Tax and Estate Planning Blog : Moodys LLP and SNC Law

 Wow! That’s quite a title! Who would think that passion, YouTube and one of the more important provisions in the Income Tax Act (the “Act”) dealing with trust attribution would appear in the same blog? Well, today they do!

Let’s start with passion…those of you who know me personally know that I am rather passionate about a few topics. One of them being income tax and the pursuit of solutions to complex income tax problems and the development of proactive plans.   Well, it seems that a rather famous comedian, David Mitchell, has picked up on our tag line “Passionate About Tax Optimization” and created a short skit on this and other things passionate. This YouTube clip has been floating around the internet for roughly two years now and every time I look at it I chuckle. In my opinion, the old adage remains that if you can’t laugh at yourself there is not much you can laugh at and therefore I thought I would share this rather humorous skit with you in case you haven’t already seen it - David Mitchell gets Passionate about the Subject of Passion.

That’s a nice segway into announcing that Moodys LLP Tax Advisors has started its own YouTube channel to develop short pieces on tax topics. We are still experimenting with YouTube and other social media tools, but we believe that short YouTube clips on important tax topics may be valuable. Take a look at our YouTube channel here, Moodys YouTube, and look regularly for updates.

Now to an important income tax topic that is starting to get a lot of traction. The issue concerns indirect transfers of property and appears to have been rekindled by the St. Michael Trust Corp. (known better as Garron Family Trust) case – that we blogged about on November 18, 2010. In that decision, the Federal Court of Appeal had the following to say:

[75]           There are undoubtedly many ways in which a transfer of property may occur directly or indirectly in any manner whatever, and there is very little guiding jurisprudence. However, it is now well established that if the existing common shares of a corporation worth, say, $100, are exchanged for preference shares with a value that is fixed at some lesser amount, say, $80, and new common shares are issued to a new shareholder for nominal consideration, the holders of the preference shares have indirectly transferred property worth $20 to the new subscriber (see Canada v. Kieboom (C.A.), [1992] 3 F.C. 488, at paragraph 21).

[76]           Kieboom recognizes that the entire value of any corporation is represented by its shares, which are property. The allocation of the value of a corporation between shares of different classes is determined by their terms and conditions. Therefore it is possible to change the value of a class of shares, and to shift value from one class of shares to another, by changing their terms and conditions. The hypothetical reorganization described above results in an indirect transfer of property worth $20 from the holders of the fixed value preference shares to the new subscriber.

Kieboom was a case that involved a situation where “Dad’s” shares of a corporation were diluted in value because certain other family members were able to subscribe for shares of the subject corporation for a nominal value. The Federal Court of Appeal found that Dad had transferred property (indirectly) to the family members equal to the diluted value.

The above two paragraphs are rather controversial amongst the tax community and much has been written about the Kieboom case. It is my opinion that if one accepts the above two paragraphs and accepts the reasoning in Kieboom then many “garden variety” estate freezes that occur where there is an under-valuation of the preferred shares could result in an indirect transfer of property to the new common shareholder. 

For example, let’s assume that “Mom” owns 100% of the shares of OpCo. OpCo has a purported fair market value (“FMV”) of $1M. One of the numerous methods to effect an estate freeze in favor of Mom’s family would be to have Mom transfer her OpCo shares on a tax deferred basis to a holding company- “HoldCo” - whereby Mom would receive $1M of redeemable, retractable preferred shares of HoldCo with an aggregate redemption value of $1M.  A new discretionary family trust could be properly settled such that Mom, Dad and family members are beneficiaries of the trust.    Given that the FMV of HoldCo at that point would be nominal (since presumably the only asset of HoldCo would be the shares of OpCo with a $1M value), the newly settled family trust could subscribe, using its own funds, for new common shares of HoldCo for a nominal amount thereby enabling any future increase in the value of its HoldCo shares to accrue in favor of the family beneficiaries. Normally, such an estate freeze transaction would be accompanied by price adjustment mechanisms which would become applicable if the $1M value was found to be the incorrect value. The price adjustment mechanism would cause the redemption value of the preferred shares to automatically be increased or decreased (as appropriate in the circumstances) thereby still resulting in a tax deferred estate freeze.

