Tax and Estate Planning Blog : Moodys LLP and SNC Law

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

1.   Deferral of Income Accruing in an RRSP

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

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

2.  Capital Dividends Received By a US Citizen

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

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

3.   Canadian “Estate Freeze” Transactions

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

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

4.   Stock Options

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

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

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

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

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

6.   Flow-through Share Deductions

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

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

7.   Principal Residence Exemption

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

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

8.   Charitable Donations

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

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

9.   Pension Income Splitting

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

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

10.  Allowable Business Investment Losses (ABILs)

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

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

11.  Medical Expenses

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

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

12.  Canadian Lottery/Gambling Winnings

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

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

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

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Late on December 7, 2011 the IRS issued Fact Sheet 2011-13 (“Information for U.S. Citizens or Dual Citizens Residing Outside the U.S.”), which provides important guidance on two matters for taxpayers residing outside of the U.S.: first it gives insight into the type of facts that would support a “reasonable cause” argument for the abatement of penalties. Second, it clarifies the procedure to bring current unfiled returns, thereby confirming the IRS’s disdain for “quiet disclosures.” The guidance provided by the Fact Sheet makes clear the importance of engaging a professional who is experienced in these matters.

Facts likely to support a “reasonable cause” argument for the abatement of penalties

 Many of the penalties faced by individuals who haven’t filed their U.S. returns may be reduced to zero provided the taxpayer can prove reasonable cause for not filing. Reasonable cause is a legal doctrine, the application of which is determined by all of the facts and circumstances surrounding the taxpayer’s failure to file. Particular facts that support its application are found in case law, administrative interpretations, the statutes, and the treasury regulations.[1]

The taxpayer was unaware of his U.S. filing obligations

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

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

The Fact Sheet then gives several examples, the facts of which support a finding of reasonable cause, the most telling of which is Example 4. Under Example 4 the IRS concludes that reasonable cause is shown based on the following facts:

·         The taxpayer complied with tax filing and payment obligations in his country of residence;

·         He was previously unaware of his U.S. filing obligations;

·         After discovering his U.S. filing obligations he filed his previously unfiled returns;

·         He attached a statement to his returns setting forth his reasonable cause argument;

·         He had a legitimate reason for maintaining non-U.S. accounts;

·         There was no indication that he had taken efforts to intentionally conceal the reporting of income or assets; and

·         There was no additional U.S. tax due.

In making the reasonable cause argument, it is critically important to analyze the facts, support the facts with affidavits or other evidence, and to make sure that the facts are supported by existing law. A U.S. lawyer who is experienced with the foregoing is an essential component to prevailing on reasonable cause argument.

Procedure to bring current unfiled returns: DO NOT ATTEMPT “QUIET DISCLOSURE”

The Fact Sheet states that if a taxpayer has not filed returns or foreign bank account reports (FBARs) he should immediately file the delinquent returns (6 years for the FBAR) and attach a statement with the filings that sets forth the reasonable cause argument. This guidance makes clear the IRS’s distain for “quiet disclosures.”

In the past many taxpayers have attempted to bring current their unfiled returns by simply filing the returns without notifying the IRS, this is what is referred to as a “quiet disclosure.” The IRS has publicly stated that it will not tolerate quiet disclosures and that those who attempt to bring their filing obligations current via quiet disclosure risk criminal prosecution. For example, in FAQ 15 of the Offshore Voluntary Disclosure Initiative (OVDI) [2] the IRS stated:

Those taxpayers making “quiet” disclosures should be aware of the risk of being examined and potentially criminally prosecuted for all applicable years.

The Fact Sheet makes clear that unfiled returns must be brought current and the IRS must be informed of the taxpayer’s actions, including his reasonable cause argument. By following these rules, the taxpayer will maximize the possibility of proving reasonable cause and thereby reducing his penalties to zero.

Other penalties may apply.

The Fact Sheet addresses only the penalties that apply for failure to file FBARs and U.S. income tax returns. However, section 3 makes clear that other failure-to-file penalties may apply for other forms that have not been filed. These other forms include:

·         Forms 3520 and 3520A, which are required for certain interests in non-U.S. trusts or estates and gifts or inheritances from non-U.S. persons;

·         Forms 5471 and 8865, which are required for certain interests in non-U.S. corporations and partnerships;

·         Forms 926 and 8865, which are required for certain transfers to non-U.S. corporations and partnerships; and

·         Form 8938, which is a new form that is required to be filed beginning in 2012. The form must be filed by certain individuals who own non-U.S. accounts (much like the FBAR). There is a $10,000 penalty for failure to file this form.

The publication of the Fact Sheet is great news for individuals living outside the U.S. who are not current on their U.S. tax filing obligations because it gives some degree of certainty as to the facts that will support a reasonable cause argument for the abatement of penalties, and it also gives guidance as to the procedure to bring delinquent filings current.

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