3 December 2019 CTF Roundtable
This provides the written questions that were posed, and summarizes the oral responses provided, at the CRA Roundtable held in Montreal on 3 December 2019 at the annual conference of the Canadian Tax Foundation. The presenters from the Income Tax Rulings Directorate were:
Stéphane Prud'Homme, Director, Income Tax Rulings Directorate
Stéphane Charette, Director, Financial Industries and Trusts Division, Income Tax Rulings Directorate, Canada Revenue Agency,
The questions were orally presented by Marie-Josée Michaud (KPMG) and Barbara Worndl (Aird & Berlis). Many of the headings are our own.
Q.1 – Application of Multilateral Instrument (MLI) PPT
The MLI received royal assent in the form of Bill C-82 on June 21, 2019.
The MLI introduces into a significant number of Canada’s existing bilateral tax treaties an amended preamble indicating the amended treaty is intended to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance. It also introduces in such treaties a broad anti-avoidance rule in its Article 7 (colloquially referred to as the “principal purpose test” or the “PPT”), which reads as follows:
Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement.
Can the CRA provide an update on the measures that were put in place for the administration of the PPT?
Charette: At the 2017 CTF Roundtable, CRA indicated that it was exploring methods of promoting consistency in its application of the PPT, and that the GAAR Committee would be used as a model for a new PPT committee. The Income Tax Rulings Directorate coordinated this consultation process with different government stakeholders on the application of PPT.
The new Treaty Abuse Prevention Committee (the “TAP Committee”) will be chaired by the Director of the International Division at Income Tax Rulings, and will include a representative of the Legislative Policy and Regulatory Affairs Branch, the International Relations and Treaty Offices Division of the Legislative Policy Directorate, the International and Business and Investigation Branch, the Tax Avoidance Division, and the International Tax Division. The Committee will also include the Tax Legislation Division of the Department of Finance, and the Tax Legal Services Division of the Department of Justice.
The TAP Committee will be in charge of making recommendations on the application and non-application of the PPT (or its equivalent, depending on the Treaty). It will make recommendations to the Rulings Directorate regarding advance tax rulings, and to the International and Large Business Directorate for proposed assessments.
The proceedings of the TAP Committee will mirror those of the GAAR Committee. Where a s. 245(1) “tax benefit” emanates from a bilateral treaty, the TAP Committee is charged with considering both the PPT and the GAAR, taking over GAAR responsibility from the GAAR Committee in this Treaty context.
Q.2 – Translation under s. 126 of foreign taxes paid
Section 126 permits credits for foreign taxes paid in respect of the relevant taxation year.
a) Where the foreign tax is paid at a different time than the income arose, does the CRA consider it acceptable for the taxpayer to translate at the foreign exchange rate(s) applicable:
- On the date(s) on which the foreign income was earned or received?
- On the date(s) on which the foreign taxes were paid?
- On either date, as either would be a reasonable approximation of the actual foreign taxes paid, in Canadian funds?
b) The Canada-US Treaty, Article XXIV(2)(a)(i) provides that “income tax paid or accrued to the United States on profits, income or gains arising in the United States” are deductible from Canadian taxes on those items. Article XXIV(2)(a)(ii) provides that individuals can also claim most social security taxes paid, without the word “accrued”. The Canada - UK Treaty Article 21(1)(a) refers to tax payable in the UK.
Does the CRA concur that, where taxes are accrued but not paid to a nation with a Tax Treaty using such terminology, a foreign tax credit may be claimed for taxes payable, even if they have not yet been paid?
Preliminary Response - Q.2(a)
Charette: Assume that the taxpayer’s tax reporting currency is the Canadian dollar.
S. 261(2)(a) requires that a taxpayer determine its Canadian tax results in Canadian dollars and s. 262(2)(b) requires that an amount that is relevant in establishing a taxpayer’s Canadian tax results, and that is not already in Canadian dollars, be converted to Canadian dollars using the relevant spot rate for the day on which the particular amount arose. “Relevant spot rate” is defined in s. 261(1) as the exchange rates quoted by the Bank of Canada on that particular day – and allows for another conversion rate where that rate was acceptable to CRA.
The foreign tax credit rules in s. 126 require that the tax actually be paid. CRA considers the date of payment of the foreign tax to be the relevant date for the purpose of s. 126 – and, therefore, the date that the amount arose for the purpose of s. 261(2)(b).
Respecting the provision in s. 261(2)(b) for the use of another conversion rate that is acceptable to CRA, CRA will accept the use of the same relevant spot rate that was used for the conversion for the foreign income itself. Either method is acceptable as long as it is used consistently from one year to another.
Preliminary Response - Q.2(b)
Art. 21 of the Canada-UK Treaty addresses the elimination of double-taxation. Para. 1(a) thereof expressly provides that the relief is “[s]ubject to the existing provisions of the law of Canada regarding the deduction from tax payable in Canada of tax paid in a territory outside Canada and to any subsequent modification of those provisions”.
Many Canadian treaties have a similar clause and, 2015-0601781E5 commented on this “subject to Canadian law” clause in Art. XXIV of the Canada-US Treaty – and took the view that this meant that a Canadian resident was subject to the timing requirements of s. 126.
