. It will be interesting to see how the government intends to change / improve the existing system.

2.        Charitable Tax Credit Changes

Many of the recent Federal Budgets have contained targeted changes to the tax system for charities and donors. Most changes have been significant improvements. Some, however, have been anti-avoidance rules designed to stop certain abusive “strategies” or charitable tax shelters from being effective. There has been some speculation that that the Federal Budget might introduce a “stretch credit” for charitable donations much like what Alberta has done. A stretch credit is where the underlying tax credit granted for making the charitable donation is greater than the top rate of income tax for donors. For example, in Alberta, donors to charities of amounts greater than $200 per year will receive a combined Federal - Alberta tax credit of 50 percent notwithstanding that the highest personal tax rate on salary type income is 39 percent. Will the federal government follow suit? I am guessing a hedged maybe. There has also been speculation that the government might introduce proposals to exempt realized capital gains on private company shares or certain real property from taxation when donated directly to charity (similar to that for listed securities). While nice in theory, I am guessing that this will not happen in Budget 2012. Having said that, I think it is a safe bet that Budget 2012 will have some charitable tax proposals. 

3.        Depreciation Rates

This is almost a certainty. Every year the government reviews the current depreciation rates (the technical phrase being “capital cost allowance” or “CCA”) for various types of depreciable property and attempts to adjust such rates to reflect commercial realities. It is a pure guess as to what properties' CCA rates will be adjusted to this year, but wouldn't it be nice if the rate for computer equipment was finally (and permanently) adjusted to 100 percent? 

4.        Personal Tax Credits

In recent Budgets, there have been a flurry of new personal tax credits offered. Some of the more high profile credits introduced recently have been the Children's Fitness Credit, Children's Art Credit and the Transit Pass Credit. I am guessing there will be more of these types of credits proposed in the 2012 Budget, although I wish there were not. While these credits are high profile, they do not actually amount to a lot of dollars per person. It would shock me if the recent credits actually change behavioral patterns. For example, did the introduction of the Transit Pass Credit actually cause more people to take public transportation? I doubt it. Does the Children's Fitness Credit actually cause most families to enroll their children in fitness programs? Doubtful. As stated, the credits amount to a very low amount of tax savings per family, but unfortunately come with a tremendous amount of administration (keeping receipts, filing the receipts with the tax returns, causing tax preparers angst for such low dollar amounts, etc). Notwithstanding, the present government seems to like these high profile / low value tax credits and I am confident we will see more.

5.        Anti-Avoidance Measures

The two last Budgets could be characterized as anti-avoidance Budgets. In 2011, we saw proposals that shut down deferrals for corporate partners of partnerships, measures to expand the “kiddie tax” and a restriction on the donation of flow-through shares to charity. In 2010, we saw proposals that would require certain aggressive tax strategies to be reported to the Canada Revenue Agency (these proposals have not yet been passed into law). Will there be more anti-avoidance rules introduced? I am guessing “yes”. The question is what will be targeted? Will certain income splitting strategies be targeted? Will the use of trusts to split income and capital gains be the subject of attack? Will Canada follow the lead of the US and force large companies to report their uncertain tax positions (“UTP”)? (In the US, certain companies must report their UTP to the IRS). Will charities be subject to even more reporting so as to ferret out the unsavory ones? Will ponzi scheme receipts be subject to tax to overturn the effect of a recent Tax Court decision? Not sure on any of this.

6.        Tax Rates

This seems to be the favorite subject of many people who write on the Budget....whether or not there will be any changes to income tax or GST rates. My educated guess is no. The government appears convinced (and I think they are right), that a low corporate tax rate is good for the economy and helps attract foreign investment. Accordingly, I do not envision any changes with corporate tax rates. For personal income tax rates, I simply think it would be the wrong time to play with rates and the corresponding brackets, so I am guessing there will be no change here as well. Same with the GST. Let's see if I am right!

7.        Registered Tax Preparers? 

As I wrote about in an earlier blog, I believe that Canada should follow the lead of the US and require paid income tax preparers to be registered. Up until recently, the government did not seem interested in such a proposal but their tone has changed. Will we see the introduction of a registration system for paid tax preparers? I doubt we will see it for Budget 2012 but stay tuned on this.

8.       Employees Profit Sharing Plan Trusts ("EPSPs")

The 2011 Budget announced the government was studying EPSPs and whether changes were needed. The Department of Finance sought public input and the time for such consultation has expired. Will we see proposed changes in Budget 2012 as a result of such a study / public consultation? I am guessing yes.

While I am probably missing a lot, the above highlights all that immediately comes to mind. Let's see how close I am when Budget 2012 is released.

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Roy A. Berg JD. LL.M. (US Tax) & Nicholas J. Dancey JD, LL.M. (US Tax)

On February 08, 2012 the IRS issued IR 2012-15, which contains proposed regulations that clarify the manner in which non-US financial institutions will find and report US persons to the IRS, which is required by the Foreign Account Tax Compliance Act (FATCA), enacted by the US Congress in 2010. The new regulations set forth: a) the type of information the financial institution will search for; and b) the manner in which it will search for that information.

Information the Financial Institution Will Search For
In order to determine whether an account holder is a US person, the financial institution is required to search for the following specific items:

1. Identification of the account holder as a US person;
2. Whether the account holder was born in the US;
3. Whether the account holder has a US address or US telephone number;
4. Whether there are instructions to transfer funds to an account maintained in the US; and
5. Whether power of attorney or signatory authority has been granted to a person with a US address or telephone number.  

If any of the foregoing are present, the institution must require the account holder to complete a US information report (form W-9) and that report will be submitted to the IRS.  If the report is not completed, or the account holder refuses to comply, then the institution will be required to withhold 30% of any distributions to the account holder and remit that amount to the IRS.

Manner in Which the Financial Institution Will Search For This Information

The manner in which the institution must search for indications that an account holder is a US person depends on the balance of the account, whether the account is new or existing, and whether the account holder is an individual or an entity.

