8 October 1999 APFF Roundtable Q. 1, 9M19190 - APFF 1999 ROUND TABLE

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 1

Immigrant acquiring shares in a foreign corporation, which is the immigrant's employer

An American citizen received stock options from an American public corporation. The taxpayer received these stock options while the taxpayer was working for the American public corporation and living in the United States. At no time during the employment with the American public corporation did the taxpayer reside in Canada. However, before the taxpayer exercised the stock options, the taxpayer became a Canadian resident for the purposes of the Act. The taxpayer is no longer an employee of the Corporation and is not employed by a corporation with which the corporation deals at non-arm's length.

1.1 Does paragraph 128.1(1)(b)(v) of the Act apply to this situation?

1.2 To what extent does section 7 of the Act apply when this taxpayer exercises the stock options?

1.3 Could the taxpayer claim the deduction provided for in paragraph 110(1)(d) of the Act if the shares qualify as "prescribed shares" within the meaning of the Act and the Income Tax Regulations?

Response from the Department of Revenue

1.1 The exception to the rule governing the deemed disposition of property by a taxpayer who recently took up residence in Canada in paragraph 128.1(1)(b)(v) of the Act applies to the right to acquire shares of the capital stock of a corporation when section 7 of the Act would apply to the taxpayer if the taxpayer disposed of the right to a person with whom the taxpayer was dealing at arm's length.

In our opinion, section 7 of the Act would apply to the situation described if the taxpayer disposed of the taxpayer's rights to acquire the shares to a person with whom the taxpayer was dealing at arm's length. Consequently, the exception provided for in paragraph 128.1(1)(b)(v) of the Act would apply to the situation described, and the taxpayer would not be deemed to have disposed of the taxpayer's rights to acquire the shares because the taxpayer immigrated to Canada.

1.2 Section 7 of the Act would apply after the taxpayer immigrated to Canada and exercised the right to acquire the shares. This taxpayer would then be deemed to have received, because of the taxpayer's employment, in the taxation year in which the taxpayer exercised the taxpayer's right to acquire the shares, a benefit equal to the amount by which the shares at the time the taxpayer acquired them exceeded the total of the amount paid or to be paid to the corporation to acquire these shares and the amount the taxpayer paid to acquire the right to acquire the shares.

1.3 In this particular case, we feel that if the other conditions of paragraph 110(1)(d) of the Act are met, particularly those in paragraph 110(1)(d)(ii) of the Act, this taxpayer could deduct an amount equal to 1/4 of the amount of the benefit deemed by subsection 7(1) to have been received by the taxpayer in the year in respect of the share.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 2

LLC - Deductibility of interest

A Canadian public corporation ("Publico") decides to invest in its wholly owned US subsidiary, a Limited Liability Company ("LLC") as defined by US corporate law. To do so, this corporation decides to borrow C$1 million in order to subscribe an amount not exceeding this amount in units ("shares") of the LLC.

i) Is the interest on this loan deductible in Canada?

ii) If this influx of funds was used to buy preferred shares, would the interest on this loan be deductible?

Response from the Department of Revenue

We presume that the LLC referred to in the question is a corporation for the purposes of the Act.

When the borrowed money is used to acquire units of a LLC which have the same features as a common share, the Department generally feels that the interest on the borrowed money will be deductible if the potential income of the holder can exceed the cost of interest.

When the features of the units acquired have the same features as a preferred share, the Department feels that the amount of interest not exceeding the income (dividends) received will be deductible.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 3

Repatriating capital from a LLC

A Canadian public corporation ("Publico") decides to invest in its wholly owned US subsidiary, a Limited Liability Company ("LLC") as defined by US corporate law. To do so, it subscribes an amount not exceeding $1 million in units of the LLC. If Publico decides to repatriate the amount of the subscription to Canada, what tax treatment will the funds from the initial subscription in the LLC receive when they are repatriated? Is it a return on capital or an inter-corporate dividend?

Response from the Department of Revenue

In the foregoing situation, after the initial subscription of $1 million, we presume that the "paid-up capital", as defined in subsection 89(1) of the Act, of the "shares" of the LLC held by Publico would be $1 million.

In a given situation, whether an amount is paid as a reimbursement of an initial subscription in a LLC is a question of fact. However, in a case where an amount paid to Publico by the LLC could be considered a reimbursement of its initial subscription under its relevant constituting documents, the amount paid would be considered a reduction in the paid-up capital rather than a dividend for the purposes of the Act.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 4

Loss deemed nil: impact on earned income on hand

Under paragraph 40(2)(g)(ii) of the Act, the losses stemming from certain transactions are deemed to be nil under certain circumstances.

