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

As you know, Canadian GAAP is being replaced as the required accounting standard for financial reporting in Canada. Effective January 1, 2011 IFRS will now be the new accounting standard for public enterprises.  The Canadian Institute of Chartered Accountants (“CICA”) has created a useful guide for users of financial reports in order to assist in interpreting the consequences as a result of the IRFS convergence.

Private enterprises will have the ability to use so-called private enterprise GAAP rather than IFRS as their new accounting standard.  For further information on this please see a good report published by the Accounting Standards Board of Canada.

Regular readers of our blog know that Moodys LLP Tax Advisors does not engage in any accounting services whatsoever.  Notwithstanding, many of our clients have questioned us as to what the conversion to IFRS or private enterprise GAAP will mean as it relates to their tax affairs.  Specifically, will the calculation of taxable income for enterprises that use IFRS or the new private enterprise GAAP be negatively impacted?  Overly simplified, it is our firm’s view that the conversion to IFRS or private enterprise GAAP should generally not have any negative impact on the computation of taxable income as compared to prior years.  This is because the Income Tax Act (the “Act”) does not mandate that GAAP accounting profits be used in the first instance to compute taxable income (or, simply, to calculate profit for tax purposes).  GAAP is not the law.  In addition, the Supreme Court of Canada, in the leading case of Canderel, has made it clear that a taxpayer’s goal, in seeking to ascertain profit (for tax purposes) is to obtain an accurate picture of the taxpayer’s profit for purposes of section 3 of the Act for the given year.   The Supreme Court stated in Canderel that a taxpayer is free to adopt any method to compute profit which is not inconsistent with:

a) the provisions of the Act;
b) established case law principles; and
c) well accepted business principles.

Practically speaking, IFRS and private enterprise GAAP (and current GAAP) may be a good starting point to compute an accurate picture of profit.  However, other methods are certainly available and may not be inconsistent with computations of profit used for tax purposes prior to the mandatory adoption of IFRS or private enterprise GAAP.1  What will be necessary, however, is to understand the detailed differences in computing accounting profits under current GAAP vs.  IFRS and/or private enterprise GAAP.   Such differences may be a required adjustment in order to get back to the method of computing tax tax profits as was used in prior years.

To illustrate, let us assume that a corporate taxpayer currently uses Canadian GAAP as its starting point to compute profit for tax purposes. While the Act will require many adjustments to the profit calculation (given that the Act contains very specific rules for how certain matters must be treated), IFRS and/or private enterprise GAAP may change the computation of accounting profits for 2011 forward.  As an example, what may have been previously expensed in the accounting financial statements of a taxpayer may now be capitalized (and therefore not expensed) pursuant to IFRS and/or private enterprise GAAP.  To the extent that the now capitalized item for accounting purposes would be more appropriate as a deduction (and was previously deducted in prior years when computing tax profits) such an adjustment will need to be made to the tax profit calculation which is consistent with the principles of Canderel.  Accordingly, tax practitioners will need to be very aware of the detailed differences between current GAAP and IFRS and/or private enterprise GAAP starting in 2011.

The CRA has published a number of publications which appear on their website.  Specifically, they have commented on the impact of IFRS on taxable income.  In addition, they have published a technical news document - Income Tax Technical News #42 dated May 31, 2010 – which provides useful information on this subject.

The tax professionals at Moodys LLP would be pleased to comment on your own specific issues regarding this topic.  Please feel free to contact any one of our tax professionals.


1 To be clear, it is only mandatory for public enterprises to use IFRS as their accounting standard.  For private enterprises, if there is no need to use GAAP when preparing financial statements (for example, the users of the financial statements have determined that there is no need to use GAAP) then private enterprise GAAP need not be used.

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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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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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First off, what an Olympics! As a proud Canadian, yesterday will certainly go down in the memory banks as one of the most significant days in Canadian sports history. Vancouver did an amazing job hosting the Olympics and did Canada proud. Of course, many of us were interested in the Canadian men's hockey team result and watching the game was a "pins and needles" exercise but when Sidney Crosby scored the overtime goal what a rush of excitement! Oh Canada!!

Two weeks ago, I was fortunate to attend the Olympics and watch three hockey games. What a fascinating experience to walk the streets of Vancouver and soak in the atmosphere and watch excellent hockey. Like my recent trip to Vancouver to watch AC/DC, one could not help but think about tax.

With the many countries in attendance, I sat in the audience and thought about all the different international tax jurisdictions that were at play. How were the Olympic athletes being taxed? Was Canada going to tax such international athlete's income? (The answer to the latter question is "generally no" given that various technical amendments were added to the Income Tax Act - see, for example subsection 115(2.3) that exempts the international athlete's income earned during the Olympics).