Existing accounts held by individuals

1.     The financial institution is not required to conduct a search provided the account had a balance of less than $50,000. However, if the financial institution decides to make an inquiry, it must follow the methodology described below.

2.     If the account balance is at least $50,000 but less than $1,000,000, the financial institution must review its electronically searchable data for the information listed above.

3.     If the account balance is $1,000,000 or more the financial institution must review its electronically searchable data for the same indications listed above.  In addition, however, the institution is obligated to search all non-electronic files for the same information, including interviewing any relationship manager associated with the account.

New accounts held by individuals

When an individual opens a new account, the financial institution will be required to review all information provided when opening the account under appropriate know-your-customer and anti-money laundering rules.  Accordingly, the institution will generally not need to make significant changes to the information collected during the account opening process in order to identify US accounts, except to the extent that the above-referenced information is identified.

So what does this mean for the US citizen who is resident in Canada?  First, if the individual meets the thresholds under a preexisting account he may or may not be asked by the financial institution if he is a US citizen.  Second, when the individual opens a new financial account in the future he will most likely be asked for his place of birth, a copy of his passport, or asked about ties to the US.

As stated in our previous blogs on January 09, 2012 the IRS extended the Offshore Voluntary Disclosure programs indefinitely for US citizens who live abroad and who are not current on their US tax obligations.  The penalties for taxes and non-filing are draconian, and do not appear to be going away.  Those who have not brought their filings current should act quickly before FATCA compliance becomes effective. 

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The study and practice of tax is tough. I have said it before and I'll say it again, I believe that tax is one of the most difficult areas of practice in existence.

In my many years of being a tax specialist, there have been no shortages of "tax myths" that I have run across and dealt with in practice.  Here are my answers / rebuttals to some of the more popular ones:

1.      Yes, the imposition of income tax in Canada IS legal in Canada and anyone who states otherwise is leading you down the wrong path.

2.    No, the Canada Revenue Agency (the "CRA") has not accepted your filing positions simply because you received a notice of assessment. The CRA generally has three years, with many exceptions that can extend this time, from the date of the notice of assessment to review and make changes to your return. We talk generally about this topic in one of our recent blogs Filing On The Basis Of Proposed Tax Legislation.

3.    No, the CRA does not "allow" say $10,000 of salaries to be paid to minor family members. The law provides that only reasonable salaries in the circumstances with a business purpose are deductible to the business.

4.    No, you can't avoid tax on death by simply gifting property to the next generation. There are taxes that can arise, such as capital gains taxes, by virtue of such property being deemed to have disposed of at fair market value. If you're a US citizen, then US gift tax might apply.

5.    So, someone is saying that if you buy a charitable tax shelter that you will be able to save more in taxes than the actual cost of the "investment" that will be "donated"?  Dream on.....if it's too good to be true it likely is. The CRA has been successfully attacking charitable tax shelters for years. The CRA has written on this often.

6.    So you're buying a vacation property and someone has told you that you can save a lot of tax by purchasing it through a corporation? Get some advice on this.....such a "plan" is usually ripe for disaster. Read what we've written on this.

7.    So you're a US citizen resident in Canada and you're not compliant with your US tax filings? "How will they find me?" or "The US has bigger fish to fry than me!" are your mantras? Well, your mantras are about to become very challenged. The US is aggressively trying to find you and there's a good chance they will....especially when FATCA comes into force.

8.     So someone has told you that you don't pay Canadian tax on investment earnings on offshore bank accounts? Wrong...dead wrong. As a Canadian resident, you must pay income tax on your world-wide income. You may also have reporting obligations on your foreign assets as discussed below.

9.    So you think the disclosure of foreign assets does not include US securities like Microsoft, Apple, Cisco, etc.....right? Wrong. It does. The definition of "specified foreign property" in subsection 233.3(1) of the Income Tax Act (the “Act”) (which is the section that requires foreign property disclosure by virtue of the requirement to file prescribed form T1135) specifically includes a share of the capital stock of a non-resident corporation. We have previously written about this.

10. So you've lived in a house that you just constructed or otherwise acquired for just one day since someone has told you that if you live it in for a day that it will be considered your principal residence and thus any gain realized on a sale will be tax free.....right? If it was only that simple. The definition of "principal residence" in section 54 of the Act is very lengthy and requires very detailed conditions to be met.   One of the requirements is that the housing unit must have been "ordinarily inhabited" in the year by the taxpayer, the taxpayer's spouse or common law partner or by a child of the taxpayer. Will one day occupancy meet the test of being "ordinarily inhabited"? Each situation will need to be reviewed for the facts and circumstances but it would be highly unlikely that one day occupancy would meet the test of being ordinarily inhabited.

The CRA is also aware of tax myths and has recently published a good Tax Alert . The US Internal Revenue Service also has a tax myth publication.

The bottom line is this.....tax is tough. Be very wary of accepting tax advice from someone who does not practice in the area.

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RRSPs are an extremely popular investment vehicle for Canadians. With the mild weather, it may be easy to forget it is February and the RRSP deadline is February 29^th. (The deadline is usually March 1, but with 2012 being a leap year it will be the last day of February.) This RRSP season, taxpayers and their advisors should be aware of a change in the RRSP rules enacted as a result of the 2011 Federal Budget. These new “advantage rules” target tax avoidance schemes and other structures that most taxpayers would not be involved in, but these rules also set a trap for the unwary. If the advantage rules apply, the Canada Revenue Agency (“CRA”) may impose a penalty tax of 100%. In general terms, this 100% tax is on the amount of the “advantage”, which may be the entire value of the investment. .

The advantage rules are complex and their intended policy may be subject to debate. But in very broad strokes, these rules target schemes including economic benefits resulting from trading RRSP room between taxpayers, transactions that artificially inflate RRSP room, conversion of taxable employment income or business income into tax-sheltered RRSP investments, and a variety of other tax-avoidance concoctions yet to be conceived that take advantage of the RRSP rules in an inappropriate manner. 