CRA views the same interpretation as applicable to Art. 21(1)(a) of the Canada-UK Treaty. Therefore, the amount of the foreign tax needs to be paid in order to be eligible for the foreign tax credit.
Q.3 – Translation of s. s. 55(5)(d)(i) TFSB at SIDT
- Can Holdco owns all the shares of Can Opco which owns 100% of the shares of US FA and has no other assets
- The currency maintained by US FA for reporting purposes is the US$
- The ACB of the shares of Can Opco to Can Holdco is nil
- The ACB of the shares of US FA to Can Opco is nil
- The time (“Time 1”), that is immediately before the safe-income determination time as determined under subsection 55(1) occurs before the time (“Time 2”) that is immediately before the payment of the dividend from Can Opco to Can Holdco
- At both times (Time 1 and Time 2):
- US FA has US$100 of cash and no other assets
- The “tax-free surplus balance” of US FA as referred to in subparagraph 55(5)(d)(i) is US$100; and
- There is no fluctuation in these amounts between Time 1 and Time 2
The definition of safe-income determination time for a transaction or event or a series of transactions or events in subsection 55(1) refers to the time that is the earlier of:
a) the time that is immediately after the earliest disposition or increase in interest described in any of subparagraphs 55(3)(a)(i) to (v) that resulted from the transaction, event or series, and
b) the time that is immediately before the earliest time that a dividend is paid as part of the transaction, event or series.
Paragraph 55(5)(d) states that the income earned or realized by a corporation for a period ending at a time where the corporation was a foreign affiliate of another corporation is deemed to be the lesser of:
i. the amount that would be the tax-free surplus balance of the corporation in respect of the other corporation at that time, and
ii. the fair market value at that time of all the issued and outstanding shares of the corporation.
If the Canada-US foreign exchange rate changes after the safe-income determination time such that the Canadian dollar equivalent of the US$100 cash is, say, C$90, the FMV of the shares of US FA and Can Opco should be limited to C$90 and the safe income should be limited to that same amount.
If, instead, the Canada-US foreign exchange rate changes after the safe-income determination time such that the Canadian dollar equivalent of the US$100 cash is, say, C$110, the FMV of the shares of US FA and Can Opco should be C$110.
It seems appropriate that the safe income should be $110 using the exchange rate at the time of the dividend payment.
Does the CRA agree that the exchange rate at the time of the dividend payment should be used rather than the exchange rate at the safe-income determination time?
- In Scenario 1, the exchange rate of the US dollar is US $1 = CDN $1 at Time 1 and US $1 = CDN $1.2 at Time 2
- At Time 2 Can Opco pays a dividend of $120 to Can Holdco
- In Scenario 2, the exchange rate of the US dollar is US $1 = CDN $1.2 at Time 1 and US $1 = CDN $1 at Time 2
- At Time 2 Can Opco pays a dividend of $100 to Can Holdco.
Prud'Homme: As background, under s. 55(2.1), a taxable dividend is subject to s. 55(2) if the amount of dividend exceeds the amount of the income earned or realized after 1971 and before the safe-income determination time that could reasonably be considered to contribute to the capital gain that could be realized on the disposition of the shares at fair market value immediately before the dividend.
The phrase “income earned or realized by any corporation” permits the consolidation of safe income within a corporate group. S. 55(5)(d) provides rules for calculating the income earned or realized by a foreign affiliate that can be added to the safe income of the Canadian parent.
In Scenario 1, at Time 2 Can Opco will pay a dividend of $120 to Can Holdco. The question is whether such dividend exceeds the amount of income earned or realized by Can Opco at Time 1 that could reasonably be considered to contribute to the capital gain of $120 on the Can Opco shares at Time 2.
The s. 55(5)(d) amount is the lesser of the tax-free surplus balance of US FA at Time 1 and the fair market value of the shares of US FA at Time 1. CRA’s view is that, under the scheme of s. 55(5)(d), the exchange rate to be used should be the rate at Time 1, or US$1 = CAN$1, making the amount under s. 55(5)(d)(i) equal to $100. The fair market value of the shares of US FA would not exceed $100 at Time 1. Therefore, the amount of income of US FA to be added to the income earned or realized by Can Opco at Time 1 is $100.
The dividend of $120 would therefore exceed the amount determined to be income earned or realized by Can Opco.
Scenario 2 follows the same approach. At Time 2, Can Opco pays a dividend of $100 to Can Holdco. The question is whether such dividend exceeds the amount of income earned or realized by Can Opco at Time 1 that could reasonably be considered to contribute to the capital gain of $100 on the Can Opco shares at Time 2.
The amount determined under s. 55(5)(d)(i) would be $120 if the exchange rate was US $1 = CDN $1.2 at Time 1. The fair market value of the shares of US FA would also be $120 at Time 1, so that the amount of income of US FA to be added to the income earned or realized by Can Opco at Time 1 is $120.
The gain that could be realized on the disposition of the shares of Can Opco immediately before the dividend is only $100. The income earned or realized by Can Opco that can reasonably be considered to contribute to the accrued gain on the shares of Can Opco would be limited to $100.
The dividend paid by Can Opco of $100 would not exceed the amount determined to be the income earned or realized by Can Opco of $100.