Such an above plan is rather standard estate planning and has been for years. Tax practitioners and advisors go to great lengths to ensure that a devastating trust attribution rule – subsection 75(2) – does not apply when using a trust in such a plan. Subsection 75(2) reads as follows:

(2) Trusts [revocable, etc.] -- Where, by a trust created in any manner whatever since 1934, property is held on condition

     (a) that it or propertysubstituted therefor may

 (i) revert to the person from whom the property or property for which it was substituted was directly or indirectly received (in this subsection referred to as "the person"), or

 (ii) pass to persons to be determined by the person at a time subsequent to the creation of the trust, or

 (b) that, during the existence of the person, the property shall not be disposed of except with the person's consent or in accordance with the person's direction,

any income or loss from the property or from propertysubstituted for the property, and any taxable capital gain or allowable capital loss from the disposition of the property or of propertysubstituted for the property, shall, during the existence of the person while the person is resident in Canada, be deemed to be income or a loss, as the case may be, or a taxable capital gain or allowable capital loss, as the case may be, of the person.

 To the extent that subsection 75(2) applies in respect of the trust property, all income, losses, capital gains, and capital losses attributes back to the person who transferred the property to the trust. In addition, if subsection 75(2) was applicable, any transfer of capital property from the trust to a capital beneficiary, in satisfaction or partial satisfaction of one’s capital interest in the trust, would occur at FMV which would often be tax deferred otherwise. Accordingly, the application of subsection 75(2) is usually devastating for an estate freeze plan including a trust.   

Given the comments of the Federal Court of Appeal in Kieboom and recently in St. Michael Trust/Garron Family Trust, if the FMV of the OpCo shares referred to in the example above is actually $3M as opposed to $1M, could it be viewed that Mom transferred $2M of property to the newly settled family trust, thereby evoking the provisions of subsection 75(2)?   If one holds the view that there has been an indirect transfer of property to the trust then the answer would be “yes”.    Given such, tax advisors and their clients will need to be well aware of this fast moving area of tax law and be very careful to ensure that there has been no indirect transfers of property to a trust which might cause subsection 75(2) to apply (especially if the price adjustment mechanisms in the agreements are not effective).

It appears that the CRA is already starting to pick up on this view after the St. Michael Trust/Garron Family Trust decision. A Technical Interpretation released on April 13, 2011 into the tax databases (Technical Interpretation 2010-0366301I7) describes a fact pattern that is very similar to the example described above. The CRA uses the reasoning in the St. Michael Trust/Garron Family Trust and Kieboom cases to assert that there is an indirect transfer of property to a trust.    In other words, the CRA is of the view that the freezor transferred property indirectly to a trust that had subscribed for new common shares of a corporation that was the subject of the estate freeze. To be clear, the CRA has stated for years that it would apply the reasoning in Kieboom in a fact pattern similar to that as described in the example herein (see for example Technical Interpretation 982385 dated October 13, 1999). However, the CRA has also said that it would not apply the reasoning in Kieboom in the course of an estate freeze where the trust pays full FMV for the equity shares that are issued in the course of an estate freeze (see Technical Interpretation 9225295 dated December 9, 1992).

I could get into a lot more detail on this issue and debate its merits but I will have to leave this to another time where I can spill more ink on this subject (and my assistant’s ears are feeling better so that she can transcribe more of my dictation). Stay tuned…this subject will certainly be the subject of discussion in the tax community for months and years to come.

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Section 231.2 - Requirement to Provide Documents or Information to the CRA - is Unconstitutional and Without Effect – In Quebec at Least: Chambre des notaries du Quebec c. Canada

Most tax practitioners are familiar with CRA’s attempts to obtain their clients information by way of sections 231.2 of the Income Tax Act (the “Act”). This provision allows the CRA to require that any person provide any information or any documents for the purpose of administering or enforcing the Act. What practitioners may not be familiar with is a recent Quebec Superior Court decision which declares this provision (and connected provisions) unconstitutional and without effect by virtue of sections 52 of the Canadian Charter of Rights and Freedoms! This decision is Chambre des Notaires du Quebec c. Canada [2010] R.J.Q. 2069. So, why have you not heard of this decision? Most likely because it has only been released in French – the English translation is no doubt pending.