As mentioned, the advantage rules are unlikely to effect the transactions or investments of most taxpayers. However, the pitfall lies in “swap transactions”, which are probably completed by a number of taxpayers fairly regularly.

It is well known that a withdrawal from an RRSP is generally included in a taxpayer’s income, subject to certain exceptions.[1] In certain cases, a deduction is available where an amount is withdrawn from an RRSP, but these exceptions are narrow. These exceptions are where a taxpayer recontributes or transfers an amount to a pension plan,[2] a retirement compensation plan,[3] or a retiring allowance.[4] There is also an exception involving the death of an RRSP annuitant.[5] That said, many advisors had believed it to be permissible to “swap” investments to or from an RRSP. For example, before the enactment of the advantage rules, taxpayers might withdraw cash from their RRSP but contribute other investments to the RRSP, and provided that the investments contributed were of at least the same value as the amount withdrawn, it was believed that the withdrawal would not be a taxable amount. Prior to the advantage rules, we understand the CRA generally took no issue with this practice.

The advantage rules, however, impose the penalty tax on a “swap transaction”, which is defined as follows

“swap transaction”, in respect of a registered plan, means a transfer of property between the registered plan and its controlling individual or a person with whom the controlling individual does not deal at arm's length, but does not include

(a) a payment out of or under the registered plan in satisfaction of all or part of the controlling individual's interest in the registered plan;

(b) a payment into the registered plan that is a contribution, a premium, or an amount transferred in accordance with paragraph 146.3(2)(f);

(c) a transfer of a prohibited investment or a non-qualified investment from the registered plan, in circumstances where the controlling individual is entitled to a refund under subsection 207.04(4) on the transfer; or

(d) a transfer of property from one registered plan of a controlling individual to another registered plan of the controlling individual if

(i) both registered plans are RRIFs or RRSPs, or
(ii) both registered plans are TFSAs.

These broad provisions contemplate a variety of transfers in and out registered plans as well as transfers between “registered plans” (which is defined to include RRSPs, RRIFs, and TFSAs).[6] Indeed, the seemingly innocuous practice of replacing cash inside an RRSP with other investments of the same value held outside an RRSP, or vice versa, seems to be caught.

The CRA has confirmed this is the case in a recent technical interpretation.[7] The CRA noted that fair market value transactions are not excluded from the “swap transaction” definition. There are limited exceptions to the “swap transaction” definition set out in paragraphs (a) through (d) reproduced above. Otherwise, in the CRA’s view, the advantage rules effectively create a wholesale prohibition on swap transactions.

As a result, taxpayers and investment advisors should avoid moving assets in and out of RRSPs unless they are prepared to suffer an income inclusion, as they would under most RRSP withdrawals – or, even more unfavourably, pay the 100% penalty tax.

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This is not a new topic. However, it is one that we deal with time and time again....especially in recent years.

Tax policy and the implementation of tax legislation in Canada is under the purview of The Department of Finance. Much of Canada's new tax legislation arises from the annual Federal Budget. However, there are also technical amendments released in draft form (often for public comment) throughout the year. Such draft or proposed legislation may be further amended to correct for errors, provide clarification and address public submissions before it is finally released into a Bill. The Bill is then put before Canada's House of Commons and the Senate for debate and eventually receives Royal Assent and becomes law (unless for some reason the Bill fails to pass). The proposed legislation will often contain detailed “coming into force” provisions that establish the date from which a specific proposed provision will have legal application. Often, but not always, the application of the proposed legislation will be effective from a date earlier (i.e. retroactive effect) than the date that the provision is actually passed into law. The process to convert draft legislation to law can often take a long time.

The Department of Finance may also release “comfort letters” in response to parties' concerns with the technical accuracy of certain existing provisions of the Income Tax Act (the “Act”). Such comfort letters often state that The Department of Finance is prepared to correct the perceived problem and further undertake to recommend to the Minister of Finance to release proposals that will achieve such objective. However, the comfort letters are appropriately hedged and state that there is no guarantee that such proposed amendments will become law.

In recent years, there has been a tremendous amount of draft legislation and comfort letters that have been released and have not yet been proclaimed as law. The Office of the Auditor General of Canada pointed out this problem in its 2009 Fall Report.

Two obvious examples of proposed legislation not yet being passed into law come to mind. The first is the non-resident trust and foreign investment entity proposals. These proposals were first introduced in the 1999 Federal Budget and the resulting draft legislation has been revised at least six times over the last 13 years and still remains “proposed” (i.e. not law). The most recent revision resulted in the virtual scrapping of the foreign investment entity proposals but retained the non-resident trust proposals. If passed, much of the effect of these proposals will have retroactive effect to 2007 (with the date of the proposed application being changed many times over the years). The second are the restrictive covenant proposals that were first announced by the Department of Finance on October 7, 2003. Such proposals are extremely complex and we have written extensively on this subject. The restrictive covenant proposals have been amended many times with the most recent being July 2010. Such proposals also have not been passed into law but if passed will generally have retroactive effect to October 7, 2003 (with some exceptions to this general date).

Canada's tax system provides, under section 152, that an individual's tax return for a particular taxation year is generally "statute-barred" from a reassessment on the 3rd anniversary date of the date that the particular taxation year was assessed. For example, if Mr. Apple's 2006 personal tax return was filed in April 2007 and was assessed by the Canada Revenue Agency ("CRA") say May 15, 2007, then Mr. Apple's 2006 tax return would be prevented from any amendment (either by the CRA or by Mr. Apple) on May 15, 2010.

There are some exceptions to the general rule. For example, if Mr. Apple or the person filing the return made any misrepresentation on the 2006 tax return that was attributable to neglect, carelessness, willful default or committed a fraud then the CRA may reassess beyond the May 15, 2010 date (see subsection 152(4) of the Act). Also, there are some circumstances where Mr. Apple may want to file a waiver, also provided for under subsection 152(4), to the CRA that keeps all or parts of the 2006 return open for reassessment. Mr. Apple may also be able to rely on the “taxpayer relief provisions” of subsection 152(4.2) to extend the statute-barred date if he makes an application no later than the day that is 10 calendar years after the end of the particular taxation year in question if he was entitled to a refund or a reduction of taxes payable for that particular year. Corporations or inter vivos trusts are not entitled to benefit from the “taxpayer relief provisions” unlike Mr. Apple as earlier described. Corporations, other than Canadian-controlled private corporations, have similar rules regarding statute-barred dates but generally the date is four years from the date of notice of assessment.