Q.4 - Ss. 84.1(1)(b) and 129(1)(a)
Consider the following scenario:
- Mr. A is married to Mrs. A and both individuals are resident in Canada
- Mr. A owns all of the issued and outstanding shares of the capital stock of Opco 1
- Mr. A and Mrs. A each own 50% of the issued and outstanding shares of the capital stock of Opco 2
- Opco 1 and Opco 2 are both private corporations as that expression is defined in subsection 89(1)
- Mr. A transfers his shares of the capital stock of Opco 1 to Opco 2 in consideration for a note
- Paragraph 84.1(1)(b) applies and a dividend is deemed to have been paid by Opco 2 to Mr. A and received by him from Opco 2 at the time of the disposition
Paragraph 129(1)(a) states that Opco 2 may obtain a dividend refund in respect of taxable dividends paid on shares of its capital stock in its taxation year and at the time it was a private corporation.
In technical interpretation 2002-0128955 (the “Technical Interpretation”), the CRA took the position that a corporation is not entitled to a dividend refund under paragraph 129(1)(a) with respect to a dividend it is deemed to have paid under paragraph 84.1(1)(b).
Would the CRA still apply the position expressed in the Technical Interpretation in situations similar to the one described above?
As indicated in Q.1 of the 2019 APFF Roundtable we have concluded that 2002-0128955 no longer represents CRA’s position. The granting of a dividend refund to a corporation deemed by s. 84.1 to have paid a dividend provides an outcome that better accords with the integration principle.
The deemed dividend treatment under s. 84.1 allows the individual taxpayer on the receipt side to benefit from the integration mechanisms that are provided in the Act such as the gross-up and the dividend tax credit.
CRA also takes the position that, if the individual taxpayer is already a shareholder of the corporation, the individual can also benefit from another integration mechanism: the CDA account with respect to deemed dividend under s. 84.1. In our view, it is hard to justify why an individual taxpayer could benefit from the various integration mechanisms while the purchaser corporation could not.
Q.5 - S. 212.1(6) and post-mortem pipelines
In the 2018 Federal Budget, the Department of Finance expanded the scope of section 212.1 of the Act by including rules in subsections 212.1(5) to 212.1(7) that look through partnerships and trusts so that section 212.1 cannot be frustrated by transactions involving partnerships and trusts.
In general terms, section 212.1 applies when (i) a non-resident person disposes of shares of a corporation resident in Canada to another corporation resident in Canada with which the non-resident person does not deal at arm’s length and (ii) immediately after the disposition, the Canadian resident corporations are “connected”.
S. 212.1 is a rule that is meant to prevent cross-border surplus stripping and is similar to section 84.1 in the domestic context. However, generally, section 212.1 can result in a dividend deemed to be received by a non-resident of Canada where the fair market value of the non-share consideration received by the non-resident of Canada exceeds the paid-up capital of the shares disposed of, even where there is full adjusted cost base (“ACB”) in those shares.
The new look-through rules in ss. 212.1(5) to 212.1(7) may apply to certain common transactions.
In a post-mortem “pipeline” transaction context, a Canadian resident estate (the “Trust”) has full ACB and low paid-up capital in shares of a private corporation resident in Canada (“Canco”).
The Trust transfers the shares of Canco to Holdco, a non-arm’s length Canadian resident corporation, for a note (the “Note”).
If the Trust has a non-resident beneficiary, such non-resident beneficiary would be deemed to receive a certain proportion of any non-share consideration (the Note) received by the Trust on the disposition of the Canco low paid-up capital shares.
This would result in a dividend deemed to the non-resident beneficiary, subject to Canadian withholding tax, notwithstanding the fact that the non-share consideration does not exceed the ACB of the Canco shares.
In this scenario, where section 84.1 would not apply because the Trust has full ACB in the Canco shares, would the CRA seek to apply s. 212.1 based on a technical application of the look-through rules, even though the non-share consideration received by the Trust does not exceed the ACB of the shares that are disposed?
Charette: Although the Department of Finance provided some surprise good news this morning, the answer below is still relevant for non-GREs. The written response will be revised to refer to this comfort letter.
The aim of s. 212.1 is to prevent cross-border surplus-stripping. It was amended by Budget 2018 to provide the look-through rules in ss. (5) through (7). Where a Canadian-resident trust disposes shares of a Canadian-resident corporation, those look-through rules will apply to the non-resident beneficiary regardless of whether the trust has full ACB of the shares of the Canco.
Under s. 212.1(6)(b)(i), there will be a deemed disposition by each non-resident beneficiary, based on the fair market value of the beneficiary’s interest in the trust, divided by the fair market value of all the direct interests in the trust. Under s. 212.1(6)(b)(ii), each non-resident beneficiary will be deemed to have received consideration other than the shares of the purchaser corporation, and that consideration received will, again, be equal to the proportion of their interest in the trust. If that amount exceeds the PUC of the disposed-of shares, and all the conditions of s. 212.1(1) have been met for the non-resident beneficiary, that amount in excess of the PUC would generally be a deemed dividend under s. 212.1(1.1).