Notaries in Quebec are required to go through law school like lawyers. They also have the same obligations to maintain solicitor-client privilege as lawyers. As such, consider notaries and lawyers to be the same for the purposes of this decision – lawyers, please do not take offense. In this decision, a number of notaries were required, pursuant to section 231.2, to provide information and documents regarding their clients. In addition to the request for documents or information, the CRA would usually remind the notaries of the possibility of a fine and imprisonment if the request was not complied with.[1] Needless to say, the notaries were placed in a somewhat uncomfortable position of either complying with the order and compromising the solicitor-client relationship or ignoring the order and exposing themselves to potential fines and imprisonment! Following further CRA requests under section 231.2 to the notaries, the Chambre des notaries du Quebec decided to obtain a declaratory judgment declaring that section 231.2 was an unconstitutional violation of the solicitor-client relationship. The Quebec Superior Court agreed!

Following an extensive review of Supreme Court’s jurisprudence on solicitor-client privilege, the Court summarizes solicitor-client principals as follows:

1.       With respect to the privilege, there is no reason to make a distinction between a criminal law matter and a civil law matter;

2.       A soon as there is a legitimate professional relationship between a lawyer and a client, all actions, documents and all information are, prima facie, covered by the solicitor-client privilege;

3.       The party challenging the existence of the privilege has the burden of proving that the privilege does not exist;

4.       The exceptions to solicitor-client privilege should be extremely rare and should be used only as a last measure, once all other possibilities have been exhausted;

5.       Legislation (such as the Act) must make sure that they scrupulously respect the existence of the privilege to prevent untimely divulgation of protected information; and

6.       Any legislation that is susceptible to impair the privilege should be interpreted restrictively and cannot require the divulgation of protected documents.

The Court notes the Supreme Court’s statement in Lavallee v. R [2002] 3 S.C.R. 209 that the legislator should strive to take all necessary steps to assure that solicitor-client privilege is respected to the fullest extent. The Court also notes the Supreme Court’s statement that any legislative regime which does not directly allow a client, who is the holder of the privilege, to know that his privilege is threatened and therefore protect his rights under the privilege, is constitutionally unreasonable.

Based on the foregoing, the Court identifies three fatal lacunas in section 231.2 and 231.7. Firstly, these sections are not drafted in such a way that the client, holder of the privilege, can learn of the threat to his rights and thus protect it. Indeed, requests under section 231.2 were sent directly to the notaries without warning to the client. Secondly, the Court found the five day delay under section 231.7 to be unreasonably short. Finally, the Act did not impose as a condition that it is demonstrated that the violation of the solicitor-client privilege was a last resort solution. As such, the Court found that section 231.2 was not a minimal infringement of the solicitor-client privilege and declared it to be unconstitutional and without effect.

The Attorney General of Canada had requested a stay of the decision for a period of one year, so as to allow for potential legislative changes. The Chambre des Notaires du Quebec did not object to this stay. However, the Court refused this request on the basis that the rights under the solicitor-client privilege trumped administrative considerations! Strangely enough, the Court also declared section 231.2 and 231.7 to be unconstitutional and without effect – but only with respect to Quebec lawyers and notaries!!   Quite odd considering the Act is a Federal statute. Furthermore, it is odd that Quebec residents should arguably be afforded better constitutional protection than residents elsewhere in Canada. Do not all Canadian residents benefit from the same principals of fundamental justice? 

In any event, this decision is very important for any tax lawyers facing a CRA request under section 231.2, especially in light of CRA’s recent aggressive attempts to obtain privileged information. Unsurprisingly, this decision is under appeal to the Quebec Court of Appeal. It also has Supreme Court written all over it.

