Tax and Estate Planning : Canada Tax & Estate Planning Lawyers & Advisors : Moodys LLP Tax Advisors & Shea Nerland Calnan Law Firm : Capital Gains, Succession Planning

On July 16, 2010, the Department of Finance released a significant package of income tax technical amendments and explanatory notes.  As I am writing this blog, I have a binder of material in front of me that contains all of the material released by the Department of Finance and it is approximately 2 ½ inches thick.  Oh joy!  Great summer time reading!!

In all seriousness, though, this material is very welcome news given that it contains significant provisions some of which have been outstanding for approximately 8 years.  Let’s hope this package gets passed into law soon.

One of the significant amendments included in the income tax technical package are the restrictive covenant proposals.  Such provisions are horrifically complex.  Our firm wrote a paper on the restrictive covenant draft proposals in 2008.  For those interested in an exercise in complexity, feel free to read the paper.  Such provisions are wide sweeping and will change how most purchase and sale agreements are handled from a taxation perspective.  For further information, take a look at our blog of April 10, 2008.

For the technically inclined, the July 16, 2010 release had the following changes to proposed section 56.4 (the section of the Act that is proposed to deal with the taxation of restrictive covenant amounts):

1. The definition of  “eligible corporation” in subsection 56.4(1) (this definition is relevant for the purpose of determining whether the rules in subsections 56.4(5) and (7) apply to provide an exception - for goodwill amounts- from the rule in section 68 that may deem a person who grants a restrictive covenant to receive an amount for the restrictive covenant irrespective of the legal agreement) has been changed to eliminate the previous rule which required that individuals with whom the taxpayer does not deal at arm’s length not hold in aggregate, directly and indirectly, more than 10% of the issued and outstanding share capital of the subject corporation.  No such 10% rule now exists in the revised definition. 

2. The definition of “restrictive covenant” under subsection 56.4(1) has been amended and tightened to try and provide more clarity than the previous draft definition. 

3. There is a new definition of “eligible person” in subsection 56.4(1) which is relevant for the purpose of applying new subsection 56.4(8.1) which will be discussed briefly below.  In general, an eligible person in respect of a grantor (the “vendor”) of a restrictive covenant at any time means an individual who is related to the vendor and who is attained the age of 18 years at that time or before.

4. Proposed subsection 56.4(8) (a provision that provides a set of conditions that, if met will cause section 68 to not apply to deem consideration to have been received or receivable by the person granting a restrictive covenant) has been amended in two places.  The first is in paragraph (d) which clarifies that to the extent that any amounts have been received, essentially as goodwill, then subsection 56.4(8) cannot apply with respect to such goodwill amounts.  The second is that there is now a new paragraph (h) which requires that there be no proceeds received or receivable by the vendor for granting a restrictive covenant in order for subsection 56.4(8) to apply.  There are corresponding “coming-into-force” provisions with respect to these new additions as well.

5. As mentioned above, there is a new proposed subsection 56.4(8.1).  To the extent that the conditions in the new subsection 56.4(8.1) apply, then section 68 will not apply to deem consideration to be received or receivable by the individual for granting restrictive covenants.  Overly simplified, to the extent that the conditions apply, a restrictive covenant granted by an individual who is resident in Canada (at the time of grant) to an “eligible person” (with all the other conditions not documented here being met) then the restrictive covenant rules will not apply.  This new provision will be helpful to the extent that a father, for example, sells shares of “Opco” with a restrictive covenant grant to his son and/or daughter.  The previous version of the rules made it clear that the restrictive covenant proposals would apply in such an example thus causing problems in succession planning.
 
6. There are technical amendments, beyond the scope of this blog, in proposed subsection 56.4(9), 212(13)(g) and corresponding “coming-into–force” provisions. 

Although complex, taxpayers and their advisors will need to pay particular attention to the restrictive covenant proposals when acquiring or disposing of businesses.

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By Paul R. Lebreux LLB, LLM, TEP, Ryan T. Carey CPA (US), LL.M. (US Tax) and Kristina Ash JD LLM (US Tax)

For Canadian residents spending time in the United States (“US”), it is important to ensure that the heat you receive next time you venture south is only felt from the sun, and not the Internal Revenue Service (“IRS”). 

Each year thousands of Canadians make the trek to warmer climates in an attempt to avoid Canada’s long, cold winter months.  More often than not, these winter retreats take Canadians to the US.  Whether your passion is Florida, Arizona or some other favourite southern state, such a retreat may not only put you closer to the sun, but closer to the IRS.

Depending upon the duration of your stay in the US, you may be classified as a US resident for income tax purposes and be required to complete certain tax filings.  Most Canadians who spend significant time in the US are required to file a US tax return or other filing in order to avoid paying US taxes on worldwide income.

Determination of US Tax Residency

If you visit the US on a regular basis, there are three categories into which you may fall:

1. Present in the US for 183 days or more in the current tax year.  Pursuant to the provisions of the Internal Revenue Code (“IRC” or the “Code”), if you are present in the US for 183 days or more in the current tax year, you will automatically be classified as a US resident and may be required to file a US tax return (Form 1040) in order to report your worldwide income in the US.  You may be able to claim a treaty tie breaker under the Canada-US income tax treaty in order to file a non-resident  return (Form 1040NR).

2. Present in the US for greater than 31 days, but less than 183 days during the current year and you meet the Substantial Presence Test.  If this is the category into which you fall, you will be considered a resident alien and be required to file a Form 1040 in order to report your worldwide income in the US, unless you use the treaty-tie breaker rule or you can demonstrate a closer connection to Canada than to the US (see discussion below under the heading “Substantial Presence Test”).

3. Present in the US for less than 31 days during the current year or do not meet the Substantial Presence Test as set out in category two above.  If this is your situation, you will be categorized as a non-resident alien and not be required to file a US tax return unless you have certain US source income for which adequate withholdings have not been made or you are engaged in a US trade or business (including employment within the US).   

Substantial Presence Test

In order to determine who is a US resident, the US utilizes a formula which considers the days that an individual is present in the US over a three year period.  This formula is commonly known as the Substantial Presence Test.  The test calculates the number of days actually spent in the US during the current year, plus the number of days spent in the US in the immediately preceding year multiplied by 1/3, plus the number of days spent in the US in the second preceding year multiplied by 1/6.  If the calculation totals 183 days or more, the individual meets the substantial presence test and will be classified as a resident alien.  It is important to note that for the purposes of this test, the days present in the US need not be consecutive.  You will be considered to have been present in the US on any day that you were physically in the US, whether you are present for the entire day or only part of the day.