Q.6 - Distribution of TCP by resident trust to NR-owned corporate beneficiary
At the 2017 CTF Annual Conference the CRA addressed a situation involving the distribution of property by a Canadian resident discretionary trust to a Canadian corporation whose shares would be wholly owned by a nonresident beneficiary. CRA’s view was that the situation addressed circumvented the application of subsection 107(5) and 107(2.1) in a manner that frustrates or defeats the object, spirit or purpose of those provisions, subsections 70(5), 104(4) and 107(2) and the Act as a whole.
Would CRA’s view be different where the property distributed from a Canadian resident discretionary trust constituted taxable Canadian property (but not property described in subparagraphs 128.1(4)(b)(i) to (iii) nor a share of the capital stock of a non-resident-owned investment corporation)?
Charette: In the last few years , at the CTF and STEP roundtables, CRA has given its views on the tax implications associated with some 21 year disposition planning methods. Q.1 of the 2016 CTF Roundtable dealt with circumvention of s. 104(5.8). Q.1 of the 2017 CTF Roundtable dealt with the circumvention of s. 107(5) by transferring, on a tax-deferred basis pursuant to s. 107(2), property that was not taxable Canadian property to a newly formed Canadian corporation which was a corporate beneficiary. It was determined at the time that such transfers avoided the application of s. 107(5) because the corporate beneficiary was resident of Canada. In that situation, the application of s. 107(5) would have triggered a deemed disposition by the trust of the property by virtue of s. 107(2.1).
The present scenario is different because the property transferred to Canco is taxable Canadian property. A similar file was recently reviewed by the GAAR Committee, where the property transferred was shares of a Canco that fell within para. (d) of “taxable Canadian property” in s. 248(1). S. 107(5) contains an exception that carves out certain types of property from the ambit of that subsection, including property identified in any of ss. 128.1(4)(b)(i)-(iii) and also shares of a non-resident owned investment corporation. I will focus on s. 128.1(4) property.
The property identified by s. 128.1(4) comprises real or immovable property situated in Canada, Canadian resource property, timber resource property, Class 14.1 property that are used in a business carried on in Canada, and an excluded right or interest as defined under s. 128.1(10). In the present situation, a share of a corporation, that satisfies the requirement of para. (d) of the s. 248(1) definition of TCP, is not identified by the carve-outs in s. 107(5).
The Committee therefore recommended that GAAR be applied to that transaction or series of transactions on the basis that, even though the property that was transferred was TCP, it was not the type of property that was specifically carved out in s. 107(5). The Committee also considered that such a transfer is an abuse or misuse of ss. 107(2), (2.1) and (5).
CRA has significant concerns about transactions like this one, and will consider applying GAAR when faced with similar transactions unless substantial evidence is provided that GAAR does not apply.
CRA is also of the view that GAAR may be applicable in other situations that involve the distribution of property from the family trust to a Canco with one or more non-resident shareholders. For example, it would be appropriate to apply the same conclusion whether or not the transactions are undertaken to avoid the 21-year disposition rule under s. 104(4).
CRA will therefore not provide any advance income tax ruling on proposed transactions in this area, absent substantial evidence that GAAR should not apply.
Q.7 – S. 120.4(1.1)(b)(ii) where share distribution by inter vivos trust on death
Does subparagraph 120.4(1.1)(b)(ii) apply in two fact scenarios?
Background – before Mr. X’s death
- Mr. X owns 100,000 voting preference shares of a corporation (“Investco”)
- The common shares of Investco are non-voting and are held by a discretionary inter vivos trust (the “Family Trust”). The settlor of the Family Trust is Mr. X. The trustees of the Family Trust are Mr. X and two arm’s length third parties. The beneficiaries of the Family Trust include Ms. X, Ms. Y and Ms. Z. Ms. X is Mr. X’s spouse. Ms. Y and Ms. Z are the children of Mr. X and Ms. X.
- The Family Trust acquired its common shares of Investco as a result of an estate freeze.
- The terms of the Family Trust include the restrictions described in subsection 74.4(4). But for such restrictions, subsection 74.4(2) would have applied to Mr. X as a result of the freeze.
- None of the other attribution rules in sections 74.1 to 74.3 and subsection 75(2) will apply.
- Mr. X, Ms. X, Ms. Y and Ms. Z are now all over age 18.
- Investco’s business is carried on by Mr. X and Ms. Y.
- Mr. X has worked in Investco’s business on average for more than 20 hours per week a year for more than five years.
- In Year 1, Mr. X passes away. Pursuant to the terms of Mr. X’s will, Mr. X leaves one preference share to Ms. Y, one preference share to Ms. Z and 99,998 preference shares to Ms. X.
- In Year 2, Investco pays a dividend on its common shares. The Family Trust pays the dividend to Ms. Z in the year and makes a designation in respect of Ms. Z under subsection 104(19). The Family Trust deducts the amount of the dividend from its income under subsection 104(6) and the amount is included in Ms. Z’s income as a dividend received on the Investco common shares under subsections 104(13) and (19).
Under paragraph 120.4(1.1)(a), an individual may be deemed to be actively engaged in a business in a taxation year where the individual works at least an average of 20 hours per week during the portion of the year in which the business operates.