Accordingly, what is a taxpayer to do when they are dealing with a tax matter that might be the subject of proposed legislation? For example, if a taxpayer granted a restrictive covenant in 2011, should he file his tax return on the basis of existing law or under the basis of the proposed legislation (which will generally be very complicated to deal with and may not have favorable tax results in comparison to existing law)? Good question and quite a quandary. When analyzing the issue, one should consider statute barred issues as discussed above and also whether the proposed legislation contains specific provisions that might override the normal rules of subsection 152(4) if a person wanted to ignore the proposed legislation and file on the basis of existing law.

The CRA has a long standing policy that encourages taxpayers to file their tax returns on the basis of proposed legislation. In CRA Income Tax Technical News No. 44, the CRA had the following to say on the topic:

It is the CRA’s longstanding practice to ask taxpayers to file on the basis of proposed legislation. This practice eases both the compliance burden on taxpayers and the administrative burden on the CRA. However, where proposed legislation results in an increase in benefits (for example, Canada child tax benefit) to the taxpayer, or if a significant rebate or refund is at stake, the CRA’s past practice has generally been to wait until the measure has been enacted.

A comfort letter is not considered proposed legislation and usually only reflects the Department of Finance’s views on a particular issue affecting a specific taxpayer. Given that our tax system is on the basis of self?assessment, taxpayers may decide to file on the basis of a comfort letter. Generally, the CRA will not reassess taxpayers who filed on the basis of a comfort letter, provided that they did so in conformity with the comfort letter.

Generally speaking, the CRA will not reassess if the initial assessment was correct in law. As a result, a taxpayer’s request to amend their tax records to reflect proposed legislation will be denied. It is recommended that taxpayers file a waiver in respect of the normal reassessment period to protect their interests.

In the event that the government announces that it will not proceed with a particular amendment, any taxpayers who have filed on the basis of the proposed amendment are expected to take immediate steps to put their affairs in order and, if applicable, pay any taxes owing. Where taxpayers acted reasonably in the circumstances, took immediate steps to put their affairs in order, and paid any taxes owing, the CRA will waive penalties and/or interest as appropriate.

In my opinion, the CRA's guidance usually, but not always, makes sense. From a practical perspective it is also sound. However, everyone's facts are different and, of course, one would need to carefully consider what is appropriate in their circumstances. People should heed professional tax advice on this difficult area of tax law.
 

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Firstly, this is my list not yours. It is very subjective and is a reflection of my many years of experience of being a tax specialist and building a “tax only” advisory practice. Most of the practitioners that are clients and friends of our firm know their tax limitations. However, there are other practitioners whose work we often trip across that do not know their limitations. The simple fact is that tax is tough. I would venture to say that it is one of the most challenging professions in existence.  Unfortunately, there is no tax specialist designation in Canada to help the public identify professionals who have credible knowledge and experience in tax. I’m hopeful that will change soon. 

With the above in mind, here are the top five mistakes we often see.

1.        Taxable Benefit Issues Not Considered
The Canadian Income Tax Act (the ”Act”) is littered with benefit provisions. For example, section 6 of the Act deals with employment benefits. The section is purposefully drafted broadly to capture many types of benefits into the employee's taxable income. Section 15 is another example and applies to many types of benefits received by a shareholder of a corporation. Again, section 15 is purposefully drafted very broadly but also has specific provisions so as to capture certain types of benefits into the shareholder's taxable income. We find in many cases that an inexperienced practitioner may not have considered taxable benefit exposure when reporting on a taxpayer's situation.

For example, consider the situation of Mr. Apple who is the shareholder of a Canadian - controlled private corporation, "Opco". Mr. Apple's acquaintances, and perhaps his advisor, have told him that he should purchase his personal use vacation property through Opco since he “will save a lot of tax”. Wrong. While the specific facts would need to be reviewed in order to give proper advice, it is highly likely that Opco has conferred a taxable benefit on Mr. Apple by virtue of section 15 of the Act as a result of the purchase and personal use of the vacation property. In some cases, such a taxable benefit can lead to ultimate double taxation. I've written and lectured about this many times. Accordingly, be very aware of situations that can cause taxable benefits to arise.

2.        Taxation of Prepaid Amounts

One of the fundamental accounting principles that is taught to accounting students early on in their studies is the ”matching principle”. Overly simplified, it stands for the proposition that expenditures must be matched to the derivation of the related income. For example, if Opco pays $10,000 on January 1, 2012 for an insurance policy that will expire on December 31, 2013, the matching principle will generally cause accountants to not expense the full $10,000 in Opco's 2012 fiscal year (assuming a calendar year end for Opco) but will instead amortize the cost over the period of benefit being 24 months. Accordingly, the prepaid portion of the insurance contact will be capitalized and reflected as an asset on the balance sheet of Opco. 

The same logic applies for amounts received by Opco. For example, let's assume that Opco provides consulting services and charges one of its customers a lump sum amount of $24,000 on January 1, 2012 for services that it will provide over the next 24 months. Let's further assume that Opco has received the $24,000 on January 1, 2012. Using the matching principle, most accountants would record the $24,000 as a deferred liability on the balance sheet of Opco as of January 1, 2012 and amortize such amount to revenue over the next 24 months.
 

For Canadian tax purposes, the receipt of the $24,000 on January 1, 2012 is likely immediately taxable under paragraph 12(1)(a) of the Act irrespective of the fact that it may not have yet been earned for accounting purposes. There are certain reserves under section 20 of the Act that may be available to defer such unearned amounts until the time that it is earned but the facts and circumstances would need to be reviewed as the eligibility for the section 20 reserves are very specific and narrow.