The following example demonstrates the effect of the above formula.  Mr. and Mrs. Sunshine are residents of Canada and have a winter home in Florida.  For the past several years Mr. and Mrs. Sunshine have spent a portion of the winter months in Florida and also some time in the US during other parts of the year.

In 2008, Mr. and Mrs. Sunshine spent 3 months (91 days) in Florida during the winter and an additional 3 weeks (21 days) in the summer.  In 2009, Mr. and Mrs. Sunshine spent 4 months (122 days) in Florida during the winter and a further 2 weeks (14 days) in May.  In 2010, Mr. and Mrs. Sunshine spent 6 weeks (42 days) traveling in the US and another 11 weeks (77 days) at their home in Florida.

Based on the above, the “substantial presence” test would be applied as follows:

Years                  # of days in US                    Multiplier                    Formula Days
2008                              112                                   1/6                               18.66
2009                              136                                   1/3                                45.33
2010                              119                                     1                                119.00
                                                                                                                   183.00

Mr. and Mrs. Sunshine will therefore be deemed to have been in the US for 183 days during the current year and will meet the Substantial Presence Test.  Although this will effectively result in their being classified as resident aliens, they may be able to use an exception to avoid being liable for US income taxes on their worldwide income.

In order to avoid the requirement to file a US 1040 tax return, Mr. and Mrs. Sunshine will each be required to complete and file a “Closer Connection Exception Statement For Aliens” (Form 8840).  They must provide evidence to the IRS that they have a closer connection to Canada than to the US in order to escape US taxation.  In the event that Form 8840 is not filed on time (June 15, 2011 for the 2010 tax year), Mr. and Mrs. Sunshine would be estopped from claiming a closer connection to Canada, which could result in US taxation of their worldwide income.

You will be considered to have a closer connection to Canada if you can demonstrate that your economic and social ties to Canada are more significant than are your economic and social ties to the US.  The following are some of the indicia that the IRS considers in determining the “closer connection”:

 1. location of permanent home(s);

 2. location of personal belongings (ie. cars, furnishings);

 3.  location of banking relationships and investments;

 4.  location of drivers licenses;

 5.  countries from which you derive the majority of your income; and

 6. business and personal ties.

If you have applied for or been granted a “green card” you will not be permitted to claim a closer connection to Canada.

If you are successful in establishing a closer connection to Canada by timely filing a Form 8840, you avoid the necessity of filing a US resident tax return and possibly incurring double taxation.

Residence under the Canada-United States Income Tax Convention

Generally, if an individual fails to file a Form 8840 on time, the individual will be considered a US resident for tax purposes and be required to pay US income tax on his or her worldwide income.  Nonetheless, it may still be possible for the individual to have his or her residency status determined under Article IV of the Canada – United States Tax Convention (the “Treaty”).

The main purpose of the Treaty is to reduce the potential of an individual being taxed twice on the same income.  The treaty attempts to resolve the issue where an individual is deemed to be a resident in both the US and Canada.  You may be classified as a non-resident alien under Article IV for the purposes of calculating your US income tax liability if the following conditions are met:

 1. you are deemed to be a resident of both the US and Canada pursuant to each country’s respective tax laws; and

 2. your permanent home is in Canada and your personal and economic ties are closer to Canada than to the US.

Although relying on the Treaty may permit you to escape US taxation as a resident on worldwide income, you will still be required to file a US Form 1040NR with a “Treaty-Based Return Position Disclosure under Section 6114 or 7701(b)” (Form 8833).  These filings are far more complicated (and thus more expensive to have prepared) and intrusive than a Closer Connection Exception Statement, so most clients prefer to file a Closer Connection Exception Statement if at all possible.

Conclusion

If you are among the thousands of Canadians returning to Canada after a long cold winter, you may want to consider your potential US tax liability and filing requirements before it is too late.  If you are a Canadian who spends significant time in the US, it is imperative that you obtain professional advice to determine the extent of your tax filing and tax payment obligations.  We expect that the IRS’s increased scrutiny of taxpayers with foreign connections, combined with increasing use of technology, will cause the IRS to pay closer attention to those that are not filing required US forms and returns.

 The foregoing information is provided for general informational purposes only and readers are encouraged to consult with their professional advisors as to their specific circumstances.

U.S. Tax (IRS Circular 230): Nothing in this communication (including in any attachment) is U.S. tax or other legal advice that is intended or written to be used, and it cannot be used, by any person to
(i) avoid penalties under U.S. federal, state or local tax law, or
(ii) promote, market or recommend to any person any transaction or matter addressed herein.

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The past six weeks have been very busy with attending and speaking at various conferences.  At three of the conferences (Institute of Chartered Accountants of Alberta Tax Roundtable, Canadian Tax Foundation Prairie Provinces Conference and the STEP National Conference) the CRA was in attendance answering various questions posed by practitioners.  The topic of domestic trusts was high on the agenda for questions posed by practitioners.

In the midst of attending the above-noted three conferences, the CRA made it known that a national project on the review of domestic trusts commenced in 2005 and ended in the 2007 and 2008 fiscal year.  The CRA noted, from its review, the following recurring issues involving domestic trusts:

1. Domestic trusts had inappropriately deducted trustee/investment fees in the computation of its taxable income;

2. Certain of the domestic trusts had entered into transactions whereby the character of its income had been changed so as to avoid the incidence of “kiddie tax”.  Often times this would involve an otherwise dividend being characterized as a capital gain, since capital gains are not subject to the “kiddie tax” (the “kiddie tax” is an informal phrase to describe certain income that is ultimately taxed at the highest tax rate to the extent that it is allocated from a trust, in this example, to a minor beneficiary);

3. Certain of the trusts had entered into transactions whereby the capital gains deduction applicable for qualified small business corporation shares or a qualified farm property had been multiplied amongst various beneficiaries;

4. The trust did not have any evidence of paying income or making the income payable to the beneficiaries.  To the extent that such income is not paid or made payable to the beneficiary then the trust would not be able to deduct such income in the computation of its income; and

5. Certain of the attribution rules (such as sections 74.1, 74.2 and subsection 75(2)) applied to the trusts.

The CRA made it known that they would be taking a national approach to their review of trusts once again and, in particular, looking for the above noted issues.  Accordingly, practitioners and clients should be aware and be prepared. Trust records should be immaculate and attention paid to detail when entering into tax planning involving domestic trusts. 