Provision is made in subsection 55(2) of the Act for the concept of income earned or realized by any corporation after 1971 ("safe income") which means that, under certain circumstances, an inter-corporate dividend can be distributed tax free. Over the years, the Department has developed the additional concept of "safe income on hand", which is a more restrictive concept than safe income.

Since the loss is deemed nil, it therefore does not reduce safe income. However, does Revenue Canada feel that a loss deemed nil reduces the safe income on hand?

Response from the Department of Revenue

The safe income from a share of a corporation means the net income of the corporation determined in accordance with the Act and adjusted by the application of paragraphs 55(5)(b), (c) or (d) of the Act, depending on the case. Safe income on hand means the safe adjusted income that could reasonably be considered to be contributing to the capital gain that would have been earned on the disposition of a share of a corporation.

When a corporation incurred a loss on the disposition of a property, and, as a result of paragraph 40(2)(g)(ii) of the Act, this loss is deemed nil, the loss in question would not be included in calculating the corporation's net income as determined in accordance with the Act, and would automatically have no impact on the calculation of safe income. Since this loss is not considered to be contributing to the capital gain that would have been earned on the disposition of a share of the corporation, it should be deducted when calculating the safe income on hand.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 5

Application of subsection 55(2) of the Act

Mr. A owns all of the issued shares of the capital stock of Portco corporation. Mr. A has de jure control of Portco for the purposes of the Act. His two adult children, Mr. B and Ms C, each hold 50% of the common (voting and participating) shares of ABC corporation through their respective holding companies, that is, B Inc. and C Inc. The common shares of the capital stock of ABC Inc. which are held by B Inc. and C Inc. are the only issued shares of the capital stock of ABC Inc. The paid-up capital of each of the issued common shares of the capital stock of ABC Inc. is $1, the adjusted cost base, $1, and the fair market value, $1,000. The safe income on hand per share is $600.

Question

Is subsection 55(2) of the Act applicable in both of the following two situations?

1. ABC Inc. buys all of its common shares held by Mr. B's holding company. C Inc. thus becomes the sole holder of ABC Inc. shares ("Situation 1" below).

2. ABC Inc. simultaneously purchases all of its issued common shares, and Mr. A subscribes to new common shares ("Situation 2" below) immediately after.

Response from the Department of Revenue

For the purposes of our response, we have presumed that B Inc. and C Inc. form a group of persons who have de jure control of ABC Inc. for the purposes of the Act. The Department feels that in nearly all cases where the voting rights in a corporation are exercised equally by two persons, the corporation is controlled by the group composed of the two persons (see Page 7 of Income Tax Technical News No. 7 dated February 21, 1996 in this regard).

Mr. A and Ms C are related persons as defined in paragraphs 251(2)(a) and 251(6)(a) of the Act because they are connected by a blood relationship. According to paragraphs 251(2)(a) and 251(6)(a) of the Act, Mr. A and Ms B are also related. However, Mr. B and Ms C are not related for the purposes of section 55 of the Act because of paragraph 55(5)(e)(i) in which provision is made that a person shall be deemed to be dealing with another person at arm's length if the person is the brother or sister of the other person.

B Inc. and Portco, as well as C Inc. and Portco are related under paragraph 251(2)(c)(ii) of the Act because each of the corporations is controlled by one person and the person who controls one of the corporations is related to the person who controls the other corporation. B Inc. and C Inc. are related under subsection 251(3) of the Act because they are both related to the same corporation: Portco. Paragraph 55(5)(e)(i) of the Act does not prevent B Inc. and C Inc. from being related to each other for the purposes of section 55 of the Act. We feel that this finding is debatable in terms of tax policy, and we have informed the Department of Finance.

B Inc. and C Inc. form a related group as defined in subsection 251(4). B Inc. and ABC Inc. as well as C Inc. and ABC Inc. are related to each other under paragraph 251(2)(b)(ii) of the Act because A Inc. and B Inc. are each a member of a related group that controls ABC Inc.

Under subsection 55(4) of the Act, B Inc. and C Inc. and ABC Inc. could sometimes not be related for the purposes of section 55 of the Act if it is reasonable to consider that one of the main reasons Mr. A acquired shares in Portco corporation was to make B Inc., C Inc. and ABC Inc. related, so that subsection 55(2) of the Act would not apply.