Notwithstanding, the Vancouver Olympics was certainly an eye opener and a very good lesson that the world is small, constantly changing and the tax implications of earning income around the world are extremely complex!

In Canada, income tax law is also changing quickly. This week will be significant in that the Federal Budget will be released on March 4. In addition, on Friday, February 26, 2010, the Department of Finance released new tax proposals to accommodate Employee Life and Health Trusts ("ELHTs").

The proposals (which, if passed, will apply for 2010 forward) create a new type of taxable inter-vivos trust that will enable funds to be accumulated within the ELHT by employer contributions for the benefit of employees' health benefits.

To re-emphasize, the new trust would be a taxable trust which would need to meet very specific requirements with respect to the types of beneficiaries (generally employees, but "key employees" like shareholders need to be carefully considered).

Generally, subject to specific rules, the contributions by an employer to an ELHT will be deductible to the employer. Again, very generally, the new proposals enable that any distributions of income to the employee beneficiaries of the ELHT will also be deductible to the trust including amounts that, prior to these previous proposals, would not have been deductible to the trust (such as reimbursements to employees) under existing law.

While the new proposals for ELHTs appear to be positive, our firm will continue to study the new material but I query whether or not such proposals are intended to replace "health and welfare trusts" (that are not defined in the Income Tax Act but the CRA's administrative comments on health and welfare trusts are laid out in Interpretation Bulletin IT-85R2). Will IT-85R2 eventually be withdrawn by the CRA?

As stated, this is an interesting new set of proposals which we will continue to keep you up-to-date on. Stay tuned.
 

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In the recent decision of Collins v. The Queen, 2010 FCA 12, the Federal Court of Appeal clarifies the meaning of "an amount payable in respect of the year" - one of the requirements for interest deductibility under paragraph 20(1)(c) of the Income Tax Act (the "Act").

Specifically, in order for interest to be deductible under paragraph 20(1)(c) of the Act, there must be:

(i) an amount paid or payable in respect of the year

(ii) pursuant to a legal obligation to pay interest

(iii) on borrowed money used for the purpose of earning income from a business or property

According to the Federal Court of Appeal, "payable in respect of the year" does NOT mean "due in the year", or "required to be paid in the year".

Interest is considered "payable in respect of the year" where it is properly accrued in the year, even though the full amount of interest was not required to be paid in the year of accrual, but rather, was required to be paid in a subsequent year.

Collins v. The Queen, reversing an earlier decision by the Tax Court of Canada, represents a good win for the taxpayer.
 

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The Federal Court of Appeal has recently confirmed that a taxpayer and a company controlled by the taxpayer’s nephew are considered to “act at arm’s length” in a transaction where the nephew’s company purchases promissory notes from a charity controlled by the taxpayer only to help the taxpayer solve a tax problem.

The Queen v. Remai 2009 FCA 340 involved a charitable donation plan in which the taxpayer, Frank Remai, endorsed $15M worth of notes payable to him from FRM, his wholly-owned company, to the Frank and Ellen Remai Foundation, a charitable Foundation which Frank controlled. Unbeknownst to the taxpayer, such plans had already been shut down in 1997 with the enactment of paragraphs 118.1(13)(a) and 118.1(18)(a) of the Income Tax Act (the “Act”).

These paragraphs made gifts of “non qualifying securities” ineligible for the charitable tax credit. Once the taxpayer realized he could not claim the credit, he attempted to rectify the problem by falling under the relieving provision of paragraph 118.1(13)(c) of the Act. (Under paragraph 118.1(13)(c), a non-qualifying security ceases to be “non-qualifying” if the charity sells the gifted security to a third person with whom the donor deals at arm’s length.)

Accordingly, the Foundation sold the notes for their face amount to Sweet, a company that was controlled by Frank’s nephew. Frank then claimed the charitable donation credit on the assumption that the notes were no longer “non-qualifying” within the meaning of 118.1(13)(c).

The Minister disallowed the charitable donation credit, and the taxpayer’s estate appealed to the Tax Court of Canada, where it was held that the taxpayer properly claimed the charitable donation credit. The Minister then appealed to the Federal Court of Appeal, which examined whether the Tax Court of Canada had properly concluded that the parties were dealing at arm’s length and that the general anti-avoidance rule (“GAAR”) did not apply.

In this case, Frank and Sweet were not related. Thus, paragraph 251(1)(a) — the rule which deems related persons not to be dealing at arm’s length — did not apply. Moreover, as no personal trust was involved, paragraph 251(1)(b) did not apply. The question was how to apply paragraph 251(1)(c), which provides as follows:

(c) where paragraph (b) doesn’t apply, it is a question of fact whether persons not related to each other are at a particular time dealing with each other at arm’s length.