This subject will get more attention in the coming months and years and, accordingly, Moodys is exploring the possibility of having a special seminar to discuss the pending audits of domestic trusts in the fall.  Stay tuned…..
 

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In an episode of Corner Gas, the main character, Brent, (who is single, has no children and is 40 years old) finds himself overwhelmed by a hot-wheels-tossing 6 year old boy and besieged under a kitchen table while babysitting for a friend.  Brent enlists the help of his mother, Emma, who quickly gains control of the situation and explains her two-pronged philosophy for disciplining kids:

“Use their whole name.  They hardly ever hear all three of their names so it kind of puts them off balance [mentally].  Second, give them an open ended threat, nothing specific, that way their fertile little imaginations fill in the gap with the worst thing they can think of.  A child’s imagination is their strength and their weakness.”

To watch this portion of the episode“Oh Baby,” start at 3:38 of the linked video.

Emma’s philosophy made me think of the general anti-avoidance rule (the “GAAR”).  Until the introduction of the GAAR in 1988, one of the greater certainties in tax, while not absolute, was the Duke of Westminster principle that taxpayers may order their affairs so as to minimize the amount of tax payable.  The GAAR introduced significant uncertainty and great apprehension as to whether taxpayers could seek to minimize tax.  Initially, the GAAR was feared as a “big stick” to reign-in taxpayers and tax planners alike.  As the GAAR cases worked their way through the courts, the apprehension may have diminished, but uncertainty remained.

The decision from the Supreme Court of Canada (“Supreme Court”) in Canada Trustco Mortgage Co. v. The Queen  2005 SCC 54 provided a welcome framework in applying the GAAR and restored a measure of certainty.  Particular comfort was gleaned from the following words of the Supreme Court:

“The GAAR was enacted as a provision of last resort in order to address abusive tax avoidance, it was not intended to introduce uncertainty in tax planning.”

With the Supreme Court’s split decision in Earl Lipson v. The Queen 2009 SCC 1, many commentators have expressed concern that Lipson introduced new and improved uncertainty.  (We discussed the facts of Lipson in our January 9, 2009 blog.)  Consider the view of one dissenting judge:

“The approbation by the Court of the Minister's resort to vague generalities or "overriding policy" would only increase the element of uncertainty in tax planning that Canada Trustco sought to avoid.” 

There are fears that the “big stick” is back and even whispers of a smell test.

Lehigh

On May 17, 2010, the “certainty” of the GAAR took another twist when the Federal Court of Appeal (“Federal Court”) allowed the taxpayer’s appeal in Lehigh Cement Limited v. The Queen, 2010 FCA 124, reversing the decision of the Tax Court of Canada (the “Tax Court”).  The Tax Court had applied the GAAR to a series of transactions that resulted in the avoidance of withholding tax under subparagraph 212(1)(b)(vii) of the Income Tax Act (the “Act”), which, in general terms, exempted interest from withholding tax when paid to an arm’s length party on debt that under no circumstances was 25% of the principal required to be repaid within 5 years of the date of issue of the debt ( the “5/25 Exemption”).  Canada has since eliminated withholding tax on all arm’s length interest (other than participating interest payments).

Misuse or Doubt?

The Crown’s primary argument in applying the GAAR in Lehigh was that a non-resident person is not entitled to benefit from the 5/25 Exemption where the right to receive interest is split from the right to receive the principal amount because the transaction did not result in Lehigh “accessing funds in an international capital market.”  This phrase is an excerpt from a 1975 Department of Finance budget paper that first proposed the 5/25 Exemption.

The Federal Court rejected the Crown’s invitation to conclude that entitlement to the exemption is “subject to a condition necessarily implied by the existence of a fiscal policy, evidenced only by a sentence in a 1975 budget paper that is said to explain why the exemption was enacted.”  The Federal Court emphasized: 
 

“Most importantly, if there is any doubt as to whether the transaction in issue results in a misuse […], Lehigh is entitled to the benefit of that doubt.”
 

Although the reversal of Lehigh itself by the Federal Court may be viewed as contributing to the uncertainty surrounding the GAAR, the message may be broader than that.  Arguably, Lehigh restores a measure of certainty to the principle that when there is any doubt as to whether there is a misuse or abuse of the provisions of the Act when a taxpayer is arranging his or her affairs to minimize tax, the taxpayer should be entitled to the benefit of the doubt.  It also inspires confidence that, as questioned by the Supreme Court in Canada Trustco, the Federal Court is unwilling to formulate taxation policies that are not grounded in the provisions of the Act and certainly will not apply ungrounded policies to override the specific provisions of the Act.  So it would seem that certainty can be found in doubt.
 

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Wow, time flies when you’re having fun……!  

May and June are conference months with our firm recently speaking at the STEP Pacific Rim Conference and the Canadian Association of Gift Planners Conference in Edmonton.  Our firm will also soon be speaking at the Canadian Tax Foundation Prairie Provinces Conference and the STEP National Conference.  Certainly no shortage of activity.

Similarly, the Department of Finance has been busy in the last couple months.  Here are some updates:

1.   Non-Resident Trust (“NRT”) and Foreign Investment Entity (“FIE”) Proposals

As mentioned in our budget blog of March 5, 2010, it was noted that the Federal Government was reviewing the NRT and FIE proposals.   The Government has now established a consultative group to assist it in introducing new draft legislation in this area.  Certain organizations have been asked to participate in the consultations with the Department of Finance and therefore we expect activity in this area soon.

Organizations like the Society of Trust and Estate Practitioners (“STEP”) have provided their response to the proposals, so it will be interesting to follow this space. 

2.   Information Reporting of Tax Avoidance Transactions

As mentioned in our budget blog of March 5, 2010, the Federal Government is proposing new reporting rules which will require certain tax avoidance transactions to be positively disclosed on an ongoing basis.  On May 7, 2010 the Department of Finance released a description of the proposals and asked for public comments on the proposals by July 7, 2010.