Paragraph 120.4(1.1)(b)(ii) expands the scope of the deeming rule in paragraph 120.4(1.1)(a) in certain circumstances for property acquired as a consequence of the death of another person.
a) Would the taxable dividend deemed to be received by Ms. Z be an excluded amount because it is an amount derived directly or indirectly from an “excluded business” of Ms. Z taking into consideration the application of the deeming rule in subparagraph 120.4(1.1)(b)(ii)?
b) Assume the same facts as Question 7(a), except that Mr. X leaves all of his preference shares to Ms. X and the terms of the Family Trust dictate that, on the death of Mr. X, the trustees of the Family Trust are subject to an absolute obligation and must wind-up and distribute the trust property (i.e. the Investco common shares) equally to Mr. X’s children in satisfaction of their capital interest.
- As a result, and pursuant to the terms of the trust, the dividend paid by Investco in Year 2 will be received directly by Ms. Z on the Investco common shares distributed to her on the winding-up of the Family Trust following the death of Mr. X.
Would the CRA consider the acquisition of shares by Ms. Z to be “as a consequence of the death” of Mr. X for the purposes of paragraph 120.4(1.1)(b)?
Preliminary Response (a)
Prud'Homme: S. 120.4(1.1)(b) provides a continuity rule for inherited property. In this first scenario, in order for that deeming rule to apply to the dividend, the amount must be in respect of property that was acquired by, or for the benefit of, the specified individual as a consequence of the death of another person (i.e. Mr. X).
Because the dividend is in respect of the common shares of Investco, the deeming rule would not apply, because those shares are owned by the family trust and were not acquired by, or for the benefit of, Mrs. Z as a consequence of the death of Mr. X.
The excluded business exception will therefore not apply in respect of Ms. Z. The taxable dividend will be subject to TOSI unless it falls within another category or excluded amount.
Preliminary Response (b)
Prud'Homme: In this case, the amount of the dividend received by Ms. Z was in respect of the Investco common shares acquired by her on the winding up of the inter vivos trust. In the past, the CRA has taken the position that property received from an inter vivos trust, the terms of which require without condition that the trust distribute the property to the individual on the death of another person, can be considered to be property that was acquired as a consequence of the death of the person.
Applying that interpretation to the present scenario, the Investco common shares received by Ms. Z from the trust will be considered property that was acquired by, or as a consequence of, the death of another person, so that the deeming rule in s. 120.4(1.1)(b)(ii) will apply to the amount of the dividend received by Ms. Z on the Investco common shares, and will deem Ms. Z to have been actively engaged in Investco’s business based on Mr. X’s previous involvement in the business.
As a result, Investco’s business will be an excluded business of Ms. Z and the amount of the dividend received on the Investco common shares will be an excluded amount and not subject to TOSI.
However, a different result would apply where it is reasonable to infer in the circumstances that the terms of the trust were arranged to inappropriately benefit from s. 120.4(1.1)(b) in light of the stated object and purpose of the provision, including by reason of the application of GAAR.
Regarding GAAR, CRA would look for a sufficient connection between the deceased person and the property that is being distributed, and the specified individual, to justify or support the application of the deeming rule in these circumstances.
Q.8 – TOSI and replacement of excluded business
- ABC Co. is owned 100% by a family trust, of which Mr. and Mrs. A are both beneficiaries.
- ABC Co. historically carried on a trucking business from incorporation in 1990, and each of Mr. and Mrs. A were actively engaged on a regular, continuous and substantial basis throughout all of the years of its operations.
- The business operations were sold in 2018, and the proceeds have been invested inside ABC Co. ABC Co. now carries on an investment business.
- Mrs. A is active in the investment business but Mr. A is not.
- As Mr. and Mrs. A, who are both over 24 years old, do not own shares of ABC Co. directly, they will not meet the “excluded share” exception.
Will the excluded business exception apply to Mr. A, given that he had previously been actively engaged on a regular, continuous and substantial basis in the trucking business carried on by ABC Co. for more than five years, notwithstanding that the trucking business has ceased and the proceeds from the sale of its assets have been invested in ABC Co.’s investment business?
Prud'Homme: Here, the trucking business operations have completely ceased, and its assets sold and reinvested into the investment business carried on by ABC Co. The investment business is a related business in respect of Mr. A, a specified individual, since Mrs. A, a source individual, is actively engaged in the activities of ABC Co.
The investment business directly carried out by ABC Co. is clearly not the same business as the former trucking business. Any taxable dividends that Mr. A is deemed to receive are considered to be derived directly or indirectly from such investment business. If Mr. A is not actively engaged in the investment business, the amount will not be an “excluded amount” under (b)(ii) of that definition, because such amount will not be “derived directly or indirectly from an excluded business” of Mr. A “for the year.” Those are the key words.
Consequently, the taxable dividend received by Mr. A, will be split income, subject to TOSI (unless another excluded amount exception applies).
Q.9 - TOSI related business exclusion after arm's length sale
For individuals age eighteen or over, income which is not derived directly or indirectly from a related business in respect of the individual is an “excluded amount” (subpara. (e)(i) of the definition of that term in subsection 120.4(1)). Consider the situation where a specified individual (the “Individual”) receives a dividend from a corporation (the “Corporation”) which, in the past, carried on a related business, but did not do so during the year.