It therefore follows that, for the purposes of paragraph 55(3)(a) of the Act (except if subsection 55(4) of the Act otherwise applies), that in the case where B Inc. would be the dividend recipient, ABC Inc. and C Inc. would not be "unrelated persons" within the meaning of paragraph 55(3.01)(a) of the Act; and that, in the case where B Inc. and C Inc. were the dividend recipients, ABC Inc. and Mr. A would not be "unrelated persons" within the meaning of paragraph 55(3.01)(a) of the Act.

Consequently, subsection 55(2) of the Act would not apply because of the purchase of B Inc. shares in Situation 1 above, or because of the purchase of B Inc. and C Inc. shares in Situation 2, insofar as subsection 55(4) does not apply, because there are no "unrelated persons" involved in the transactions for the purposes of paragraph 55(3)(a), and as a result, none of the conditions provided for in paragraph 55(3)(a) of the Act were met.

Comments from the Department of Finance

As mentioned at the 1998 Conference, subsection 55(4) of the Act constitutes a specific anti-avoidance provision to ensure that subsection 55(2) of the Act is applied. Provision is made, among other things, in subsection 55(4) of the Act that where it can reasonably be considered that one of the purposes of a series of transactions or events was to cause persons to be related to each other so that subsection 55(2) of the Act would not apply, those persons shall be deemed not to be related to each other. It is therefore a question of fact whether subsection 55(4) applies.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 6

Interest on participating loan

During the Round Table on Federal Taxation at the 1998 APFF Conference, the Department of National Revenue expressed its position on the application of the principles raised by the Federal Court of Appeal in the Sherway decision. The Department explained that despite this decision, provision was not made in paragraph 20(1)(e) of the Act to allow payments made in consideration for using funds to be deducted. For its part, the Department of Finance had explained that it did not plan to recommend changes further to this decision.

On March 8, 1999, the Department of National Revenue published Income Tax Technical News No. 16 in which it commented once again on the repercussions of the Sherway decision: "It is still our view that paragraph 20(1)(e) deals with other financing expenses excluding interest. We do not agree that paragraph 20(1)(e) permits the deduction of interest-like expenses. However, from the approach of the Court in both the Eglinton-Yonge and Sherway decisions, it seems that paragraph 20(1)(e) should be clarified to ensure it reflects the tax policy intent."

What are the intentions of Revenue Canada and the Department of Finance in this regard?

Response from the Department of Revenue

The Department has already informed the Department of Finance that it would be desirable to amend paragraph 20(1)(e) in order to clarify the underlying intention of the tax policy.

However, the Department's position on participating loans remains the same as that set out in Income Tax Technical News No. 16. In short, the Department feels that no provision is made in paragraph 20(1)(e) to allow payments made in consideration for using borrowed funds to be deducted.

Response from the Department of Finance

Revenue Canada consulted with the Department of Finance when it was formulating its position on the Sherway decision. We agree with Revenue Canada's conclusion concerning the application of paragraph 20(1)(e) on interest expenses. However, please note that in the Sherway case, the lender and the borrower were taxable. The Court itself pointed out that it was not an abusive situation or an actual case of tax avoidance. This clearly had an impact on our analysis. If the facts had been different, that is, if the borrower with taxable income had presented as interest the participation payment to a lender with no taxable income, we could have concluded that the payment had to be treated as a distribution of profits.

In this regard, the Court's observations on the possible application of paragraph 20(1)(e) of the Act concerning issuing costs are incidental and not necessarily binding. We feel that paragraph 20(1)(e) does not apply to interest on participating loans. Consequently, amendments to paragraph 20(1)(e) would only be planned as part of a technical bill.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 7

Mutual fund trust and capital dividend account

Under subsection 131(1) of the Act, a shareholder that is a corporation is allowed to include in its capital dividend account the non-taxable portion of the capital gains from a mutual fund even if it was the mutual fund that made the disposition, not the recipient corporation. Provision is not, however, made in the Act for similar treatment for the corporation that is the beneficiary under a mutual fund trust. Does the Department of Finance plan to amend the Act in order to allow this type of beneficiary to include in its capital dividend account the non-taxable portion of the capital gains received from a mutual funds trust?

Response from the Department of Finance

We are re-examining this issue and we recognize that there are principle-based arguments in favour of this type of amendment.