These proposals have the possibility to significantly impact certain tax advisors and their clients.  Stay tuned!

3.   Draft Regulations in Respect of the Place Supply Rules for Harmonized Sales Tax (“HST”).  

As mentioned in our December 16, 2009 blog, the “place of supply” rules with respect to the new HST regime for British Columbia and Ontario – to be effective July 1, 2010 – has created a lot of controversy.  The Government released its draft regulations to these place of supply rules on April 30, 2010.

4.   Responses to the Department of Finance Proposals for Employee Life and Health Trusts (“ELHT”).

 As mentioned in our March 1, 2010 blog, the Department of Finance released draft proposals on ELHTs on February 26, 2010.  If implemented, such proposals will have a dramatic impact on the way certain private and public corporations have planned for their employee benefit programs.  Certainly it is understandable, to some extent, why the Department of Finance would want to legislate these proposals.  Notwithstanding, some of the proposals appear to be far reaching and likely could be improved upon.  To that end, STEP provided its comments to the Department of Finance on April 30, 2010.

Stay tuned on all the above……it is sure to be interesting!
 

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Uncle Sam Wants YOU to file US tax returns…and he has recruited foreign banks into his army to report you!  Now you will get caught if you don’t file returns and report foreign income.

Until last week, United States persons who had never earned income in the United States and had never opened a bank account in the US were generally not on the IRS’s radar screen.  With the legislation signed into law on March 18, 2010 foreign financial institutions must determine if any of their account holders are US persons, and if so, the financial institutions must report information to the IRS about those accounts.  This blog answers the most popular questions that we have received in regards to this new legislation.

My mother/father was born in the US, but I was born in Canada and have never lived or worked in the US and I do not have a US passport or Social Security number.  I have never filed a United States tax return.  Am I a US citizen and am I required to file US tax returns?

The rules surrounding citizenship are complex and depend upon when you were born.  However, if one of your parents is a US citizen and spent sufficient time living in the US, you may be a US citizen.  If both of your parents are US citizens, you are probably a US citizen regardless of whether you or they ever lived in the US.    We can help you make a preliminary determination on citizenship, then refer you to qualified immigration counsel who can give you a final legal conclusion on whether you are a US citizen.

If you meet very low income thresholds, you are likely required to file US returns and comply with US tax laws.  The good news is that in most cases, the taxes that you paid to Canada will result in foreign tax credits that will cover the taxes that you owe in the United States.  We recommend filing tax returns for the current year, and possibly filing for the past several years, in order to avoid finding yourself on the wrong side of the table with the US Internal Revenue Service! The Moodys LLP Tax Advisors team is experienced in handling these types of returns and working with the IRS.

What information is my bank in Canada required report to the IRS?

First, your bank will need to determine whether you are a United States person.  If you are a US person, your bank must report your name, address, taxpayer identification number, account number, account balance or value, and the gross receipts and gross withdrawals from the account.

I am a US person who is a minority shareholder in a private corporation.  Will this affect me or the private corporation?

Probably.  If you own more than 10 percent of the stock in a corporation, more than 10 percent of the profits interests or capital interests in a partnership or beneficially own more than 10 percent of a trust, your bank must report the above information to the IRS. If you own a sufficient interest in the entity or if there are other US persons who own part of the entity, there could be significant tax consequences.  Your company might be a Controlled Foreign Corporation (“CFC”) or a Passive Foreign Investment Company (“PFIC”).  Ownership of CFCs and PFICs can have disastrous tax consequences if your tax situation is not proactively managed.  Talk to an advisor experienced in cross-border tax planning to determine if you have any tax liability.  Moodys LLP Tax Advisors are experienced in rendering this type of advice.

I am a shareholder in a corporation, but I am not a US citizen.  Could this legislation affect me?

That depends.  Do you have any shareholders that are US persons?  If so, you may be subject to additional reporting requirements and US tax liabilities, even if you don’t conduct any business in the United States. Discuss your situation with a tax advisor experienced in cross-border planning to determine if you have US tax reporting requirements or exposure.  Moodys LLP Tax Advisors are experienced in rendering this type of advice.

I am a shareholder in a corporation that occasionally does business in the United States or that has investments in the US.  Will this legislation affect me?

Yes.  Even if you don’t have a single US shareholder and you do not have a permanent establishment in the US, if you earn any income in the US, that income may be subject to a 30 percent withholding tax unless you provide the payor with a certificate that states that no US person owns more than 10 percent of the company.

I know that I’m supposed to file a US return, but I’ve never been caught.  Why should I start filing now?

This legislation imposes a reporting requirement on foreign (including Canadian) financial institutions.  Once these institutions report information about your account to the IRS, the IRS is more likely to find you.  If you fail to disclose your assets and the aggregate value of all of those assets is greater than $50,000, the IRS could impose a penalty of $10,000.  If you receive a notice and do not provide the information after 90 days, the IRS could impose a $10,000 penalty each month up to $50,000.  Moreover, if you fail to disclose the information and the IRS determines that there was an underpayment, an additional 40 percent tax will be assessed on the amount of the underpayment.  The statute of limitations with respect to a tax return do not begin running until a return is filed!  This means the IRS may pursue you for an unlimited period of time if you do not file a required US tax return for a particular year (or years). 

The penalties imposed by this new legislation are in many instances imposed in addition to other penalties which exist under other tax law and bank secrecy law provisions.  Failing to file required returns, particularly those related to foreign assets or entities, can result in draconian penalties and criminal prosecution.  Moodys LLP Tax Advisors has an experienced team of US tax experts who can assist you with catching up past filings and finding solutions to your tax problems.
 

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Please be warned that this blog may sound like marketing and it is different from our normal blogs. The reason for this is that we were recently asked by a prospect and a client the question:

"What is the benefit of a tax specialist?"

We thought it would be beneficial to answer this great question for our audience. Of course, this question was raised in relation to why the prospect should hire our firm and why the client should continue to work with us. They were both specifically wondering why they should work with us if their existing accounting firm (both large accounting firms) could do the work.

The short answer is that they should utilize our services because we believe that we are one of the more knowledgeable and proactive resources for tax and estate planning advice.

As we say in our mission statement, “we are passionate about tax optimization”.