The trial judge interpreted paragraph 251(1)(c) as being applicable when only paragraph 251(1)(b) was not. In other words, he assumed that paragraph (c) could not apply if both paragraphs (a) and (b) were not applicable. The Federal Court of Appeal rejected his interpretation of 251(1)(c). If paragraph (c) doesn’t apply when paragraphs (a) and (b) don’t apply, when would paragraph (c) ever apply? Parliament cannot be presumed to intend provisions to have no practical application.

On the contrary, a study of the legislative history of the provision revealed that paragraph (c) was intended to apply in cases not covered by paragraphs (a) and (b). Remai is an interesting example of how the text of a provision plays a lesser role when there is an error or ambiguity in legislative drafting. Indeed, as the Court put it: “the less than perfect drafting of the provision does not warrant an interpretation that makes a nonsense of the subsection and takes no account of its history, purpose, or structure.”

Although the trial judge had decided that paragraph 251(1)(c) was inapplicable, he nonetheless went on to analyze whether Frank and Sweet, though unrelated, were dealing at non arm’s length. In doing so, he considered the test developed under Peter Cundill & Associates Ltd. v. The Queen [1991] 2 CTC 221 for determining whether unrelated parties are acting at arm’s length, namely, whether: (i) there was a common mind directing the bargaining for both parties; (ii) the parties were acting in concert without separate interests; and (iii) one party exercised defacto control over the other.

The trial judge applied the Cundill factors in quite a taxpayer friendly manner, holding that there was no “common mind” directing the bargaining for both parties in this case because Sweet was not directly or indirectly controlled by Frank, and it freely entered into the transaction after considering its own interests. In this regard, the Federal Court of Appeal held the trial judge committed no “palpable and overriding error”, even though the Federal Court of Appeal noted that Frank entirely drove the proposal, the purpose of which was to benefit him and his Foundation, and that there was no bargaining over the terms of the exchange. (The Federal Court of Appeal noted that the standard of “palpable and overriding error” does not warrant interference by an appellate court merely because the appellate court would have reached a different conclusion if it had been the trier of fact.)

In analyzing factor (ii), both the trial judge and the Federal Court agreed that the parties had “separate interests,” given that Frank’s nephew only entered into the transaction after first ensuring that Frank’s company could honor the notes. The conclusion under factor (ii) is frankly a little surprising. Sweet seemed to have nothing to gain in the transaction, and largely entered into it as a favor to Frank. Yet, both levels of court agreed that the fact that Sweet first ensured that it wouldn’t lose the $15M required to help out the taxpayer reflected a “separate interest”.

With respect to factor (iii), the Federal Court of Appeal agreed with the trial judge that while Frank no doubt “exercised a degree of influence” over his nephew given their family relationship and their business connections, this did not amount to defacto control over Sweet. Indeed, Frank and Sweet’s business dealings had been mutually beneficial and Sweet was not entirely dependent on Frank for its business.

Finally, the Federal Court of Appeal held that the trial judge committed no palpable and overriding error in concluding that there had been no abuse under the GAAR. Relying on writings by tax authors, the Federal Court of Appeal held that the purpose of paragraph 118.1(13)(c) and subsection 118.1(18) was to disqualify certain gifts from a charitable tax credit because of the practical difficulty of assessing their fair market value. In this case, the sale price paid by Sweet provided a reliable basis for assessing the fair market value of the notes, and thus, the purpose of the relevant provisions was not frustrated.

The Crown argued that the purpose of the relevant provisions was rather to prevent donors from claiming a charitable credit for the value of a gift when they retained control of the funds from which the gift would be satisfied. While the 1997 Budget appeared to support the position of the Crown, (the budget stated that the new measures would deal with loan-backs which had been used to enable taxpayers to claim tax credits for charitable gifts without having to forego use of the funds), the Federal Court of Appeal rejected the Crown’s position.

The Court was not persuaded that preventing taxpayers from claiming a charitable tax credit where the taxpayer doesn’t forego the use of gifted funds was the purpose of the relied on provisions. In any event, the Court noted that Frank no longer retained control of the gifted funds once the promissory notes were sold to Sweet.

Although surprising in some respects, Remai is a welcome development for taxpayers.
 

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On December 14, 2009 the Minister of Finance issued a News Release and Backgrounder setting out the Government of Canada’s response to an April 2009 court decision on the application of GST to certain investment management fees.

As you may recall (from our blog of July 6, 2009), the Federal Court of Appeal had ruled in favour of the taxpayer, Canadian Medical Protective Association (“CMPA”), in their bid to have their investment management fees charged to their discretionary investment account considered as a “financial service” and thereby exempt from GST under Schedule V of the Excise Tax Act (the “ETA”).