We note, however, that, based on the provisions of subsection 108(5) of the Act, the tax policy concerning trusts considers trusts as conduits only when provision is expressly made in the Act. Consequently, the fact that a "taxable capital gain" from a trust is transferred to a beneficiary does not necessarily mean that the latter received the non-taxable portion of the capital gain. The non-taxable portion of a capital gain can be kept in the trust and never designated to the beneficiary or it can be designated to a beneficiary other than the one who received the taxable capital gain.

In addition to the principle-based arguments mentioned above, the following points must be taken into account:

the CDA of a corporation at any particular time means (regardless of the other components not having an impact on this question) the excess of the non-taxable portion of the capital gain on the undeductible portion of capital losses (including, of course, the losses incurred in previous taxation years), while the "net taxable capital gain" of a trust for a particular year according to subsection 104(21.3), is the amount by which the total of the taxable capital gains of the trust for the year exceeds the total of its allowable capital losses for the year, and the amount if any deducted under paragraph 111(1)(b).

according to subsection 104(20), the capital dividends designated by a trust in respect of an incorporated recipient (as well as the portion of the capital distribution designated to the recipient) do not increase the CDA of the recipient, while the capital dividends received directly by a corporation from another corporation do increase the CDA of the recipient corporation. If the Act were amended to allow the addition of the non-taxable portion of the capital gains of a trust in the CDA, provision should also be made for the distribution of capital dividends by a trust to a recipient corporation.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 8

Classes of beneficiaries of a trust

Provision is made in subsection 104(2) of the Act that where there is more than one trust and all of the property of the various trusts has been received from one person and the income from these trusts accrues to the same beneficiary or group or class of beneficiaries, such of the trustees as the Minister may designate shall be deemed to be in respect of all the trusts an individual whose property is the property of all the trusts and whose income is the income of all the trusts.

How does Revenue Canada interpret the expression "class of beneficiaries"?

Would the members of the same family, for example, be the same class of beneficiaries?

Response from the Department of Revenue

Subsection 104(2) of the Act is an anti-avoidance provision to prevent a beneficiary, group or class of beneficiaries from being allowed to split income by using various trusts for the same beneficiary, group or class of beneficiaries. Subsection 104(2) is expressed in general terms.

The power to determine whether several trusts will be considered one individual for the purposes of the Act lies with directors of tax services offices in accordance with paragraph 900(2)(b) of the Income Tax Regulations.

For the purposes of this determination, certain criteria are examined, including:

- whether it was clear that the author intended to create separate trusts, according to the provisions of the will or trust deed;

- whether the trusts have common beneficiaries;

- whether the assets of each of the trusts are administered and accounted for separately;

- the powers of the trustees.

"Class of beneficiaries" is not defined in the Act. We should therefore use its common meaning. We would also take any definition into account that may exist in legislation governing trusts that would apply to the particular case. One definition of "class" in Webster's reads "a group, set, or kind sharing common attributes". The definition in the Oxford reads "group of persons or things having some characteristics in common".

We feel that the "members of the same family" could be one class of beneficiaries.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 9

Distribution of property by a legal representative

Information Circular IC 82-6R2 provides explanations concerning the certificate before distribution for which provision is made in subsection 159(2) of the Act.

According to Paragraph 2 of Information Circular IC 82-6R2, the legal representative does not need a clearance certificate before each distribution as long as sufficient properties are kept to pay any liabilities to the Department.

a) Does the "any liability" used in this paragraph of the Circular refer to any liability stemming from a notice of first assessment?

b) If the liability is not limited to that stemming from a notice of first assessment, is the legal representative of a taxpayer also responsible for proceeding with the distribution of property without obtaining a certificate?

Response from the Department of Revenue

a) We found no provision in subsection 159(3) limiting the Department to issuing only one notice of first assessment to a taxpayer. We feel that "any liability" in Paragraph 2 of the Circular means any liability stemming from a notice of first assessment and any liability stemming from any other notice of assessment.

b) Provision is made in subsection 159(2) of the Act that every legal representative shall, before distributing any property in the possession or control of the legal representative, obtain a certificate from the Minister. Through its administrative position, the Department recognizes that under certain circumstances, a legal representative may wish to proceed with a partial distribution before obtaining a certificate. However, according to subsection 159(3) of the Act, the fact that the legal representative distributes property before receiving a certificate could make the legal representative personally liable for the taxes, interest and penalties of the taxpayer or the amounts for which the legal representative is liable in his/her legal capacity, to the extent of the value of the property distributed without a certificate.