All of our professionals aggressively stay up-to-date on new case law, legislation and administrative positions. We hold weekly meetings for continuing education and to discuss new developments in tax and estate planning.

Our team of tax lawyers and tax accountants work together in our multi-disciplinary practice which allows us to better identify issues, research, create and implement optimal strategic plans for clients all within one firm. We are the only firm that we are aware of that is structured in this way. In addition, we are one of the few firms in Canada that has in-house US tax practitioners that can offer cross-border solutions.

In many traditional accounting firms, the tax department is often reactive in their approach to client needs. Certainly the existence of the tax department to support the audit and assurance practice is sufficient in many cases and there are many great accounting firms out there. However, given the current business and regulatory environment, we believe that the traditional model makes it more challenging to deliver leading edge services in both accounting and tax, especially if tax is a supporting service and not a leading service. Graphically depicted, we believe that a traditional accounting firm with a tax department is structured like this:

We believe our unique multi-disciplinary and cross-border practice is a proactive approach to tax advisory services that can offer our clients the following benefits:

• Specialist level knowledge on a very complex subject matter;
• Arrange solicitor client privilege if desired or deemed necessary;
• Capability to both develop and implement bespoke tax plans in-house;
• Ability to assist accounting firms and law firms with tax matters for their clients; and
• Fewer conflicts of interest due to the fact we do not offer audit or accounting services and are focused solely on tax advisory.

Our model enables us to work with our law firm partner to deliver tax advisory services in the model depicted below. We believe that this model is logical, efficient and provides greater value when delivering tax advisory services.

Our research has shown that our tax advisory model is common in Europe, but not in North America due to a variety of reasons including industry regulations. We believe that ultimately our role is to provide specialized, proactive advice that complements your existing advisor, not to compete with them.

Will your professional advisory fees be less as a result of our involvement? In many cases the answer will be “no”. However, if your goal is to reduce your total costs and obtain greater overall value, we believe our firm’s value proposition makes the answer to the question “yes, your overall costs will be less”.

When we explained our tax advisory model to the prospect and the client, they both understood and trusted us to deliver on our value proposition. We believe that our model is the wave of the future and more “stand alone” professional service firms will be created to fill client needs and complement existing advisors.
 

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This blog was authored by Kristina Ash JD (US), LL.M. (US Tax)

The US Government has required its citizens to report on their foreign bank accounts since 1970; however, its controversial revisions of October 2008 continue to cause tax practitioners, citizens and persons doing business in the US headaches.  We expect the US Government to aggressively enforce these reporting requirements since they assist the US Government in identifying abusive offshore accounts such as the UBS accounts (discussed in our blogs on September 8, 2009 and February 10, 2010).

The foreign bank account reporting requirements are promulgated under the Bank Secrecy Act,1 not the Internal Revenue Code (“IRC”).  If a US person has a financial interest in or signature authority over financial accounts in a foreign country where the aggregate value exceeds $10,000, that US person is required to file a Report of Foreign Bank and Financial Accounts (“FBAR,” Form TD F 90-22.1) on or before June 30 of the succeeding year.  The potential penalty for an inadvertent failure to file is $10,000; a wilful failure could cost as much as $100,000.  In the 2000 version of the FBAR form, the term “United States person” was defined in manner similar to that in the IRC:

United States Person. The term "United States person" means (1) a citizen or resident of the United States, (2) a domestic partnership, (3) a domestic corporation, or (4) a domestic estate or trust.2

In October of 2008, the IRS released a revised FBAR form and accompanying instructions. In the 2008 version, the definition of US persons was expanded to include foreign persons who were doing business in the US.  For example, under that definition, a Canadian salesperson from Calgary who goes to Texas once a month to, say, sell oil pumps, would probably be required to report each of his/her personal Canadian bank accounts to the US government.  This revised definition caused panic for some Canadians.

On June 5, 2009, the IRS admitted that it “received a number of questions and comments from the public concerning the new filing requirement.”3 It temporarily suspended reporting requirements for those persons who were not US citizens, residents, or domestic entities for the FBARs due on June 30, 2009, and directed the public to rely on the prior (2000) FBAR definition of a US person.  Now, the Canadian salesperson in the previous example had a reprieve from the FBAR reporting, but only for the 2008 reporting year.

On February 28, 2010, the IRS published two documents that attempted to further clarify the confusion over its 2008 FBAR form.  First, in IRS Announcement 2010-16 (Feb. 28, 2010), it continued its suspension of a filing requirement for non-US citizens, residents or entities, and expanded the suspension to FBARs which would otherwise have been required to be filed for the 2009 and earlier years.  Second, the IRS published IRS Notice 2010-23(Feb. 28, 2010) that changed its rules for some filers with signatory authority and some people with foreign hedge funds or private equity funds.  The Notice temporarily suspended reporting requirements for persons who have signature authority over, but no financial interest in, foreign accounts until June 30, 2011. Note that the temporary suspension for the signature authority only covers those persons who do not have any other interest in foreign accounts. The Notice also provided relief for persons with an interest in or signature authority over foreign hedge funds or private equity funds.  Relief was not extended to persons with interests in foreign mutual funds.

The end result of this additional IRS guidance issued in 2010 is that foreign persons who are not US citizens residents or domestic entities are generally not required to file an FBAR form.  This is generally great news for Canadians!  Additionally, US persons with interests in foreign hedge funds or foreign private equity funds are not required to report such interests to the US Government.  US persons who hold separate interests, joint interests or signature authority over foreign financial accounts (so long as that is not their only foreign account) are still required to deliver Form TD F 90-22.1 to the US Treasury by June 30, 2010.  To determine whether you have a reporting requirement under FBAR, feel free to contact our US tax group.

1 31 USC §§5311–5331.
2 IRS Announcement 2010-16 (Feb. 28, 2010) (quoting the July 2000 version of the FBAR instructions).
3 IRS Announcement 2009-51 (June 5, 2009).

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This blog is co-authored with Faizal Valli and Paul R. LeBreux (of Global Tax Law Corporation, Counsel to Moodys LLP)

On March 4, 2010, Federal Finance Minister Jim Flaherty released the 2010 Federal Budget (the "Budget"). The Budget contained a significant amount of tax material in comparison to recent budgets. Find below the relevant tax measures that are worthy of discussion.

