Tax and Estate Planning Blog : Moodys LLP and SNC Law

On March 22, 2011, Finance Minister Jim Flaherty, introduced the 2011 Federal Budget. The Budget contains a few “goodies” but will be remembered more for the anti-avoidance provisions that it contains. The more interesting and relevant (for our clients and friends) income tax measures that were introduced in the Budget were as follows:

No Tax Rate Changes

The Budget does not propose any tax rate changes for individuals or corporations.

New “Kiddie Tax” for Capital Gains

The Federal Budget proposes to introduce a new “Kiddie Tax” for capital gains realized by, or included in the income of, a minor from a disposition of shares of a corporation to a person who does not deal at arm’s length with a minor, if taxable dividends on such shares would have been subject to the “Kiddie Tax”.   Capital gains that are subject to this measure will be treated as non-eligible dividends and, therefore, will not benefit from capital gains inclusion rates and will not qualify for the lifetime capital gains deduction.

This proposal appears to target certain transactions which would attempt to create capital gains by entering into a series of complex transactions with private corporation shares and having such capital gains taxed in a minor’s hands. The first version of the “Kiddie Tax” rules, first introduced in year 2000, were not applicable to capital gains realized by a minor individual. The CRA had been attacking such strategies and transactions using the general anti-avoidance rule (“GAAR”) but now will have the legislative authority to deny the usefulness of such a strategy. 

This new measure will apply to capital gains realized on or after March 22, 2011. 

Elimination of the Deferral of Corporate Tax by the Use of Partnerships

For those classic rock lovers (or perhaps better described as 1980s music lovers), you might recall a classic line in a Prince song “…we’re gonna to party like it’s 1999…” Well, tax advisors and their clients will have to substitute the words “party” for “cry” and “1999” for “1995”. This is because these new proposals, described below, smell an awful lot like the rules introduced in 1995 (under sections 34.1 and 34.2) which eliminated deferrals for individual proprietors/partners and professional corporations.

Presently, the income tax rules enable two or more corporations to enter into a partnership relationship and have a significant deferral of corporate income tax to the extent that a business is carried on through the partnership. Corporate partners are only required to include its proportionate share of partnership income in its taxable income for completed fiscal periods of the underlying partnership. For example, assume that two corporations have December 31, 2010 as its most recent normal taxation year end. Let us further assume that the two corporations are partners in a partnership relationship and the underlying partnership has a January 1 taxation year end. The two corporations would report in their December 31, 2010 tax return their share of partnership earnings for the completed taxation year of the partnership that ended during its December 31, 2010 year end. This, in our example, would be the completed partnership taxation year of January 1, 2010 thereby, in substance, enabling a deferral of income tax for one year of the partnership profits.

The Budget papers state “the deferral of tax, whether intentional or not, when income is earned through a partnership, is inequitable. It also creates an incentive to use business structures that have little purpose other than tax deferral which is not economically productive”.

Accordingly, the 2011 Federal Budget “proposes to limit the deferral of tax by a corporation that has a significant interest in a partnership having a fiscal period different from the corporation’s taxation year. In computing the corporation’s income for a taxation year, in respect of a fiscal period of the partnership that begins in the taxation year and ends in a subsequent year, the corporation will be required to accrue income from the partnership for the portion of the partnership’s fiscal period that falls within the corporations’ taxation year (“Stub Period”)”.

This new measure will apply to a corporate partner (other than a professional corporation) for a taxation year if:

• the corporate partner is a member of a partnership at the end of the taxation year;
• the partnership’s last fiscal period that began in the taxation year ends in a subsequent taxation year of the corporate partner; and
• the corporate partner, together with affiliated and related parties, was entitled to more than 10 percent of the partnership’s income (or assets in the case of wind-up) at the end of the last fiscal period of the partnership that ended in the taxation year.

As mentioned, the government introduced similar rules for individuals in 1995. It appears these new proposals piggyback on much of the 1995 legislation in the way that it will require corporate partners to accrue their Stub Period income.  

In general, the corporate partner will be required to calculate their income as follows:

1. Add the corporate partner’s share of the income or loss of the partnership from the fiscal period that ends in the year;
2. Add the accrued income, if any for the Stub Period (“Adjusted Stub Period Accrual”); and
3. Subtract the Adjusted Stub Period Accrual, if any, for the corporate partner’s previous taxation year.