If the legal representative would rather obtain a certificate before the partial distribution, the Department will consider any such request.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 10

Increasing the adjusted cost base on winding-up

Provision is made in paragraph 88(1)(d.3) of the Act for a special rule governing increasing the adjusted cost base of certain property (other than depreciable property) of a subsidiary on winding-up in accordance with paragraphs 88(1)(c) and (d) of the Act when the control of this subsidiary is acquired by an estate as a consequence of the death of an individual. More specifically, a presumption is made in the Act to the effect that the estate acquires control of the subsidiary immediately after the death of a person with whom it had dealt at arm's length. When the shares of a corporation are held by a trust for a spouse, provision is made in the Act for a deemed disposition of the shares held by the trust when the spouse dies. However, since the trust still holds the shares, there is no acquisition of control. Would the Department of Finance consider proposing an amendment to the Act to permit the application of paragraph 88(1)(d) in a situation where the spouse, in the case of a trust for a spouse, dies when in theory there is no acquisition of control when the spouse dies?

Response from the Department of Finance

We are not aware of an actual situation like this. We are not willing to recommend changes to an already complicated section of the Act, unless a situation arises where it is impossible to make the adjustment provided for in paragraph 88(1)(d). Subsection 88(1) was amended in the past further to requests that seemed legitimate from a tax policy standpoint. Consequently, the Department of Finance is willing to examine any actual situation that the APFF brings to its attention with a view to determining the relevance of recommending an amendment.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 11
Gift by will to a foundation

When provision is made in a will for a gift to be made to a private foundation, but the foundation must be established by the estate (for example, the foundation does not exist when the death occurs), will the gift nonetheless be deemed to have been made by the deceased immediately before the individual died under paragraph 118.1(5) of the Act? If not,

(a) could the estate claim a credit for this gift under paragraph 118.1(3)?

(b) Will the Department accept the fact that a corporation was registered as a private foundation before the individual died solely to receive the gift when the individual died? Consequently, the foundation would not carry out any activities until the individual died. Since such a foundation could possibly exist and not carry out any activities for a certain period of time before the individual died, would Revenue Canada consider revoking its registration?

(c) Under paragraph 118.1(5), will a gift be deemed to have been made by an individual immediately before the individual died if the gift is made to a corporation that exists before the individual died, but which was not registered as a private foundation until after the individual died?

These questions stem from the comments in Interpretation Bulletin IT-226R, according to which one of the conditions of a gift being deemed to have been made is that the gift must vest with the recipient organization at the time of the transfer. A gift is vested if

(i) the person or persons entitled to the gift are in existence and are ascertained .... The comments in IT-226R seem to recognize that this type of gift can only be made after the individual dies, while the general principle set out in paragraph 118.1(5) is that a gift by a will exists when the individual dies.

Response from the Department of Revenue

Under paragraph 118.1(5) of the Act, a gift made according to an individual's will is deemed to have been made by the individual immediately before the individual died.

Paragraph 118.1(5) of the Act applies when, according to the terms of the individual's will, the individual makes a specific gift to an organization described in the definition of "total charitable gifts".

If a donee is not specified in the will, we feel that the gift will not be deemed to have been made by an individual as provided for in paragraph 118.1(5), immediately before the individual died.

The estate could claim a credit for a gift under paragraph 118.(3) on its T3 return, provided that the gift is made to a registered charity and meets the other conditions listed in Paragraph 3 of Interpretation Bulletin 110-R3.

The Department does not accept a corporation being registered as a private foundation for the sole purpose of receiving a gift. To become a registered charity, an organization must be created with a view to pursuing charitable objectives and activities.

If, however, the organization was created to pursue one of the objectives of a category of charity, it could be registered even if no charitable activities have been carried out and no income has been received. Consequently, the Department would not revoke the registration only because an organization is inactive because, since this organization has not issued any official receipts for gifts, it would not have to meet any disbursement quotas.

Interpretation Bulletin IT-226R sets out the Department's position on the gift of a residual interest in real property or equitable interest in a trust. These comments do not apply to the situation you have described.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 12

Gift to a private foundation

Under paragraph 38(a.1)(i) of the Act, a donor who makes a gift of securities to a public foundation is taxed only 37.5% on its capital gains. What is the Department of Finance's political reason for giving preferential treatment to a gift to a public foundation, and not to a private foundation?