PERSONAL TAX MEASURES

A. Stock Options

i. Elimination of Employer Deductions in Certain Cases

The use of stock options in employee remuneration has been common over the recent years. In some situations, the realization of a stock option benefit by an employee can result in tax preferential treatment given that the employee may be eligible for a 50% stock option deduction against the resulting stock option benefit. In some cases, the employee may actually dispose of the "rights" under the stock option agreement in exchange for cash paid by the employer. The result of such a disposition of rights for a cash settlement by the employer is that the employee may realize a preferential tax benefit (i.e. a stock option benefit less a 50% deduction) and the employer may deduct such payment in the computation of its income.

The Budget proposes to prevent both the stock option deduction for the employee and the expense deduction by the employer from being claimed from the same employment benefit. Accordingly, the stock option deduction will generally be available to the employees who dispose of stock option rights only in situations where the employer makes an election to forgo the deduction for the cash payment. These measures apply to dispositions of stock options after 4:00 p.m. EST March 4, 2010.

ii. Elimination of the Stock Option Deferral

In the early 2000s, the Federal Government introduced complex rules to enable employees of publicly traded companies to make an election to defer the recognition of their stock options benefits. The election was generally available for benefits in respect of up to $100,000 of employee qualifying stock options vesting in a particular year. The rules were tremendously complex but generally very useful in many cases.

The Budget proposes to repeal the tax deferral election legislation with respect to employee stock options exercised after 4 p.m. on March 4, 2010. Existing deferrals appear to be not affected by the Budget proposals. Also, deferrals for stock options exercised by employees of Canadian controlled private corporations are unaffected.

iii. Significant Relief for Under-Water Stock Options

The 2010 Budget introduced a relieving measure for "under-water" stock option shares. The proposed relief may apply to individuals who have disposed of stock option shares and previously deferred the stock option deduction over the last 10 years, by way of the "Fairness Provisions" in the Income Tax Act ("the Act").

Generally, this election may be beneficial if the tax otherwise payable on the stock option benefit is greater than the proceeds received on the sale of "under-water" shares.

a. Background and Example

Many individuals previously exercised their stock options when share prices were high. However, as a result of subsequent economic factors, the fair market value of such shares may be significantly lower than when the stock options were exercised. Such shares are commonly referred to as under-water stock option shares. In some cases, if the stock option benefit was deferred, individuals are faced with a future tax liability on the stock option benefit that is greater than the fair market value ("FMV") of their shares.

In order to understand the proposed relief provided in the 2010 Budget, consider the following example. Suppose Bill (an Alberta resident taxpayer) exercised a stock option in 2006 to purchase shares of Bill's employer, Pubco, a Canadian public corporation. Bill paid an aggregate exercise price of $20,000 for Pubco shares, which had an aggregate FMV at that time of $100,000. As a result, Bill realized a stock option benefit of $80,000 on the exercise.

Under current legislation, Bill could likely elect to defer the recognition of such stock option benefit until the year in which he disposed of his Pubco shares (pursuant to current subsection 7(8) of the Act, up to an annual limit of $100,000 of "strike price" on such stock options vesting in a particular year). In our example, Bill chose to make an election to defer the $80,000 stock option benefit.

Suppose further that in 2010, Bill's Pubco shares had a FMV of only $10,000, and were expected to decrease further in the future. Accordingly, Bill decided to sell his Pubco shares in 2010 for proceeds of $10,000. Under current legislation, the following would result:

1. Bill would realize the stock option benefit of $80,000 (that was previously deferred), and would receive a 1/2 deduction under paragraph 110(1)(d) of the Act, resulting in taxable income of $40,000, and taxes payable of $15,600.

2. Bill would realize a capital loss of $90,000 (Bill's ACB being $100,000 of FMV at time of exercise, less proceeds of $10,000).

As you can see, Bill would receive proceeds of $10,000 on the sale of shares, but would be faced with a $15,600 tax liability. In addition, Bill would have a capital loss of $90,000 which may be carried back three years or carried forward indefinitely against capital gains realized. To be further clear, the $90,000 capital loss would not be deductible against the $80,000 employment benefit.

b. Proposed Relief

To mend the above situation, the 2010 Budget has proposed that in the year in which a taxpayer is required to include the stock option benefit (as a result of disposing their under-water shares), such taxpayer may elect to pay a "special tax" equal to the taxpayer's proceeds of disposition from the sale of such under-water shares. Where such an election is made, the Budget proposes that:

1. The taxpayer will be able to fully offset the stock option benefit, and

2. The taxpayer must include a capital gain equal to the lesser of:

a. the stock option benefit, and

b. the capital loss realized on the disposition of the under-water shares.

In the example above, the proposed relief would apply as follows: Bill could elect to pay a special tax equal to the proceeds of disposition on his Pubco shares, or $10,000. If Bill made such election, the following would apply:

1. Bill would be able to claim a deduction to fully offset his stock option benefit of $80,000, and

2. Bill would have to report a capital gain equal to the lesser of:

a. Bill's stock option benefit of $80,000, and

b. the capital loss of $90,000.

Therefore, Bill would have to report a capital gain of $80,000. This would reduce his capital loss to $10,000 from $90,000.

c. A Twist

The economic impact would be slightly different if Bill realized capital gains in 2010 of $20,000 in the rest of his investment portfolio. Based on the above example, if Bill elected to pay the special tax of $10,000, the following would apply:

1. Bill could still claim a deduction to fully offset his $80,000 stock option benefit,

2. Bill would have to report a capital gain of $80,000 based on the above example.

As a result, Bill's total 2010 capital gain would be $100,000, and his capital loss on the under-water shares would be $90,000, resulting in a capital gain of $10,000 (or taxable capital gain of $5,000).

d. Application of Proposed Relief

As mentioned earlier, the proposed relief may apply to individuals who disposed of their under-water shares (and had previously deferred their stock option benefit) in the last 10 years, based on the "Fairness Provisions" in subsection 152(4.2) of the Act. This might provide HUGE relief to taxpayers who were affected by the inability to offset the capital loss against the stock option benefit within the last 10 years if they had previously deferred the stock option benefit. Individuals who have not yet disposed of their under-water shares and wish to have the proposed relief apply must do so before 2015.

e. Summary

As alluded to above, the special election will only be economically beneficial if the tax liability on the stock option benefit is greater than the proceeds received on the under-water shares.

iv. Changes to Withholding Remittance Requirements

Current law provides rules that require employers to remit source withholdings to the Government in respect of employment benefits. The Budget intends to clarify the existing law to ensure that an amount in respect of tax on the value of the stock option benefit is required to be remitted to the Government by the employer. As stated in the Budget, this proposal is intended to prevent situations in which an employee is unable to meet their tax obligation as a result of a decrease in the value of their shares.