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On March 29, 2011, the Tax Court of Canada released its decision in Bernard Demeterio v. Her Majesty The Queen 2011 TCC 192. The case involved Bernard Demeterio, a life insurance agent, who received life insurance commissions in the 2002 and 2003 taxation years. Mr. Demeterio submitted that the commissions he received should not be taxable in the year of receipt (i.e. 2002 and 2003). He felt that the commissions were not income that had been earned but instead were loans advanced to him because they were required to be paid back if the life insurance policies that he sold were cancelled within two years. [This is a rather common remuneration feature amongst life insurance sales persons and life insurance companies and is often referred to as “chargebacks”]. Mr. Demeterio submitted that the commission income should be taxable once the life insurance premiums became non-refundable in the two immediate taxation years following the year of receipt.

The Court quickly dismissed Mr. Demeterio’s appeal and agreed with the Crown that the facts in Mr. Demeterio’s case were similar to those in another case, Destacamento v. Her Majesty The Queen 2009 TCC 242.

In Destacamento, the Crown submitted that the life insurance commissions received by the appellant were only called advances because there could be a chargeback. However, the possibility of a chargeback was a condition subsequent. In other words, the event had not yet happened and may never happen. Therefore the amounts received by the appellant had the “quality of income” and had to be included as income in his tax returns. If there was a chargeback, the Crown asserted that the appellant could deduct the reimbursement in the year that it was made. Ultimately, the Tax Court agreed with the Crown’s reasoning and dismissed the appellant’s appeal.

In Demeterio, the Tax Court also stated that even if the amounts received by Mr. Demeterio were advances, paragraph 12(1)(a) of the Income Tax Act (the “Act”) would include the amount in income given that paragraph 12(1)(a) reads as follows: 

12(1) There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable:

 (a) any amount received by the taxpayer in the year in the course of a business

 (i) that is on account of services not rendered or goods not delivered before the end of the year or that, for any other reason, may be regarded as not having been earned in the year or a previous year, or

(ii) under an arrangement or understanding that it is repayable in whole or in part on the return or resale to the taxpayer of articles in or by means of which goods were delivered to a customer;  (Emphasis added)

A careful read of paragraph 12(1)(a) of the Act reveals that it captures many unearned amounts into taxable income. However, taxpayers and their advisors will often look for reserves to offset the amount captured under paragraph 12(1)(a). The reserves that are available mostly appear in section 20 of the Act, but life insurance sales persons are specifically prohibited from claiming reserves under section 20 given the language of paragraph 32(1)(a) of the Act, which reads as follows:

 32. (1) -- In computing a taxpayer's income for a taxation year from the taxpayer's business as an insurance agent or broker, no amount may be deducted under paragraph 20(1)(m) for the year in respect of unearned commissions from the business, but in computing the taxpayer's income for the year from the business there may be deducted, as a reserve in respect of such commissions, an amount equal to the lesser of

(a) the total of all amounts each of which is that proportion of an amount that has been included in computing the taxpayer's income for the year or a preceding taxation year as a commission in respect of an insurance contract (other than a life insurance contract) that  (emphasis added) ….

Accordingly, Mr. Demeterio was prevented from deferring tax on the commissions that he received in 2002 and 2003. 

The decisions in Demeterio and Destacamento are not surprising and, in my opinion, are the right results. Accordingly, the cases should serve as a gentle reminder to life insurance commissioned sales persons to properly report their income and not get clever in trying to claim reserves or other deferrals in respect of possible chargebacks that might occur into the future.

Demeterio and Destacamento are also good reminders for other taxpayers who receive deposits or other amounts that are not yet earned. In many cases, accountants who prepare the financial statements for the businesses will correctly report the unearned amounts as liabilities (such as deferred revenue) instead of revenue. However, for income tax purposes, the unearned amounts that are reflected as liabilities on the balance sheet will more than likely be caught by the provisions of paragraph 12(1)(a). Accordingly, taxpayers and their advisors will need to ensure that such unearned amounts are reported as taxable income and efforts made to look for proper reserves (usually under section 20 of the Act) to ensure that a legitimate tax deferral is sought. We find that this is a common error made by non-tax specialist accountants when they compute taxable income and therefore such advisors should be aware of the traps of paragraph 12(1)(a) and the reserves under section 20. 

The tax professionals at Moodys LLP Tax Advisors would be pleased to explore this topic with you in more detail.

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