The Government’s response to that decision was the December 14, 2009 press release; in their words, an effort to “reaffirm the policy intent and provide certainty respecting the GST”. The proposals state that they will “clarify” that “financial services”, as defined for purposes of the ETA, do not include investment management services, in spite of the Appeal Court’s ruling. In addition, they have identified a number of credit management and credit facilitatory services which are also confirmed to not be financial services.

Additional details are available at:  http://www.fin.gc.ca/n08/09-115-eng.asp.

It is important to note that these proposals apply not only to services rendered from December 14, 2009 forward, but also to previous transactions where the service provider had originally charged GST. Our understanding of this wording is that if the supplier had originally charged GST and the recipient had applied for a rebate (based on the CMPA case) the rebate will be denied. Also the Canada Revenue Agency has up to the later of one year after these proposals become law and the normal reassessment period under section 298 of the ETA to reassess. An exception exists for any case where a final determination has already been made by the courts.

Draft legislation was not included with the proposals, so complete details are not available. However, such legislation will be introduced at “an early opportunity”.

The CMPA case was of particular interest to the mutual fund industry as they faced the prospect of Ontario’s new 13% HST (beginning July 1, 2010). It would appear, at this time, that the Ontario Government is not prepared to extend an exemption to the mutual fund industry from the extension of the HST to the management fees they incur. The reason this is a concern to our readers across Canada is because the place of supply rules will likely apply to have that 13% tax apply to all mutual funds that are managed in Ontario (which is the vast majority – at least for now!).

We await the release of detailed legislation and will also monitor the HST situation, but for those hoping for a break on the application of the HST to mutual fund investment costs, these legislative proposals clearly indicate the Government is moving in the opposite direction

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Income tax is complicated. As such, mistakes in transactions are liable to occur from time to time, especially when professional advisors do not consult tax specialists prior to undertaking transactions.

The Court of Queen's Bench of Alberta ("QBA") has added another arrow to taxpayers' quivers when mistakes lead to unintended tax consequences.  In Stone's Jewellery Ltd. v. Arora 2009 ABQB 656, a well thought out and structured judgment by Madam Justice Strekaf, the taxpayer sought an order to rectify or rescind two transactions involving the transfer of land that resulted in the unanticipated assessment of more than $6 million in taxes.  The Canada Revenue Agency ("CRA") opposed the taxpayer's action.

The facts in this case are as follows: Ashok Arora and Saroj Arora (the "Aroras") - were directors and shareholders of Stone's Jewellery Ltd. ("Stone's").  In 1996 Stone's entered into a real estate purchase agreement and a caveat against the land was filed on Stone's behalf.  The purchase transaction did not close until 2004, (the "2004 transfer") by which time the land's value had substantially increased. At the time of closing and, based on advice from their lawyer and accountant, the Aroras registered the land in their personal names instead of Stone's.  This was done in an attempt to shield Stone's assets from any potential creditors that might arise on the development of the land.

In 2006, the land had further increased in value and was then transferred (the "2006 transfer") to an Alberta numbered corporation ("Alberta Ltd."), a corporation wholly-owned by the Aroras.  The transfer was to occur on a tax deferred basis pursuant to section 85 of the Income Tax Act (the "Act").

The CRA reassessed Stone's for the 2004 transfer as a disposition of the land to the Aroras.  Indeed, the CRA was of the view that Stone's had initially acquired the land.  The Aroras were also reassessed on the basis of a shareholder benefit as a result of the appropriation of the land from Stone's. The CRA further reassessed the Aroras for the 2006 transfer on the basis that the land was inventory and thus not "eligible property" and could therefore not be transferred on a tax deferred basis pursuant to section 85.

The Court seems to have been sympathetic to the fact that the transfers were made between siblings and wholly-owned corporations of the siblings.  The Court repeatedly points out that the transfers were between the Aroras and wholly-owned corporations, and thus no income was generated to offset the tax arising from the transactions.

In their application to the QBA, the taxpayers submitted that they were entitled to relief based on the principles of rectification, mistake (both at common law and equity), and failure of a condition precedent.  The CRA contested the application on the basis that rescission should not be granted where other legal remedies are available and where a taxpayer seeks to effect retroactive tax planning.

The taxpayers first argued that the transfer of land was conditional on no adverse tax consequences occurring.  As such there was failure of a condition precedent and thus no transaction ever took place.  The Court swiftly dealt with this issue by stating that lack of tax consequences was not a true condition precedent.

The Court then examined both the doctrine of equitable rectification and common law and equitable mistake. The Court also proceeded with an in-depth examination of the two leading tax cases on the issue of rectification: 771225 Ontario Inc. v. Bramco Holdings Co. Ltd. (1995), 21 O.R. (3d) 739 (C.A.) and Attorney General of Canada v. Juliar (A.G.) (2001), 50 O.R. (3d) 728 (C.A.).