B. US Social Security Benefits

US social security benefits received by Canadian residents are currently taxed at an 85% inclusion rate. However, prior to 1996, the Canada-US tax treaty only required a 50% income inclusion as opposed to 85%. The Budget proposes to reinstate the 50% income inclusion for Canadian residents who have been in receipt of US social security benefits since before January 1, 1996 and for their spouses and common-law partners who are eligible to receive survivor benefits. This measure will apply to US social security benefits received on or after January 1, 2010.

C. Roll-over of RRSP Proceeds to a Registered Reitrement Disability Plan ("RDSP")

RDSPs were introduced in the 2007 Federal Budget to assist parents and caregivers for the long term financial security of a child with a severe disability. The Budget proposes to extend the existing RRSP roll-over rules (which apply upon the death of a person where such RRSP proceeds are transferrable to a surviving spouse, financially dependant child and/or a mentally infirm child) to RDSPs. The roll-over rules to RDSPs will apply for deaths that occur on or after March 4, 2010 but will be subject to the beneficiaries' existing RDSP room. However, there are certain transitional rules that were announced in the Budget where the death of an RRSP annuitant occurs after 2007 and before 2011.

D. Medical Expense Tax Credit

The Budget proposes to disallow as a medical expense tax credit any expenses that were incurred for purely cosmetic procedures aimed at enhancing ones appearance (such a lipo-suction, hair replacement procedures, Botox injections, and teeth whitening). Cosmetic procedures that are required for medical or reconstruction purposes such as surgery to correct a deformity arising from, or directly related to a congenital abnormality, a personal injury resulting from an accident or trauma, or a disfiguring disease will continue to qualify for medical tax expense credits. Such measure will apply for expenses incurred after March 4, 2010.

BUSINESS INCOME TAX MEASURES

A. Loss Trading

Recent media articles have highlighted the Department of Finance's interest in publicly traded income trusts or publicly traded partnerships ("SIFTs") that use certain tax strategies to acquire "Losscos" as a result of the looming requirement for SIFTs to convert to a corporation. The Budget intends to amend the acquisition of control rules in the Act to ensure that such rules will impose restrictions on the use of losses of "Losscos" in situations where units of a SIFT are exchanged for shares of a corporation. Proposed legislative amendments were not included with the Budget documents and therefore the "devil is in the details" but, in reviewing the Budget Documents, it would appear that most "Lossco" type deals involving SIFTs are essentially dead.

B. Section 116 Amendments

Section 116 of the Act requires purchasers of "Taxable Canadian Property" ("TCP") acquired from non-residents of Canada to withhold a portion of the purchase price and remit it to the Government unless the non-resident obtains a "clearance certificate" from the Canada Revenue Agency ("CRA"). However, in order to obtain a clearance certificate the non-resident vendor must remit an amount or post security, or satisfy the CRA that no tax will be owing. The Budget is proposing new rules to amend the definition of TCP so as to exclude certain shares of private corporations and other interests that do not derive their value principally from real property situated in Canada, Canadian resource property, or timber resource property. This measure will eliminate section 116 compliance obligations for these types of properties. The measure is HUGE and somewhat surprising. If a non-resident disposes of, say, shares of a Canadian private corporation (whose value is not principally derived from real property in Canada, Canadian resource property or timber resource property) then such non-resident will not be subject to the section 116 requirements to apply for a clearance certificate (or remit funds, post security etc...) or file a Canadian income tax return.

This is certainly welcome news for the investment community which may be encouraged to invest in Canada as a result of the reduced administrative burden. On the other hand, one could query the tax policy behind this measure since the CRA will now have no advance notice of dispositions where it could disagree with the non-resident's assertion that the property was not TCP. Interesting.

C. NRT and FIE Proposals (this section written by Paul R. LeBreux of Global Tax Law Corporation, a well-recognized international tax expert)

It is hard to believe that it has been 11 years since the proposed changes to overhaul the taxation of non-resident trusts (NRTs) and foreign investment entities (FIEs) were first introduced in the 1999 Federal Budget. Since the first draft of the legislation was released June 22, 2000, the implementation date of the legislation and its retroactive effective date have been delayed and amended numerous times. The last 11 years have seen new drafts of the proposals released, each time with substantial amendments, no less than six times. Most recently, proposals for amendments were tabled during the second session of the 39th Parliament, however these proposals were not enacted before Parliament was dissolved in September 2008. Budget 2009 stated that the Government would review the outstanding proposals before proceeding with measures in this area and today, the Budget reintroduces this controversial initiative, with some not so minor amendments designed to "simplify" these complex provisions.

Some of the more interesting revised proposals which will address certain concerns and challenges and also provide a degree of simplification are:

• Entities exempt from tax under section 149 of the Act (for example, pension funds and registered charities) will be granted an exemption from resident-contributor and resident-beneficiary status.
• Investments in bona fide commercial trusts will not be caught by the new NRT rules.
• A commercial trust will not be caught by the deemed residence rules if it satisfies certain criteria, including that the trust not be a discretionary or personal trust and that each beneficiary be entitled to both the income and capital of the trust.
• Loans by a Canadian financial institution to a non-resident trust will not cause the financial institution to be a resident contributor to the trust provided the loan is made in the ordinary course of business.
• Resident contributors to a trust that is deemed resident under these rules will no longer be jointly and severally liable for the trust's income tax obligations, but would only be liable for their proportionate share of the trust's income.

However, the Budget will also propose substantial modifications that effectively introduce a whole new level of complexity to the NRT legislation. The Budget proposes to modify the taxation of a deemed Canadian resident trust by dividing the trust's property into "resident" and "non-resident" portions. The resident portion will consist of property acquired by the trust through contributions from residents and certain former residents (and property substituted for such property). The non-resident portion will consist of all other property contributed to the trust. It is proposed that income earned on the non-resident portion will be excluded from Canadian taxation as long as it is not from sources in Canada on which non-residents would normally be required to pay tax.