To calculate the Stub Period Accrual, one can choose to use the “Formulaic Approach” (which, in general terms extrapolates the Stub Period income using the current year partnership income inclusion) or the “Designation Approach” which enables corporate partners to designate a Stub Period Accrual that is lower than the calculated amount under the Formulaic Approach. However, if the Designated Amount turns out to be less than the actual pro-rata income then the corporate partner will be subject to an additional income inclusion in the following year. The additional income inclusion will be equal to the amount of the shortfall multiplied by the average prescribed rate for underpayment of tax for the period. In addition, if the shortfall is larger than 25% of the lesser of the pro-rated actual amount and the amount determined under the Formulaic Approach, there will be an income inclusion equal to 50% of the amount in excess of the 25% threshold.

These new proposals also contain measures which will enable partnerships to change their fiscal periods to align with the taxation year of one or more corporate partners. A one-time election, which the Budget papers call a “Single-tier Alignment Election”, will be provided that will enable a partnership to change its fiscal period on the following conditions:

• The last day of the new fiscal period must be after March 22, 2011 and no later than the latest day that is the last day of the first taxation year that ends after March 22, 2011 of a corporate partner that has been a member of the partnership continuously since before March 22, 2011;
• The election must be in writing and filed with the Minister of National Revenue on behalf of the partnership on or before the earliest of all filing-due dates for the return of income of any corporate partner for the taxation year in which the new fiscal period ends;
• At least one of the corporate partners would, in the absence of the election, have an Adjusted Stub Period Accrual greater than nil in its first taxation year ending after March 22, 2011; and
•  All members of the partnership are corporations other than professional corporations.

The Budget documents also acknowledge that these measures could result in significant taxable income for a corporate partner’s first taxation year that ends after March 22, 2011. Accordingly, the Budget proposes transitional relief to recognize the incremental amount gradually over the five taxation years that follow that first taxation year.

The amount upon which a transitional reserve may be claimed is referred to as “Qualifying Transitional Income” (QTI). This reserve will be computed on a partnership-by-partnership basis if a corporate partner is a member of two of more partnerships. A corporate partner will generally be eligible for transitional relief in respect of its QTI from a partnership in accordance with the following schedule.

Corporate partner’s first taxation year1] that ends after Budget Day and in the calendar year

Like other reserves, the amount of a QTI reserve deducted in a taxation year will be included in income in the following taxation year.

The QTI of a corporate partner in respect of a partnership will be the sum of its Adjusted Stub Period Accrual and its Alignment Income in respect of that partnership. If the sum is negative, the QTI is zero.

To try to put this in a bit of plain English, let’s look at the following example:

2011 Budget – Elimination of Partnership Income Deferral

Assumptions:

1. Corporation C has a December 30 fiscal year end and is a member of Partnership P.
2. Partnership P has a December 31 fiscal year end.
3. Under current rules, Corporation C would include in its December 30, 2011 taxation year the income from Partnership P’s December 31, 2010 fiscal period.
4. Assume Partnership P had income of $100,000 in 2010 and has the same amount of income in each of 2011 to 2016

Corporation C’s calculation of Income from Partnership P using the “Formulaic Approach”

There are other specific proposals, beyond the scope of this summary, that restrict the ability to claim a reserve and other proposals for multi-tiered partnerships.

These proposals will result in significant work for corporate partners to comply with. Start planning now.

Employee Profit Sharing Plan Trusts (“EPSP”)

EPSPs are often used for income splitting and for CPP and EI avoidance. Our firm has written on this many times and commented on this type of “Planning” and the risks therein. Obviously, the government is also concerned.  The Budget documents announce they will review the existing rules for EPSPs to determine whether technical improvements are required in order to prevent inappropriate income splitting with family members or avoid CPP or EI payments. However, the government will undertake consultations to seek the view of stakeholders before any amendments are enacted.

Children’s Arts Tax Credit

The Federal Budget proposes to introduce a Children’s Arts Tax Credit which will enable parents to claim a 15% non-refundable tax credit based on an amount of up to $500 in eligible expenses per child under the age of 16, paid in the year.

An eligible expense will be a fee paid in the taxation year to a qualifying entity to the extent that the fee is for the registration or membership of a child in an eligible program of artistic, cultural, recreational or developmental activities. It appears that this tax credit will very much be based on the parameters of the children’s fitness tax credit which was introduced in the 2007 Federal Budget. 