The Court first examines the 2006 transfer.  Based on the evidence presented to the Court, Madame Justice Strekaf concludes that the transaction was undertaken on the mistaken belief, by all the parties, that it could be done on a tax deferred basis pursuant to section 85 of the Act. 

Justice Strekaf notes that rectification is not the proper form of relief in the case at hand as "[t]he Court does not have the power to direct that the 2006 Transfer proceed on a tax free basis pursuant to section 85 of the Income Tax Act in accordance with the parties' intentions." 

The Court concludes that if relief can be obtained it must be obtained either by a declaration that the transaction is void ab initio at common law or rescinded in equity as a result of the mistake made by the parties in respect of the transaction.

The Court summarizes the doctrine of common law mistake as follows:

At common law, a distinction was drawn between a mistake that constituted an error which went to the identity of the contract and caused the contracting party to obtain something other than what they had intended and a lesser error where the contracting party obtained what they had intended but it turned out to be less valuable.  Only the former was considered to be a fundamental mistake which went to the root of the contract, or the intention to contract, so as to render the contract void ab initio.  Any lesser mistake that went only to the motivation to contract or to questions of quality would only give rise to damages.

The Court concludes that the ineligibility of the land for the section 85 rollover constitutes a "fundamental mistake that went to the root of the contract."  As such the 2006 transfer was void ab initio at common law.

The Court continues its analysis by stating that even if it had not found the contract void at common law, it would have exercised its equitable discretion to rescind the transfer agreement because:

(a) the mistake was to the effect of the transaction itself and not merely as to its consequence or the advantage to be gained by entering into the transaction;

(b) there is no alternate adequate legal remedy available. On this point it is interesting to note that the CRA's contention that the taxpayers could appeal the assessment was rejected by the Court because "if the taxes claimed by CRA are properly owing unless the transaction is rescinded, how can appealing the assessment ever provide an adequate legal remedy to address the problems created by the transaction?";

(c) rescission of the transfer does not result in retroactive tax planning. In this respect the Court distinguishes the case of Bramco in which the Ontario Court of Appeal declined to provide equitable relief on the basis that "...courts do not look with favour upon attempts to rewrite history in order to obtain more favourable tax treatment". The Court points to the Juliar decision as evidence that given the proper circumstances courts may exercise their equitable discretion to offer relief in tax cases; and

(d) granting equitable relief did not prejudice third parties in this case.

The Court also examined the 2004 transfer in light of the same criteria.  The Court also found that the 2004 transfer was void ab initio at common law, but that it would have applied its equitable discretion to rescind the transfer had common law not applied.

As a result of the above, both the 2004 and 2006 transfers were declared void ab initio by the Court, with the result that the land remained registered in the name of Stone's.  Presumably, as the Court found the transaction to never have occurred, there was no transaction on which the taxpayers could be taxed.

This decision is good news for taxpayers who are caught in the unenviable situation of having to remedy unforeseen tax consequences.  While the Juliar decision allowed a taxpayer to rectify a transaction, the doctrine of mistake, as explained in this case, provides more flexibility in restoring the parties to the situation that existed pre-transaction.  Indeed, in this case rectification could not have saved the taxpayer from more than $6 million of tax liability.

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For many years, accountants for Canadian-controlled private corporations ("CCPCs") have followed the old adage of advising their clients to "bonus down" to the Small Business Limit (the amount of active business income earned in Canada that is subject to the lowest corporate tax rate), as it generally provided the owner-manager/shareholder with higher after-tax cash than the alternative of paying tax in the corporation, and then ultimately paying dividends to the owner-manager/shareholder.

This is because corporate income subject to the general tax rate was poorly integrated when such income was eventually paid as a dividend to the owner-manager/shareholder.

Table 1 roughly displays the lack of integration for a corporation earning $1,000,000 of taxable income in the late 1990's.

Table 1 - Approximate 1990's Example

With the introduction of the eligible dividend regime effective January 1, 2006, tax integration for high rate corporate income has greatly improved.  Table 2 provides an illustration of tax integration for an Alberta based CCPC with $1,000,000 of taxable income. 

The first option in each year displayed is to pay a bonus of $500,000 down to the Small Business Limit (which is now $500,000 effective January 1, 2009) and extract the remaining surplus out as a non-eligible dividend. 

The second option in each year displayed is not to pay a bonus, but rather subject the corporate income to the lower rate of tax on the first $500,000 of corporate profits and the high rate of corporate tax on the next $500,000. The after-tax corporate surplus would then be extracted using a combination of non-eligible dividends and eligible dividends.