- the corporate income that supports the dividend is derived, directly or indirectly, from the related business carried on by the Corporation in the past; and
- the Corporation did not derive, directly or indirectly, income from a related business in respect of the Individual other than the related business carried on in the past.
Would the dividend be an “excluded amount” under this provision in the following situations:
a) The business ceased in a prior year, and is no longer operated by anyone.
b) The business was sold to an unrelated corporation in a prior year and is still active, but no source individual in respect of the dividend recipient was active in the business in the year of the dividend.
c) The business was sold to an unrelated corporation in a prior year and is still active, but a source individual in respect of the dividend recipient was active in the business in the year of the dividend (for example, a former owner related to the Individual is employed by the new owners in the business, perhaps for a transitional period).
Preliminary Response (a)
Prud'Homme: In this scenario, operations have ceased. The expression “derived directly or indirectly from a business” has a broad meaning that is clear. In this example, the income was not derived from a related business for the year because the business was not carried out in the particular year.
As a result, the dividend received by the individual will constitute an “excluded amount” and will not be subject to TOSI.
Preliminary Response (b)
Prud'Homme: The dividend received by the individual was derived directly or indirectly from a related business carried on in the past. However, in the given scenario in which the business was sold to an unrelated corporation in a prior year and is still carried on, but there is no source individual actively engaged in the year of the dividend, the dividend received by that individual in that subsequent year would not be considered to have been derived from a related business for that year.
As a result, the dividend received by the individual would be considered to be an “excluded amount” and would not be subject to TOSI.
It is assumed that the source individual in this example would no longer retain any ownership in the business. If that is not the case, para. (c) of the definition of “related business” could apply.
Preliminary Response (c)
Prud'Homme: The twist here is that there is a transitional period.
The dividend received by the individual will be considered to be derived directly or indirectly from a related business but, where the business is sold to another unrelated corporation in a prior year yet still carried on, and the source individual is active in the business in the year of the dividend, then the business carried on by the unrelated corporation will constitute a related business for that year.
The business carried on by the unrelated corporation will constitute a related business until the source individual is no longer actively engaged in the activities of the unrelated corporation. Again, depending on the facts, another exception from the TOSI may apply.
Q.10 – Reverse earnout payments to non-residents
Shareholders of a Canadian resident corporation (“Canco”) that carries on an active business sell their shares to an arm’s-length third party. The shares of Canco are not taxable Canadian property. The purchase price for the shares includes an earnout payment. The earnout relates to the goodwill of the business (EBITDA over a two-year period). The earnout is paid in the third year following the closing of the share purchase. The Canadian resident shareholders rely on the CRA administrative position in IT-426R to obtain capital gains treatment on the sale of the shares and to use the cost recovery method in reporting their gain. There are also some non-resident shareholders.
Please confirm that subparagraph 212(1)(d)(v) does not require that the purchaser withhold tax when the earnout payment is made to the nonresident shareholders.
If there is withholding under subparagraph 212(1)(d)(v), please confirm that the requirement to withhold does not apply where the recipient is resident in a treaty country that has a typical exemption from Canadian tax on gains realized on the sale of shares that do not derive more than 50% of their value from real or immovable property in Canada.
Charette: IT-426R sets out the information on earnouts. Paragraph 2 sets out the six conditions for using the cost recovery method. For the purposes of this question, we will consider the first four:
(a) The vendor and purchaser are dealing with each other at arm's length.
(b) The gain or loss on the sale of shares of the capital stock of a corporation is clearly of a capital nature.
(c) It is reasonable to assume that the earnout feature relates to underlying goodwill the value of which cannot reasonably be expected to be agreed upon by the vendor and purchaser at the date of the sale.
(d) The earnout feature in the sale agreement must end no later than 5 years after the end of the first taxation year of the corporation (whose shares are sold) in which the shares are sold. For the purposes of this condition, the CRA considers that an earnout feature in a sale agreement ends at the time the last contingent amount may become payable pursuant to the sale agreement.
Regarding the first question, a similar question was asked at the 2005 APFF Roundtable. In one of the sub-questions, CRA held that an amount payable under an earnout feature in the sales agreement is subject to s. 212(1)(d)(v), but indicated that, in a situation where the shares are TCP, it would not generally apply s. 212(1)(d)(v) to the TCP, assuming that the first four conditions in IT-426R, para. 2 are met.
This answer to the first question renders the second question moot.
For shares that are not TCP, as indicated in the 2005 answer, it is the CRA’s view that the fair market value of the right to receive an amount under the earnout clause should generally be included in the proceeds of disposition where the four conditions of paragraph 2 of IT-426R are met.
In the situation provided, s. 212(1)(d)(v) should not apply.
Q.11 – Common Reporting Standards (CRS)
How is the CRA using the CRS information obtained that is now in its possession? What methodology is being used? How is technology being deployed? What insights are being gathered in terms of patterns, outliners, etc. in the taxpayer population? How is the information being shared amongst the CRA’s peer group?
Charette: This answer was prepared by our colleagues in Compliance.
CRA is now using better data and a better approach to deliver better results. Information sharing and international cooperation are key to fighting aggressive tax avoidance. Canada is continuing to build strong relationships with its international partners to implement better tools and better approaches to combatting aggressive tax avoidance, and the Common Reporting Standard (CRS) is one of those tools.