Bottom line.....review amounts received in advance and be aware that more than likely section 12 of the Act will apply to capture such amounts into taxable income irrespective of the accounting treatment.

3.     Salaries Paid to Family Members

Canada's system of personal taxation is one which taxes income at progressive tax rates. Canada's system is also one where each taxpayer must report and pay tax on their own income separately. Unlike the US, there is no ability to jointly file returns and combine income in certain cases. Accordingly, Canada's system will often cause taxpayers and their advisors to look for clever ways to income split amongst family members so as to use multiple progressive tax rates and reduce the overall family tax burden.

One strategy that is used by certain practitioners when advising their entrepreneurial clients is to pay salaries to family members so the business can claim a deduction against its business income and the recipient family member can use their lower progressive tax rates. In some cases, we see significant salaries being paid to very young children. Simple.....but does it work? This particular strategy is one of the many tax myths that exist in practice. We often hear from people that they've heard that salaries of say $7,000 to $10,000 to kids are acceptable since the Canada Revenue Agency (“CRA”) has said so. Or that their buddy has been using such a strategy for years and the CRA has never challenged it so it must be fine.

The fact is salaries paid from a business to family members must be reasonable in the circumstances in order to be deductible and to comply with section 67 of the Act. Any non-reasonable amount will not be deductible to the business but is still taxable in the recipient's hands (which results in double taxation). The facts and circumstances will dictate what is reasonable but let's be serious. As a real example, I have 4 kids ranging from the age of 6 to 15. I love them to death but would it be reasonable to pay my 12 year old $10,000 from my business for ”administrative duties” or “licking stamps” (common examples that we often hear)? Not a chance. Or at the very minimum, highly debatable and not likely.

Further, the salaries must have been incurred to earn income from the business in order to comply with section 18 of the Act. Was the payment of the $10,000 to my 12 year old incurred to earn income from my business? Debatable but not likely. Accordingly, be wary of the many tax myths in this area and be mindful of the sections 67 and 18 risks.

4.      Corporate Surplus Stripping

The use of a corporation to carry on a business is a traditional and often sound strategy. As most readers know, a corporation is a separate legal person. While the corporate vehicle can offer many tax advantages, it also has its downsides or challenges for the private business. One of the most challenging issues is how does a shareholder remove after tax corporate surplus (or what accountants often refer to as retained earnings) in a tax efficient manner? The most traditional way is by way of taxable dividends which are the subject to personal taxation in the individual shareholder's hands.

However, some practitioners want to be clever and find ways to remove corporate surplus to the individual shareholders in a more tax efficient manner. One strategy that we often see involves the use of the $750,000 capital gains deduction (”CGD”) applicable to qualified small business corporation shares. Let's consider the case of Mr. Apple again who owns shares of Opco. Let's assume that the shares of Opco have a fair market value of $500,000 and that all the detailed conditions which need to apply for Mr. Apple to use his available CGD apply. Mr. Apple wants to access Opco's surplus tax free. Accordingly, Mr. Apple's advisor develops the following plan:

a.           Mr. Apple sells his shares of Opco to a new holding company (“Holdco”) that his wife wholly owns for $500,000. 

b.          As payment for the shares, Holdco will issue a promissory note to Mr. Apple in the amount of $500,000.

c.          Given the above sale, Mr. Apple will realize a capital gain of $500,000 (assuming that his adjusted cost base of his Opco shares was nominal) but he  will offset such gains with his available CGD.

d.          Opco then pays dividends over time (whenever it has surplus cash) to Holdco. Since the shares of Opco are wholly owned by Holdco, Holdco will be “connected” with Opco and will generally receive such dividends on a tax free basis.

e.          Holdco will then use the cash to repay the promissory note to Mr. Apple thus resulting in him receiving such cash tax free.

Sounds pretty good right? Well, if it were only that easy. Unfortunately, the above plan simply doesn't work. Section 84.1 of the Act will cause Mr. Apple's capital gain described in step c above to be recharacterized as a taxable dividend. This will result in Mr. Apple not being able to claim the CGD and cause him to pay tax at personal dividend rates. Not good. Section 84.1 is one of the most common reasons why advisors are sued in tax matters.

Similar to section 84.1, there are other anti-surplus stripping rules within the Act. Practitioners need to be aware of such anti-avoidance rules and ensure that their plans are not caught by them.

5.      US Tax Issues Not Considered

The US is one of the only countries in the world that imposes taxation on a citizenship basis. Simply put, if you are a US citizen (or if you are substantially present in the US or are a green card holder) then the US will tax you on your worldwide income (unless you renounce your citizenship which is a separate topic that can come with significant tax complications). Identifying who is a US citizen is not always an easy exercise and is very much a matter that is reserved for US immigration lawyers.

We have written often on US tax matters but for brevity, US citizens resident in Canada often have significant reporting requirements, may have unanticipated US tax liabilities and have exposure to the US transfer tax regime (including the US estate tax depending on the size of the US citizen's estate upon death). 

Know your client. Are you sure they are not US persons? Are you doubly sure? Have you or your client sought US legal advice to confirm? Be careful.

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Posted by Roberto Domagas CA and Robert Worthington LL.B.

Copthorne Holdings Ltd. v. Canada, 2011 SCC 63 (CanLII) is a recent decision from the Supreme Court of Canada regarding the general anti-avoidance rule (“GAAR”)[1] and provides the much-anticipated interpretation and confirmation of these rules. While the “main event” was whether the transactions undertaken by the taxpayer resulted in abusive tax avoidance to which the GAAR applies, this blog focuses on the Court’s analysis of the meaning of “series of transactions”. The “series of transactions” concept was critical to the outcome of this appeal. The Court provided guidance on how past, present and future transactions are “contemplated”, thereby confirming the framework by which a “series of transactions” would be identified for the application of the GAAR.    