As illustrated, the total after tax cash is only $3,600 to $4,100 higher between 2009 and 2012 for the Bonus option versus the No Bonus option.  Accordingly, one could say that for Alberta based CCPCs, the tax system is now essentially integrated. (Note that the general corporate tax rate for Alberta corporations is declining for every year from 2009 to settle at 25% in 2012. Similarly, the personal tax rate for Alberta resident individuals on eligible dividends is increasing every year from 2010 to settle at 19.29% in 2012).

Click here for Table 2.

What if the owner-manager/shareholder has no immediate need for funds? Some practitioners have suggested to us that bonusing down to the Small Business Limit still provides higher after-tax cash than retaining such cash in the corporation. We decided to test this strategy in the following example illustrated in Table 3. Again, suppose a CCPC has $1,000,000 of taxable income, and the owner-manager/shareholder has no immediate need for funds. In this case, the two options are as follows:

1.  Pay a bonus of $500,000 down to the Small Business Limit and retain the remaining after-tax corporate income within the corporation.  In this case, the owner-manager/shareholder will have some after-tax cash in their hands personally.

2.  The second option is to retain the income in the corporation, i.e. not to pay a bonus or a dividend.

In order to compare apples to apples, let's further assume that the corporate retained earnings in both options above are paid out in 2012 by way of a dividend (2012 was purposely selected as the year to withdraw the corporate surplus since this will be the year, as mentioned above, that the eligible dividend rate is settling at its highest rate of 19.29% - an increase of approximately 5% from the 2009 rate of 14.55%).

Click here for Table 3.

As Table 3 illustrates, the cumulative after-tax cash is approximately $50,000 higher in the bonus option, or about 2%.  In addition, under option 2, the lower eligible dividend rates from 2009 to 2011 are foregone in favor of retaining funds within the corporation.

However, under option 1, the bonus payment in 2009 to 2012 results in a "prepayment" of tax.  In other words, under option 1, the owner-manager/shareholder is prepaying taxes of about $50,000 to $70,000 in each of 2009 to 2012, in order to save $50,000 in taxes in 2012 when the accumulated surplus is paid out.

To elaborate, the first $500,000 of taxable income is subject to the small business tax rate under both option 1 and 2.  If the next $500,000 is paid out as a bonus in 2009, it would be subject to a 39% personal tax rate in Alberta.  However, if this $500,000 is retained (and therefore taxed) in the corporation, it would be subject to a 29% general corporate tax rate in 2009.  Therefore, there is a $50,000 "prepayment" of tax in the bonus option, or 10% of $500,000.

To put it another way, if the $500,000 is retained in the corporation, there is a tax deferral of 10% until such funds are eventually paid to the owner-manager/shareholder (by way of a dividend).  This tax deferral increases steadily to 14% by 2012 when the general corporate tax rate declines to 25%.  This deferral of tax is significant and our analysis, of course, ignores the time value of money and the rate of return that could be earned on the deferred tax.

The decision to bonus or not will ultimately depend on whether the owner-manager/shareholder needs funds personally.  If the answer is "no" then there is a very compelling argument to not bonus.  Of course, not bonusing will come with some cons (such as increased corporate income tax installments and increased cash in the company) but such cons can be easily dealt with by way of good cash management and additional planning.  CCPCs that also rely on refundable SR&ED tax credits should be careful about paying high rate corporate tax since this may reduce their refundable tax credits.  In addition, Alternative Minimum Tax ("AMT") should always be considered when paying out dividends. With regards to both Option 1 and 2 in Table 3, there is no AMT payable in 2012 when the accumulated earnings are paid out.

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As mentioned in our blog of September 29, 2009, one of the most common errors that we identify during our review of private corporations is the corporate ownership of personal use assets. The shareholders of the corporation will often believe that it is tax efficient to purchase assets inside the corporation that would otherwise involve the withdrawal of funds from the corporation to purchase such assets (which would be a taxable withdrawal). Unfortunately, the tax consequence of the acquisition of personal use property by a corporation is not pretty. We often see vacation homes, automobiles, boats, art collections, etc. owned by the corporation. Certainly the most common examples we see are vacation property and in some unusual cases the primary residence of the shareholder(s).

There has been no shortage of tax jurisprudence involving this type of issue. The biggest tax consequence is that the shareholder(s) will usually have been considered to have received a taxable benefit from the corporation. In other words, the corporation conferred a benefit on the shareholders. The obvious question becomes how to calculate the quantum of the benefit.

In Mullen v. The Minister of National Revenue 90 DTC 1551, certain individual shareholders of a holding company, which in turned owned shares of a subsidiary company, were reassessed by the Minister of National Revenue for a shareholder benefit for the use of a California condominium that the subsidiary company owned and the individuals rarely used. For the days that the individuals actually used the condo, they had included $100 each / day in their income. The Minister reassessed the individuals for the vacant days as well. However, upon appeal, the individuals were found to have not received a benefit during the vacant days. In practice, this was often found to be an acceptable way to compute the taxable benefit.....a reasonable rent or hotel rate that would be charged to arm’s length parties.