Hmmm…I wonder if the cost of my kid’s new tattoo will qualify for this new credit? Just kidding…

Family Caregiver Tax Credit

The Federal Budget proposes to introduce a Family Caregiver Tax Credit of 15% on an amount of $2,000 and will apply beginning in 2012. Caregivers of dependants with a mental or physical infirmity, including spouses, common-law partners and minor children will appear to benefit by claiming an enhanced amount for an infirm dependent under one of the existing dependency-related credits.

Donation of Flow-through Shares

Existing law enables an individual to acquire a flow-through share and donate such share to a charity with very little after-tax cost. The reason for this is that the individual acquirer of the flow-through share is often entitled to claim the renounced expenditures flowed through to the investor and also benefits from a zero capital gains inclusion rate (to the extent that the share is a listed security) if it is directly donated to a charity. In addition, the donor receives a charitable receipt/donation for the fair market value of the donated share. (Recall that the adjusted cost base of a flow-through share is nil and therefore any donation or sale of the flow-through share would normally result in a capital gain but for the tax rule that deems the capital gain to zero if the “listed security” is directly donated to charity).

The Federal Budget recognizes the significant tax benefits to individual donors to the extent that flow-through shares are donated to charity and appears to want to reduce the amount of the tax benefit on such a plan. Proposed rules will now not enable a zero capital gains inclusion rate for the capital gain up to the original cost of the flow-through share and will therefore result in a capital gain to the original cost.

RRSP Amendments

The Budget proposes to introduce rules that would significantly change the types of investments that RRSPs may hold without penalty. In addition, the Budget proposes to introduce anti-avoidance rules that would significantly restrict “RRSP strips”. These proposals are well beyond the scope of this summary but our firm would be pleased to discuss this with you in more detail.

Charitable Sector Amendments

There are numerous proposed amendments in the Budget that will tighten the receipting, regulatory and governance matters for charities that are beyond the scope of this summary.

Previously Announced Measures

The Budget confirmed their commitment to move forward with previously announced income tax proposals (such as the non-resident trust rules, the restrictive covenant rules and the March 16, 2011 proposals).

Other Miscellaneous Tax Measures

Other smaller proposed tax measures include correcting inefficiencies with the existing child tax credit, expanding medical expense tax credits for other dependants, proposed amendments to the tuition tax credit to recognize fees paid to take an examination that is required to obtain a professional status and further proposed amendments to the tuition tax credit to loosen the eligibility for the tuition tax credit for studies outside of Canada. In addition there are proposed amendments for RESPs to enable transfers between RESPs for siblings without tax penalties and without triggering the repayment of certain grants, certain amendments to the RDSP rules and proposed changes to the individual pension plan (IPP) rules.

Of course, given the existing uncertain political environment, it is questionable whether the March 22, 2011 Federal Budget will ever get voted on. Will we instead see a new budget introduced by a new government? Time will tell. In the meantime, the professionals at Moodys LLP Tax Advisors would be pleased to discuss the Federal Budget measures with you.

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 On March 16, 2011, the Department of Finance released draft income tax legislation for comment. The Department of Finance is looking for comments from the public by April 15, 2011. 

One of the proposals introduces new section 143.4 of the Act. This new section is in direct response to a Federal Court of Appeal decision – Collins v. The Queen, 2010 FCA 12 that we blogged about on our February 2, 2010 blog.  The Federal Court of Appeal, reversing an earlier decision by the Tax Court of Canada, enabled two taxpayers to deduct accrued but unpaid interest expense even though they had an existing right to satisfy their interest obligations by electing to pay a substantially lower amount of interest.   Our firm’s view was that the decision of the Federal Court of Appeal was the correct decision. However, the government obviously has a different point of view. In its explanatory notes to the release of the draft legislation, the Department of Finance stated the following:

“In response, and in general terms, the Government proposes to clarify through amendments to the ITA that the amount of a taxpayer’s unpaid expenditure otherwise deductible for income tax purposes does not include an amount in respect of which the taxpayer, or a person that does not deal at arm’s length with the taxpayer, has a right to reduce or eliminate.  For greater certainty, this treatment will also apply where the right is contingent upon the happening of another event, or in any other way, if it is reasonable to conclude having regard to all the circumstances that the right will become exercisable.  In the Collins case, this would mean that the interest payable under the original obligation in excess of the lower amount that the taxpayer could elect to pay would not be deductible for income tax purposes unless and until it was actually paid.