The case facts are exceedingly complex, but for purposes of this blog can be briefly summarized as follows: A Canadian corporation (“Holdco”) sold shares of its subsidiary (“Subco”) to its non-resident parent, thereby creating a sister company relationship between Holdco and Subco. This transaction created the opportunity for a horizontal amalgamation to occur between Holdco and Subco (“Amalco”), versus what would otherwise have been accomplished by way of a vertical amalgamation. What appears to have offended the Minister is that the taxpayer ultimately ended up with the same “structure”, i.e. non-resident parent owning an amalgamated corporation, however the horizontal amalgamation allowed the taxpayer to preserve $67 million of paid-up capital (“PUC”) of the issued shares of Subco, compared to a vertical amalgamation where the PUC would have otherwise disappeared.[2] The significance of preserving (or, in the Crown's view, “duplicating”) the $67 million of PUC is that it was later returned to the parent on a tax-free basis on a share redemption, thereby escaping the application of Canadian withholding tax. The Supreme Court of Canada affirmed the lower Courts' decision, applying the GAAR to deny the tax benefits resulting from the series of transactions, which was found to include the sale of Subco, amalgamation of Holdco and Subco, and share repurchase by Amalco.     

The definition of “series of transactions”[3] includes transactions “completed in contemplation of the series”. The contentious question answered by the Court is whether an offending transaction has to be contemplated prospectively, i.e. the offending transaction is known at the time of a particular transaction, or is it possible to contemplate the offending transaction retrospectively, i.e. whether it is sufficient to connect an offending transaction to a transaction that occurred in the past. In Copthorne, did the taxpayer have to know at the time of the share sale that they were going to undergo a future share repurchase, or is it sufficient to create “a series of transactions” where the offending transaction was executed because the prior sale was contemplated?   

In its analysis, the Court noted in the CRA’s 1988 Roundtable it was said that a “series of transactions” is to be applied prospectively, not retrospectively. The Court also cited academic commentary[4] suggesting the “series of transactions” test should be applied prospectively, and even agreed that the more common sense use of the term “contemplation” is prospective.

Nevertheless, in upholding both lower Courts’ analyses, the Court decided that contemplation of a series may include retrospective contemplation. The main rationale seemed to be a reference to the Court's earlier GAAR decision in Canada Trustco, in which the Court commented that the definition of “series of transactions” in subsection 248(10) included both prospective and retrospective contemplation. The Court was loathe to reverse its relatively recent decision in Canada Trustco. Interestingly, however, nothing in the Canada Trustco case turned on whether a series of transactions could include retrospective contemplation. Further, in its analysis, the Supreme Court stated that the text and context of subsection 248(10) leave open when the contemplation of the series must take place, i.e. the provision allows for either prospective or retrospective connection of a related transaction to a common law series.  

Before the Court’s decision in Copthorne, some commentators expressed that if a retrospective contemplation is permitted, it is all too easy to find that when a later transaction is completed, earlier transactions were known and taken into account.[5]  Indeed, hindsight is 20/20. Irrespective of whether the result in Copthorne is equitable, it seems unfair to taxpayers to allow the Crown to argue with 20/20 hindsight that an earlier transaction was contemplated when the later transaction was completed, and therefore the later transaction was an avoidance transaction as being part of the same series.

The only common law saving “test” from a transaction being considered part of a “series of transactions” is that the transaction requires more than a “mere possibility” or connection with “an extreme degree of remoteness” with the other transactions. However as the Court demonstrated, these hurdles were easily met by the Minister in this case notwithstanding that two years had passed between transactions, and that the rationale for the sale transaction was because proposed changes to the foreign accrual property income rules were imminent. The Court clarified that a “strong nexus” is not required to connect transactions into a series as proposed by the Tax Court, and by the result of this case, establishing a nexus was not onerous.  

The potential ramifications of this “reverse contemplation” principle extend well beyond the GAAR, because several other provisions of the Act contain a series of transactions test. One common example is in subsection 55(2).  We sometimes recommend clients complete a “butterfly” reorganization to “purify” a corporation by transferring assets from an operating corporation (an “Opco”) to another corporation on a tax-deferred basis. The reasons for completing a butterfly/purification reorganization may include putting shareholders in a position to claim the $750,000 capital gains deduction in the event Opco shares are sold in the future. However, a butterfly reorganization is only tax-deferred if it is not part of a series of transactions that includes a sale of shares. As such, if clients are contemplating a specific sale, we would typically advise that a butterfly should not be completed because the sale could be part of the same series of transactions as the butterfly, and consequently, the anti-avoidance rule in subsection 55(2) would apply to trigger a taxable capital gain.

If a specific sale is not contemplated, or if the owners were not marketing Opco (and assuming a number of other conditions are satisfied) a butterfly reorganization may be completed - or so we had thought, prior to Copthorne. The problem is that now the CRA could arguably apply the “retrospective contemplation” analysis and take the position that the subsequent sale was completed in contemplation of the earlier butterfly transaction! 

This result would be unfortunate, and we believe would not be consistent with the tax policy in the Act. We hope the CRA may administratively clarify that it would not apply the series of transactions test retrospectively other than in the GAAR context. In any event, taxpayers should be cautious when undertaking transactions that involve provisions of the Act that contain the “series” test, particularly where anti-avoidance rules are concerned.

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On December 15^th and 16^th I attended the International Taxation conference sponsored by the IRS and held in Washington DC.  There were more than 700 people in attendance and the lunchtime speaker on the first day was Douglas Shulman, the Commissioner of the IRS. At the end of his prepared remarks he answered only three questions posed by the audience. The first question he answered was mine, which was the following:

“On December 2 the US Ambassador to Canada announced that, before the end of the year, the IRS would issue guidance on tax compliance and penalty relief for Canadian residents [Click here for my prior blog on that topic] and then on December 7 the IRS Issued Fact Sheet 2011-13, which doesn’t really address the relief the Ambassador alluded to, though it does provide some guidance. [Click here for my prior blog on the IRS announcement]. Is the Fact Sheet the guidance the Ambassador was alluding to, or should we expect further guidance from the IRS?