However, in cases since Mullen and in particular two significant cases – Youngman v. The Queen 90 DTC (FCA) and Fingold v. The Queen 97 DTC 5449 (FCA) - the Court found that fair market value rental was not the correct methods to determine the quantum of the shareholder benefit. Instead, the Court determined in both cases that an equity rate of return on the personal use assets was the correct standard to determine the benefit. In other words, what price would the shareholder have had to pay, in similar circumstances, to get the same benefit from a company of which he was not a shareholder. This, of course, will be always a question of fact, but following the legal principles as set out above, can lead to some staggering shareholder benefit inclusions which far exceed fair market value rentals. A recent case – Arpeg Holdings Ltd. v. The Queen (FCA) 2008 DTC 6087, recently challenged the appropriateness of the cost of capital approach to computing the shareholder benefit. However, the Federal Court of Appeal dismissed such a challenge. The Canada Revenue Agency confirms that it calculates the quantum of the benefit using the rate of return method as stated in Interpretation Bulletin IT-432R2 (see paragraph 11).

In addition to the taxable benefits, when dealing with personal use real estate property, additional tax consequences can result given that the fact that the principal residence exemption will not be available upon an ultimate disposition of the property by the corporation. (As a gentle reminder, the principal residence exemption can be utilized by individual Canadian residents to the extent that they habitually use the property as their personal residence and the property is not a rental property). Any surplus removed from the corporation will likely result in certain taxation amounts as well.

Accordingly, personal use property owned by a corporation can be a tremendous headache with very little planning available to offset the negative consequences. Our usual recommendation is to always remove personal use property from a corporation so as to relieve oneself from the significant taxable benefits and headaches that surround this matter.

Caution!

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Why would we be writing a blog on future legislative amendments to the Quebec Taxation Act when we are Alberta tax advisors and most of our clients are in Western Canada? We believe the new Quebec proposals that are the subject of this blog may have national significance if the federal or provincial governments ever follow suit. Over the years, Quebec has been the subject of certain aggressive tax planning. It appears that Quebec has been seething over these aggressive transactions ever since and has finally come out with a heavy handed proverbial slap to the taxpayer's face.

On January 30, 2009 the Quebec Minister of Finance released a working paper entitled “Aggressive Tax Planning”. The purpose of the paper was to expose what the Quebec Minister of Finance considered to be aggressive tax planning (“ATP”) and actions being contemplated to curb ATP. Interested persons were asked to provide their comments on the Minister’s proposed actions up until April 1, 2009. The result of this consultation process was announced on October 15, 2009 with an information bulletin laying out Quebec’s initiative to combat ATP. While some of these measures are not as far reaching as feared, some of them have quite an impact on how tax planning advisory services may be provided in Quebec.

The following is a summary of some of the more important legislation to be enacted:

1. Mandatory disclosure transactions: The Quebec Minister of Finance has identified circumstantial factors relating to taxpayers and their advisors that are likely, in their opinion, to lead to ATP. These are confidential transactions and transactions with conditional remuneration. A taxpayer will have to disclose transactions in respect to which the taxpayer has entered into a confidentiality agreement. The de minimis threshold under which a transaction need not be disclosed is a transaction with a tax benefit of less than $25,000 or an impact on income of less than $100,000.

Taxpayers will also be required to disclose transactions for which the tax advisor’s remuneration is conditional on obtaining a tax benefit, is refundable if the expected tax benefit does not materialize or is paid to the advisor only after the expiry of the limitation period applicable to the taxation year the transaction was undertaken.

Disclosure will have to be made in prescribed form under separate cover, by registered mail or electronically, on the due date for filing the taxpayer’s tax return. Failure to disclose will result in a $10,000 penalty with an additional $1,000 per day as of the second day, to a maximum of $100,000. Furthermore, failure to file a disclosure will result in the suspension of the limitation period relating to the undisclosed transaction. A defense of due diligence and the voluntary disclosure program will apply to the new disclosure rules.

2. General Anti-Avoidance Rule: More worrisome than the above mandatory disclosure requirements is the penalty provisions being added to the Quebec GAAR. Where the Quebec GAAR applies to a transaction, the normal limitation period will be extended by three years. This same approach was adopted by Alberta, effective December 2, 2008. In addition, subject to a due diligence defense, a penalty of 25% of the amount of the tax benefit will apply if GAAR applies to the transaction. Furthermore, when GAAR applies, the promoter of the transaction will incur a 12.5% penalty on all amounts of consideration received by the promoter, subject to due diligence. None of the foregoing extended limitation period or penalties will apply if the transaction was disclosed in the taxpayer’s return of income in prescribed form.