Currently, under the CRS, Canada has activated exchange relationships with 90 jurisdictions for incoming CRS data and 64 for outgoing CRS data. CRA expects that the number of activated exchange relationships under CRS will increase in the coming years.
The CRS provides information to CRA on Canadian overseas financial accounts, and this information is helpful to identify offshore financial accounts held by Canadian residents and assess potential compliance issues with Canadian tax law. This information is analyzed to identify taxpayers who are avoiding their Canadian tax obligation. More specifically, CRS information is being incorporated in CRA’s system and made available to those involved in the spectrum of compliance and collection efforts.
Operationally, CRS information complements CRA’s existing risk assessment process and contributes to compliance treatment based on risk. The CRA strategy for the use of the CRS data includes the data validation cleansing and matching of incoming CRS data to Canadian taxpayers’ accounts, an analysis and risk assessment of taxpayer data, and sharing of CRS data with appropriate compliance programs to determine compliance treatment such as compliance projects, educational campaigns, targeted audience, etc., depending on the level of risk.
CRA is also exploring ways to leverage CRS data to improve taxpayer service and encourage voluntary compliance, and continues to work with international partners through various groups, such as the OECD and foreign tax law administrations, in order to identify best practices for the use of the CRS data that is being collected.
Q.12 – Cost-recovery earnout method based on subsidiary goodwill
A taxpayer sells his/her shares of a corporation (“Company A”). The only assets owned by Company A are the shares of another corporation (“Company B”).
The proceeds of disposition of the shares of Company A are determined pursuant to an earnout clause in an agreement. In this situation, the quantum of proceeds is determined by reference to the future earnings generated by Company B. Under this scenario, the earnout feature relates only to the underlying goodwill of Company B.
Interpretation Bulletin IT-426R [archived] describes the cost recovery method of reporting capital gains or capital losses on the sale of shares subject to an earnout agreement.
Does the CRA agree to apply the cost recovery method to the sold shares of Company A?
Prud'Homme: The mere fact that the earnout feature relates to the underlying goodwill of Company B will not preclude the application of the cost recovery method.
Whether the conditions in IT-426R are met in a given fact pattern requires an analysis of all relevant facts and circumstances, but generally this position reverses 2013-0480561E5 and instead follows the approach in 2015-0589471R3.
The interpretive issue stems from IT-426R, para. 1, which refers to the “underlying assets of the corporation., and this position is applying that approach.
Q.13 – Use of Midco on triangular amalgamation
- Subco is a wholly-owned subsidiary of Parentco.
- Parentco owned no shares in Targetco.
- Subco, Targetco and Parentco are taxable Canadian corporations.
- Subco and Targetco amalgamate to form Amalco under subsection 87(9).
- The former shareholders of Targetco receive shares of Parentco.
- Parentco receives shares of Amalco
- Para. 87(9)(a.4) and (c) apply so that the cost of the shares of Amalco held by Parentco are not derived from the value of the consideration given.
- Subco is a wholly-owned subsidiary of Midco.
- Midco is a wholly-owned subsidiary of Parentco.
- Parentco owned no shares in Targetco.
- Subco, Midco Targetco and Parentco are taxable Canadian corporations.
- Subco and Targetco amalgamate to form Amalco.
- The former shareholders of Targetco receive shares of Parentco.
- Parentco receives shares of Midco.
- Midco receives shares of Amalco.
In CRA documents February 1991-110 and February 1991-108, the CRA confirmed that the compensatory shares so issued by Holdco to Parentco would have a FMV tax basis.
Can the CRA confirm if this position is still applicable?
Prud'Homme: In the first scenario, the shares received by Parentco from Amalco are subject to the application of ss. 87(9)(a.4) and (c), so that the cost of the shares of Amalco held by Parentco will not be derived from the value of the consideration given (that is the shares issued by Parentco to acquire the shares of Amalco) to the former shareholders of Targetco.
In the second scenario, involving the insertion of a Midco, the shares of Amalco that are received by Midco are subject to the application of ss. 87(9)(a.4) and (c), but the shares of Midco received by Parentco are not technically subject to those limits.
That said, where an amalgamation is subject to the application of s. 87(9), and is structured in a manner to frustrate the application of ss. 87(9)(a.4) and (c), it will potentially be subject to the application of GAAR.
Therefore, on a prospective basis, taxpayers should not rely on documents 1991-110 and 1991-108 without considering the potential application of GAAR.
Some further comments: s. 87(9), triangular amalgamations occur as a tax-deferred event to the former shareholders of Targetco. We should query whether giving FMV tax basis to Parentco for the shares issued by Midco, which would be in excess of the basis described in ss. 87(9)(a.4) and (c), is in accordance with the scheme of such provisions, and the scheme of the Act’s rollover provisions in general. This result does not seem to be in-line with the rules on corporate tax integration.
Q.14 – Replacement property acquired before disposition of former property
The replacement property rules in section 44 permit a taxpayer to defer taxation on any capital gain realized on the disposition of a former property where it is replaced by a replacement property in accordance with the rules in section 44.