Mr. Shulman said that the Fact Sheet was the guidance the Ambassador was alluding to. Further, he said “there is a lot of misinformation out there, and we wanted to clarify [the current state of the law].”

Both my question and Mr. Shulman’s response were quoted in Tax Notes Today on December 16, 2011, which you can read by clicking here.

After he answered my question he introduced me to Rosemary Sereti, who is Director of International Individual Compliance for the IRS. Ms. Sereti is the chief architect and is in charge of the Offshore Voluntary Disclosure Initiative (OVDI). I spoke with Ms. Sereti at length at the conclusion of the lunch. Ms. Sereti was very generous with her time and provided the following insight:

• She confirmed Mr. Shulman’s comment that the Fact Sheet was the guidance the Ambassador had alluded to.
• Penalty abatement for Canadian residents participating in the OVDI is available only if the taxpayer “opts out” of the program and successfully argues that he had “reasonable cause” for failing to file the returns.
• The IRS is aware of the problems caused by including registered retirement savings plans (RRSPs) in the OVDI penalty computation.
• The IRS is on the lookout for taxpayers who attempt to bring their unfiled returns current by using “quiet disclosure” and those who attempt to resolve their filing obligations in this way will face harsh penalties.

What we can conclude from my interaction with Mr. Shulman and Ms. Sereti is the following:

• First, it is unlikely that there will be a made-in-Canada-solution for those Canadian residents who are not current on their US filing obligations.
• Second, there is the possibility of penalty abatement for participants in the OVDI provided the participant “opts out” of the program and can prove they had reasonable cause for failing to file returns.
• Third, since the IRS is aware of the problems caused by including RRSPs in the OVDI penalty computation and has not issued guidance on the matter it is reasonable to conclude that, for now, the treatment of these accounts is an open issue.
• Fourth, those who attempt to bring their filing obligations current by using “quiet disclosure” may find themselves in much more trouble than if they had used “voluntary disclosure.

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Posted by Faizal Valli CA & Brian Dennehy CPA, JD, LL.M (US TAX)

Now that the OVDI Program is over and the IRS has released its Fact Sheet on US citizens or dual citizens residing outside of the US, this is a good time to reflect on some common circumstances when US citizens resident in Canada may have additional US tax to pay.

One of the common rebuttals that we hear from US citizens residing in Canada who are not compliant with their US tax affairs is “we haven’t filed our US tax returns because the Canadian tax liability is higher than the US tax liability and therefore there is no need to file”. In many cases, it may be true that the Canadian tax liability is higher than the US tax liability but one may never know until a thorough review of all of the facts and income sources has been completed. In addition, such individuals may also need to file other US reporting forms (even when there is no income tax payable) like Form 5471, FBAR, Form 3520/3520A, 8891, etc., but such filing requirements are beyond the scope of this blog. Some common circumstances where US tax may be payable are as follows:

1.   Deferral of Income Accruing in an RRSP

The RRSP rules in Canada are conceptually straight forward...a Canadian resident individual obtains a deduction when computing taxable income for contributions to a RRSP (subject to certain limits) and any earnings accumulated inside the RRSP are automatically tax deferred. Canada does not require a taxpayer to file additional forms or schedules to obtain a deferral of income accruing in an RRSP. 

However, a US citizen must properly and timely file a Form 8891 to obtain such a deferral from his/her US taxable income.  Otherwise, RRSP income is included in the US citizen’s taxable income for the current year. In addition, a Form 8833 must be filed to claim the benefits of the Canada-US Tax Treaty to deduct the current year RRSP contribution from the calculation of US taxable income.    If a return was not filed or if it was filed late, the taxpayer must follow certain procedures to defer the income generated by the account. Simply filing the forms is not sufficient. If these procedures are not followed the taxpayer will likely owe US tax. 

2.  Capital Dividends Received By a US Citizen

Capital dividends, overly simplified, are tax free dividends paid from Canadian private corporations to the extent that the corporation has a “capital dividend account”. Very generally, the capital dividend account of a Canadian private corporation is a surplus account that accumulates tax free amounts (such as the tax free portion of a realized capital gain or life insurance proceeds) that can ultimately be paid out to the shareholders of the corporation tax free. 

The US does not recognize the concept of a “capital dividend.” Corporate distributions to its shareholders are subject to ordering rules which prescribe the characterization of such income. A “dividend” is generally defined to mean any distribution of property made by a corporation to its shareholders out of its earnings and profits.^[1] If a corporation does not have earnings and profits, a corporate distribution to its shareholders is treated as (1) a return of capital and (2) capital gain to the extent the distribution exceeds earnings and profits and the shareholder’s basis. Accordingly, capital dividends are usually fully taxable as dividends for US purposes.

3.   Canadian “Estate Freeze” Transactions

A common strategy used by shareholders of Canadian private corporations is to “freeze” their interest in the corporation and transfer the future growth to some other party. To accomplish an estate freeze one must usually exchange their existing shares for new shares on a tax-deferred basis in Canada. 

An in depth discussion of the complexities of an estate freeze that involves a US person is well beyond the scope of this blog. Simply stated, an estate freeze may result in both US gift and income tax consequences from the transfer and issuance of shares. Additional complexities and potentially harsh tax results may flow by the use of a Canadian trust in the freeze. 

4.   Stock Options

Canada generally has a preferential system to deal with the taxation of stock option benefits. In many cases, the resulting benefit is only half taxable pursuant to section 7 and paragraph 110(1)(d) of the Income Tax Act. In some cases, there may be (or may have been) opportunities available to defer recognition of the resulting stock option benefit to the year of disposition of the stock. 

For US citizens, stock options may trigger taxable compensation as well as a gain on the sale of the acquired shares. Depending on whether the options are publicly traded and other factors, the US will determine compensation as arising on either the date of grant, vest, or exercise. Subsequent tax will arise on the date of sale. Both the timing and characterization of income may result in a disparity in the foreign tax credits available to offset the US income inclusion.