New ordering rules would be introduced for distributions to trust beneficiaries. For example, distributions to Canadian resident beneficiaries will be deemed to be made first out of the resident portion of the trust's income, while distributions to non-resident beneficiaries will be deemed made first out of the non-resident portion of the trust. Distributions to non-resident beneficiaries out of the non-resident portion of the trust will not be subject to Canadian withholding tax, whereas a distribution to a non-resident beneficiary out of the resident portion of the trust will be subject to withholding tax.

It is further proposed that, when income of the trust is not distributed to beneficiaries, the amount of the accumulated income will automatically be deemed to be a contribution by the trust's connected contributors and will form part of the resident portion for the next taxation year, unless the said accumulated income is kept separate and apart from all the property forming the resident portion.

Some other interesting proposals regarding NRTs:

• The reassessment period for income in respect of trusts subject to these rules will be extended by three years.
• The Tax Conventions Interpretation Act will be amended to clarify that a trust that is deemed to be resident in Canada under these rules is a resident of Canada and subject to Canadian tax for treaty purposes.
• The measures regarding non-resident trusts will apply retroactively to the 2007 and later taxation years, except for the attribution of trust income to resident contributors, which applies only to taxation years ending after March 4, 2010.

The proposals effecting FIEs were minor in comparison to that for NRTs. The Budget amends the FIE rules as follows:

• The prescribed interest rate applicable in computing the income inclusion for an interest in an offshore investment fund property is increased to the three-month average Treasury Bill rate plus two percentage points.
• Existing rules will be broadened to require beneficiaries of certain non-resident trusts to report income on a modified foreign accrual property income basis so that these rules apply to any resident beneficiary who, together with non-arm's-length persons, holds 10 percent or more of the fair market value of any class of interests in a non-resident trust.
• The reassessment period will be extended by three years for interests in offshore investment fund properties, and require more detailed reporting will be required in respect of "specified foreign property".
• The measures regarding FIEs will apply for taxation years that end after March 4, 2010.

OTHER TAX MEASURES

A. Information Reporting of Tax Avoidance Transactions

Similar to our blog on Quebec's take on tax avoidance of October 21, 2009 and also recent US proposals that we blogged about on February 10, 2010, the Budget proposes a requirement to report certain tax avoidance transactions. Legislative proposals were not released but a promise was made to release details on the proposals at an early opportunity. The Government also announced a consultation process with stakeholders will take place with the view to improving the "fairness of the Canadian tax system". The Budget did, however, announce that a "reportable transaction" would be an avoidance transaction, as currently defined in the Act, which is entered into by or for the benefit of the taxpayer that bears at least two of the following three "hallmarks":

1. A promoter or tax advisor in respect of the transaction is entitled to fees that are to any extent attributable to the amount of the tax benefit from the transaction, contingent upon the obtaining of a tax benefit from the transaction, or attributable to the number of taxpayers who participate in the transaction or who have been provided access to advice given by the promoter or advisor regarding the tax consequences from the transaction,
2. A promoter or tax advisor in respect of the transaction requires "confidential protection" about the transaction, or
3. The taxpayer or the person who entered into the transaction for the benefit of the taxpayer obtains "contractual protection" in respect of the transaction (otherwise than as a result of a fee as described in the first hallmark).

A transaction that is a tax shelter or flow-through share arrangement will not be impacted by these proposals.

Upon discovery of a reportable transaction that has not been reported when required, the CRA could deny the tax benefit resulting from the transaction. If the taxpayer still wanted to claim the tax benefit, it would be required to file with the CRA any required information and to pay a penalty (quantum unknown as at this time).

These are certainly interesting times, and these proposals are another example of the ongoing push around the world towards financial transparency. One will have to wait and see what form of penalty will be arising from such proposals and what the ultimate legislation looks like. As we mused about in our February 10, 2010 blog, we are of mixed mind with respect to such proposals. On the one hand, one can certainly see the tax policy benefits from this. However, how far will the Government go in order to seek transparency of tax transactions? Will solicitor-client privilege be of any future benefit in tax transactions? (Certainly today solicitor-client privilege is generally of great value.) Will such proposals ultimately discourage tax professionals entering into the practice of tax? The musings will continue but hopefully such issues will be discussed in the public consultation process to find an appropriate balance.

B. Taxation of Corporate Groups

The Government announced in its Budget documents that it has heard concerns from the business community and from the provinces regarding the utilization of tax losses within corporate groups. The Government announced that it will explore whether new rules for the taxation of corporate groups - such as the introduction of a formal system of loss transfers or consolidated reporting-could improve the functioning of the tax system. This is certainly welcome and may eliminate certain tax risks (such as section 67 reasonableness issues) that currently exist.

C. Previously Announced Tax Measures

The Budget documents announced that the Federal Government intends to proceed with previously announced tax measures such as amending GST legislation on Financial Services and to introduce various tax technical amendments (such as the previously announced restrictive covenant rules).

D. Repeal of Charitable Expenditure Rule

Charities are subject to a charitable expenditure rule which generally requires the charity to spend 80% of the previous year's tax receipted donations plus other amounts relating to enduring property and transfers between charities and 3.5% of all assets not currently used in charitable programs or administration if such assets exceed $25,000 ("capital accumulation rule"). The charitable expenditure rule has been the subject of much debate over the years and the Federal Government acknowledges in its Budget documents that some stakeholders have called for the elimination of the disbursement quota because it imposes an unduly complex and costly administrative burden on charities particularly small and rural charities.

Accordingly, the Budget proposes to repeal the charitable expenditure rule for fiscal years that end on or after March 4, 2010. This, to us, is a bit of a surprise but certainly welcome.

The proposal to reform the disbursement quota comes with two additions. The first is that the current exception from the capital accumulation rule for charities having $25,000 or less in assets is to be increased to $100,000 for charitable organizations. In addition, the Budget proposes to extend existing anti-avoidance rules for charities to situations where it can reasonably be considered that a purpose of a transaction was to delay unduly or avoid the application of the disbursement quota.

SUMMARY

As stated earlier, this is certainly a deep budget as compared to prior years with respect to tax measures. Moodys LLP Tax Advisors will keep you up to-date on the progress of these measures.

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