Consider this example: A manufacturer owns a plant. It needs to expand its operations and cannot do so on its current property. It acquires a piece of vacant land and proceeds to obtain approvals and to build a new plant. This process can take time, say three years from the date on which the vacant land is purchased to the date on which the property is available for use. The manufacturer moves its operations from the former property to the new property, and eight months after the move to the new property, sells the former property.
Can the CRA confirm that a property that is acquired in advance of the disposition of the former property can qualify as a replacement property?
Charette: The requirements for the application of the replacement property rules in ss. 13(4.1) and 44(5) include a condition is that it is reasonable to conclude that the property was acquired by the taxpayer to replace the former property. This implies a degree of correlation or direct substitution – one might say a “causal relationship” – between the disposition of the former property and the acquisition of the new one.
Even though the property is purchased under a business expansion, this will not, in itself, prevent it from being considered a replacement property.
For the purpose of the replacement property rules in the Act, there is no requirement that the replacement property be acquired after the former property is disposed of. If the replacement property conditions are met, there is no impediment to the new property being a replacement property.
While it is still a question of fact, the acquisition of the new property in advance of the disposition of the former property again would not, in itself, prevent it from being a replacement property.
Q.15 – 104(13.4) and Alter Ego Trusts/ Joint Spousal Trusts
Pursuant to paragraph 104(13.4)(a), life interest trusts, such as Alter Ego Trusts and Joint Spousal Trusts, have a deemed year end on the date of the death of the last life interest beneficiary. Paragraph 104(4)(a) deems the trust to have disposed of certain property of the trust at the date of death.
Tax on the resulting capital gains is payable by the trust on the trust’s “balance-due day” as defined in subsection 248(1).
If a loss occurs in the first taxation year after death, this loss may be known at the time of filing both tax returns for the calendar year in which the death occurred.
Can a loss which occurs in the taxation year immediately after the death be reported on the tax return filed for the date of death, rather than requiring the filing of a T3A loss carryback request?
Charette: It will be necessary to file two returns and a loss-carryback request.
The application of s. 104(13.4) will deem a year end and start a new year, resulting in two taxation years in the same calendar year. The description of capital gains and capital loss in s. 3 and s. 39(1) refer to the taxation year, so each provision will have to be applied to the specific taxation year: report the gain in the first year and the loss in the second one.
S. 104(13.4)(c)(i) provides some modifications to the wording of s. 150(1)(c) and also to s. (a)(ii) of the definition of “balance-due date”. It essentially changes “taxation year” to “calendar year.” Consider a simple situation where a capital loss is incurred in the second taxation year ending December 31st and a capital gain is realized in the first taxation year ending July 31st, and the capital loss is equal to or greater than the capital gain the first taxation year.
By filing the two tax returns, and the loss-carryback request before the balance due-date, once the first taxation year has been reassessed to recognize the loss for the second taxation year, the effect should be that no Part I tax is payable, and the Part I tax that was initially assessed on the first taxation year should be reversed.
Although it is more work, s. 104(13.4) thus should provide an easy way out. However, the loss of the second year cannot simply be reported in the first taxation year of the trust.
Q.16 – Eligible dividend designations by private corporations
In order for a dividend to be an eligible dividend, subsection 89(14) requires that the dividend must be designated as such by notifying the dividend recipient in writing at the time the dividend is paid. The CRA has taken the administrative position that a public corporation can meet this requirement by posting a statement on its website that “all dividends are eligible dividends unless indicated otherwise”.
Similarly, a notice in an annual or quarterly report that an eligible dividend has been paid is considered valid for that quarter. This is a reasonable and practical approach.
Is the CRA willing to adopt a practical approach and extend that administrative position to private corporations by permitting a Canadian controlled private corporation (“CCPC”), as that term is defined in subsection 125(7) of the Act, to meet this requirement by providing its shareholders with a written notice in advance that all dividends are eligible dividends unless otherwise indicated?
Prud'Homme: No. There are limits to how “practical” we can be!
Note: comments in the official response included:
Since it is our understanding that most public corporations will generally not have an LRIP balance, dividends paid by a public corporation should generally be eligible dividends. Consequently, our administrative position with respect to public corporations is intended to alleviate certain administrative hardships vis-à-vis the designation requirements, while continuing to preserve the dividend recipient’s entitlement to certainty with respect to the tax implications of corporate distribution. ...
.. 2009-0347491C6 … provided examples of acceptable notifications of the payment of an eligible dividend from a corporation other than a public corporation to the dividend recipient. Examples of notification included identifying eligible dividends through letters to shareholders and dividend cheque stubs, or where all of the shareholders are Directors of a corporation, a notation in the Minutes.
With respect to a notification by way of notation in the Minutes, we have allowed corporations, other than public corporations, to notify their shareholders of an eligible dividend designation in this manner, where all of the shareholders are the directors of the corporation. Our position is based on the fact that, for practical purposes, non-public corporations will generally have fewer shareholders than public corporations, and such shareholders may often have a seat on the corporation’s Board of Directors in order to take part in the internal management of the corporation. Thus, where all of the shareholders are also directors of the corporation, we consider that a directors’ resolution declaring a dividend and containing a designation that such dividend is an eligible dividend constitutes valid notification in writing for the purposes of subsection 89(14). In these circumstances, such resolution provides certainty to the taxpayers receiving the dividends with respect to the tax consequences of the corporate distributions.