5.   Use of the $750,000 Capital Gains Deduction

Astute readers of our blogs will know that Canadian residents who hold shares of a qualified small business corporation may be able to benefit (to the extent that very detailed tests are met) from the $750,000 capital gains deduction upon the disposition of such shares. 

Generally, gain from the sale of stock is treated as capital gain in the US. The US does not recognize the capital gains deduction claimed by a Canadian resident US citizen. Accordingly, any such gain would be fully taxable in the US in the year of sale. The capital gains deduction claim and reduced tax in Canada may result in insufficient Canadian tax available to offset US tax payable. 

6.   Flow-through Share Deductions

A common tax deduction for high income earning Canadian residents is flow-through share deductions. Overly simplified, a flow-through share deduction is available as a result of an investment in an oil and gas corporation (or partnership) which will renounce their ability to claim deductions on Canadian Exploration Expenses or Canadian Development Expenses in favour of the investor. This can often times reduce Canadian income tax (subject to possible alternative minimum tax). 

From a US tax perspective, deductions and credits available to a corporation cannot be shifted to its shareholders. These deductions/credits comprise a portion of the tax attributes of the corporation. If flow-through share deductions are used by a US citizen to offset his/her Canadian taxable income, he/she may lack sufficient Canadian tax payable to offset US tax payable. 

7.   Principal Residence Exemption

As many people know, Canadian residents are generally exempt from capital gains taxation on realized gains from their “principal residence”. The discussion of a principal residence is beyond the scope of this blog but generally includes a property where a person ordinarily and habitually lives. 

The US allows an individual to exclude up to US$250,000 from the sale or exchange of his/her principal residence from gross income.^[2] To qualify for the exemption, the property for which such exclusion is being claimed must have been used by the person 2 of the previous 5 years. In order to calculate the gain, a US citizen must convert the purchase and sale price into US dollars using the exchange rate in effect on the respective dates. With the rise in the value of the loonie against the US dollar, a US citizen selling his home in Canada may experience an unexpectedly large US taxable gain. 

8.   Charitable Donations

Canada has a preferential tax system for donations of “listed securities” directly to charity. To the extent that certain conditions are met, the capital gains inclusion rate on a direct donation of listed securities to charity will be zero thereby avoiding any capital gains tax that would otherwise apply. In addition, when calculating allowable charitable donations as a tax credit, Canada limits the amount of charitable donations (that are subject to the credit) in the taxation year to 75% of the taxpayer’s net income plus 25% of taxable capital gains realized on the disposition of property donated to charity and other amounts beyond the scope of this blog. Also, Canada and it provinces provide a generous tax credit equal to the highest marginal tax rate for donations over $200, which can further reduce Canadian tax paid for large donation amounts claimed.

The calculation of the tax benefit for charitable donations generally yields more favourable results in Canada than the US.  In general, the deduction for charitable donations is limited to 20%, 30%, or 50% of a taxpayer’s gross income depending on the property contributed and the classification of the charity.[3] A US tax filer must report charitable donations as an itemized deduction[4] on Schedule A of the Form 1040.  Itemized deductions are restricted in two important ways (1) they are subject to a reduction for high income earning taxpayers and (2) if claimed, must be used in lieu of the standard deduction to which the taxpayer is otherwise entitled.  In 2011, the standard deduction available to a US taxpayer is $5,700.  In other words, a taxpayer only realizes benefits from itemized deductions to the extent he/she can claim an amount in excess of $5,700.  Thus in certain circumstances, a US taxpayer may receive little or no tax benefit for charitable contributions.    

9.   Pension Income Splitting

In 2007, the Canadian Government introduced pension income splitting legislation which enables optional pension income splitting with a spouse. In some cases, this can result in significant tax savings amongst spouses. 

However, pension income earned by a US citizen is attributable and taxable to the person who earned it for US purposes. Although US citizens filing a joint return may realize a similar result, splitting pension income is simply not allowed in the US. As a result, the entire amount of pension income will be recognized by the recipient with only a portion of the tax that would otherwise have been creditable to offset the US taxable income to the extent that Canadian pension splitting is utilized. 

10.  Allowable Business Investment Losses (ABILs)

ABILs are a special type of capital loss that, if certain conditions are met, will result in the allowable loss (which is one half of the realized loss) to be utilized to reduce all other sources of Canadian taxable income. This can be beneficial given that capital losses are only deductible against capital gains. 

Unfortunately, ABILs do not have similar treatment in the US. In general, a loss from the sale of stock is treated as a capital loss. A US citizen may utilize up to $1,500 a year in capital losses to offset other types of income. However, any remaining capital loss can only be used to offset capital gains or be carried forward to another tax year. 

11.  Medical Expenses

Canada has a comprehensive medical expense tax credit regime whereby only certain medical expenses are creditable. 

When calculating US taxable income, medical expenses are deductible as an itemized deduction (as described above in discussing the deduction available for charitable donations). However, the ability to use such expenses to offset US taxable income is even more limited. Medical expenses are only available as an itemized deduction to the extent they exceed 7.5% of an individual’s adjusted gross income. Again, many US citizens may receive little or no tax benefit from incurring medical expenses. 

12.  Canadian Lottery/Gambling Winnings

In Canada, lottery/gambling winnings are generally tax free. 

In the hands of a US citizen, lottery winnings are fully taxable as ordinary income. A taxpayer’s winnings can be offset by substantiated lottery losses. However, the taxpayer must claim these losses as an itemized deduction subject to the overall limit on itemized deductions and the loss of the standard deduction. 

While the above list is not exhaustive, it should give you a flavour that the two taxation systems - Canada’s and the US’ - are not entirely consistent. Although the Canada-US Income Tax Treaty does a very good job of trying to eliminate double taxation, the treaty does not resolve the two countries’ differing tax treatment on certain sources of income and availability of deductions/credits thereby causing different taxes payable. US citizens resident in Canada need to exercise great caution in assuming that their ultimate US income tax liability may not be nil notwithstanding the fact that their Canadian tax affairs are up-to-date. Seek professional help!

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