The new legislation will be effective after the day of publication of the information bulletin (i.e. October 16, 2009) for transactions carried out on or after the date of publication of the information bulletin, but not for series of transactions that began before this date. As you can see from the foregoing, the Quebec Minister of Finance has decided to get “tough” on what they perceive as being abusive tax avoidance. It remains to be seen what impact these provisions will have on business in Quebec and on tax advisors. It also remains to be seen whether the Federal Government, or other provinces, will follow Quebec’s lead and legislate in the same direction. This is yet another clear sign that tax authorities and related organizations (including the OECD) are taking tougher positions against tax avoidance. Stay tuned …

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As a tax specialist firm, we work with many private corporations and their accounting and legal advisors.  We see a lot of opportunities for planning and take great pleasure in working with the fabulous advisors that serve our clients.

Unfortunately, however, we often come across plans that could perhaps have been better thought out.  One of the common strategies that we trip across is the use of “management fees” to reduce income of one corporation and increase the income of another corporation.  Often times the payor corporation and the recipient corporation have different taxation year ends and therefore the plan is a loose attempt to try and get an income tax deferral.  In some cases, advisors will recommend the use of a disassociated “Management Co” (owned by a related person) to receive management fees in an attempt to multiply access to the small business deduction (with the result being lower income tax rates on retained profits).

There are a host of income tax issues that need to be considered with the use of management fees between related corporations.  For example, are the management fees legitimate, are they reasonable, were they incurred for the purpose of earning from a business or property, are the management fees earned over the course of the year (and, if so, is the resulting deferral eliminated or reduced) and are GST issues properly considered?

The recent case of Nielsen Development Company Limited (2009 TCC 160) highlights the problems when management fees are utilized.  Very generally, Nielsen owned and operated a hotel in British Columbia.  Nielson was owned by Mr. Jason Lo and he caused Nielsen to pay $275,000 of “management fees” to a company controlled by his wife.  The Canada Revenue Agency (“CRA”) disallowed $223,330 of the fees as a deduction stating that the amount was unreasonable in the circumstances.  The CRA similarly disallowed certain management fees as a deduction in a subsequent taxation year as well.  After reviewing the facts, the Court found that the management fees were reasonable under the circumstances.  WHEW!  This was a good result given that the Court had the ability to deny the deduction of the management fees from the payor but still include the amount in income of the recipient corporation pursuant to section 67 of the Income Tax Act.  This would result in double taxation.

Our firm has written a paper on this subject and for practitioners who would like to explore this topic further we would refer you to our 2004 Canadian Tax Foundation paper.

Another common error that we trip across is the ownership of personal use property through a corporation.  This will be the subject of another blog.

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In the recent past, US taxpayers who wanted to invest in Canada would often do so with structures that would avoid inefficient tax results on both sides of the border. One of the common structures that was employed in the corporate context was to utilize certain Canadian Unlimited Liability Corporations ("ULCs") that were fiscally transparent for US purposes.

In Canada, such corporations only existed in Nova Scotia (as a Nova Scotia Unlimited Liability Corporation) or in Alberta (as an Alberta Unlimited Liability Corporation). To the extent that a US taxpayer owned, say 100% of the shares of the ULC, all of the profits of the ULC would generally be fiscally transparent for US tax purposes (meaning that the US would not respect the ULC as being a separate legal entity and would require the profits of the ULC to be included in the US taxpayer's income directly).

For Canadian purposes, the ULC was treated as a "normal" corporation for taxation purposes and thus the profits were subject to Canadian tax with such tax generally being creditable against the US tax on the ULC's profits. The result was the avoidance of potential inefficient tax results on an overall basis.

To the extent that the profits of the ULC were repatriated to the US parent by way of a dividend, such dividends would often be subject to "treaty benefits" which would result in a reduced withholding tax rate.

Conversely, a Canadian taxpayer who wished to invest in the US would often utilize a US Limited Liability Corporation ("LLC") for reasons that are similar to the above but are beyond the scope of this blog entry.

On December 15, 2008, the Fifth Protocol to the Canada-United States Income Tax Convention came into force. A large surprise with the new Protocol was how ULCs and other fiscally transparent entities such as US LLCs (or sometimes partnerships) were to be treated.

New paragraph 7 of Article 4 of the revised treaty contains provisions that essentially deny treaty benefits to such fiscally transparent entities in many cases. However, the impact and implementation of the new provisions was delayed until January 1, 2010.

Accordingly, taxpayers and their advisors now have roughly four months to deal with the pending impact of the new provisions. Taxpayers who are impacted by such a change should consider alternative structures that would avoid the negative consequences of the new rules.

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