This proposal is to apply in computing income for taxation years that end on or after Announcement Date”

 Proposed section 143.4 consists of seven new proposed subsections. In general, as the above quote indicates, a taxpayer will be restricted by the amount that they are able to deduct for an expenditure (or capitalize to an asset) for amounts that the taxpayer has a “right to reduce.” To the extent that the taxpayer ultimately pays the “right to reduce” amount, the taxpayer will be able to deduct the payment at that time. The new proposals also contain provisions that would require an income inclusion to the extent that a “right to reduce” an expenditure (that was previously deducted for in a previous taxation year) now exists and the new proposals would have applied to reduce the expenditure to the extent that the law had been in place. 

These income tax proposals are controversial. From many practitioners point of view, the decision in Collins was the correct one. However, as earlier stated, the government obviously has a different point of view and wishes to “protect Canada’s tax base.” 

To the extent that these provisions are passed into law, the new proposals are intended to apply in respect of taxation years ending on or after March 16, 2011. Accordingly, friends and clients of our firm will need to ensure that, when calculating taxable income and/or computing appropriate amounts that are capitalized, they will need to review for “rights to reduce” amounts in order to carefully apply new proposed section 143.4.

For example, some of the various expenditures or arrangements that will need to be carefully looked at will be:

1.    Lease Agreements – do the agreements contain contractual provisions that offer the lessor certain options to reduce the cost?

2.    Debt Arrangements – similar to Collins, are there contractual arrangements that enable the debt holder to reduce their future carrying costs?

3.    Earn-outs – many business acquisitions are arranged in such a way that future profits (or other amounts thereof) are paid to the vendor into the future. Will these new proposals affect such arrangements? Perhaps. A close review of the business deal and the new proposals will need to be carried out,

The tax professionals at Moodys would be pleased to discuss these proposals with you.

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As discussed in our February 9, 2011 blog, the IRS announced, on February 8, 2011, the creation of a second voluntary disclosure program for taxpayers with unreported foreign assets (OVDI). In announcing the 2011 OVDI, IRS Commissioner Douglas H. Shulman stated “The situation will just get worse in the months ahead for those hiding assets and income offshore. The new disclosure program is the last, best chance for people to get back into the system.” In 2009, the IRS offered a similar program which resulted in approximately 15,000 disclosures prior to the October 15, 2009 deadline and approximately 3,000 between then and the start of this new program. 

The following is a general description of the 2011 OVDI Rules:

Years Applicable – In order to participate in the new program, taxpayers are required to resolve any non-compliance within the eight year period from 2003-2010.

Penalties – The 2011 OVDI requires taxpayers to pay the following: (1) income tax deficiencies during the eight year period, (2) interest on the deficiencies, (3) a 25% penalty on the highest aggregate balance held within the foreign accounts during the eight year period, and (4) accuracy related penalties of 20% of the back taxes, and if applicable, 25% of back taxes for failure to timely file a return or pay tax shown on a filed return.   In addition, for smaller offshore holdings of not more than $75,000 at any time from 2003 to 2010 the penalty will be reduced to 12.5%. The rate could also be reduced to 5% if the taxpayer did not know they were U.S. citizens or if the account was inherited. 

Deadline – The 2011 OVDI terminates on August 31, 2011 and taxpayers will have to submit all of the appropriate returns to the IRS by that date. 

Benefits – Participants in the new program will generally avoid the risk of: (1) criminal prosecution, (2) civil and criminal penalties for failure to file a Report of Foreign Bank and Financial Accounts (FBAR), and (4) any taxes, interest, and penalties prior to 2003. 

Clearly, the IRS is giving all noncompliant U.S. citizens a clear warning. IRS Commissioner Shulman further stated “As we continue to amass more information and pursue more people internationally, the risk to individuals hiding assets offshore is increasing. This new effort gives those hiding money in foreign accounts a tough, fair way to resolve their tax problems once and for all. And it gives people a chance to come in before we find them. The risk of being caught will only increase.” 

Given the Commissioner’s remarks and the constant warnings from the IRS, it is well advised to come into compliance. Whether you have an undeclared foreign account or other international noncompliance, Moodys LLP Tax Advisors and Shea Nerland Calnan LLP is well placed to offer assistance. Please contact us if you have any questions. 

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