Response from the Department of Finance

In its February 18, 1997 budget, the Government implemented special tax relief for gifts of securities listed on a stock exchange to a registered charity, other than a private foundation. This relief takes the form of a decrease from 75% to 37.5% in the capital gains inclusion rate stemming from gifts of these securities.

When this relief was announced, the Government was careful to point out that it was an "experimental" initiative, and that it would apply only from February 19, 1997 to the end of 2001, and would then be abolished if it did not increase gifts and equitably distribute the extra gifts among the various categories of charities.

Since this initiative was announced, we have received many requests to expand it to other properties that are given as gifts and to other donees, such as private foundations. It is still too early to evaluate whether to continue to provide this relief or to make certain specific changes to it. There are therefore no plans to change the scope of the initiative before the end of 2001.

The following explains why a gift to a private foundation is ineligible for the special relief.

When a taxpayer makes a gift to a registered charity, the taxpayer's federal-provincial tax savings is 50% of the value of the gift. In other words, the donor and Canadians in general contribute equally to the gift. In the case of a gift that is eligible for the reduced capital gains inclusion rate, the tax savings could easily be 60 to 70% of the value of the gift. In other words, Canadian taxpayers mainly fund the gift in this case. Under these circumstances, and given that a gift represents a purely discretionary outlay, it does not seem appropriate to ask these taxpayers to absorb the bulk of the cost of a gift to a private foundation, which, by its very nature, usually pursues limited objectives that Canadians in general do not necessarily support.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 13

TOB and taxable preferred shares

An offer is made to purchase the shares of a public corporation for a specified price. The shares of the corporation are not, however, taxable preferred shares. The price offered for the shares when the offer is made is more than the fair market value of the shares. The bidder will be able to withdraw the bid if the conditions of the offer are not met. Provided that the offer is accepted, the shares could not be purchased within 60 days of the offer being made.

Do the corporation's shares become taxable preferred shares as a result of the take-over bid?

Do the corporation's shares become short-term preferred shares as a result of the take-over bid?

Response from the Department of Revenue

The definitions in subsection 248(1) for "taxable preferred share" and "short-term preferred share" are very general and apply, among other things, when an issuing corporation or related person (within the meaning of paragraph (h) of the definition of taxable preferred share) to the corporation is party to an agreement to acquire a share for a specified amount. The exception to this rule is when the amount specified in the agreement to acquire the share does not exceed the fair market value of the share when it is acquired. To this end, the fair market value of a share must be determined without referring to the agreement in question.

In the situation described, the corporation's shares will not necessarily become taxable preferred shares or short-term preferred shares as a result of the take-over bid. Only the fair market value of the shares when they are acquired could answer this question. This determination is a question of fact. In this regard, although the value of a share on the stock exchange is an indication of its market value, the Department feels that the circumstances surrounding each particular situation must be examined to make this determination.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 14
Safe-income determination time

The corporation running Opco has two shareholders: Corporation A, which has 60% interest, and Corporation B, which has 40% interest. Both shareholders are about to sell the Opco shares. Transactions prior to the sale which are part of the series of transactions that will include the sale, occur successively as follows:

Step 1 Opco incorporates Filco

Step 2 Opco disposes of a property to Filco in consideration for common shares of Filco. This disposition occurs at the fair market value of the property transferred, and the common shares are the first shares issued of Filco's capital stock.

Step 3 A dividend equivalent to Opco's safe income is paid by the latter to its shareholders.

Step 4 Finally, A and B dispose of their Opco shares to Thirdco, an unrelated person.

Provision is made in the preamble to the definition of "safe-income determination time" in subsection 55(1) of the Act "for a transaction or event or a series of transactions or events means the time that is the earlier of ..."

Does the safe-income determination time have to be determined with respect to the series of transactions?

In the foregoing situation, the event in question stems from the fact that B is not related to Opco. As a result of this interpretation, the safe-income determination time of A would be the same as B, despite the fact that A is related to Opco.

Response from the Department of Revenue

Subsection 55(2) of the Act applies to any dividend received by a corporation resident in Canada as part of a transaction or event or a series of transactions or events. The examination concerning the possible application of subsection 55(2) as part of a series of transactions must therefore be conducted with respect to each dividend recipient.

Subsection 55(2) refers, among other things, to the concept of "safe-income determination time" with respect to the transaction, event or series. The "safe-income determination time", as defined in subsection 55(1) roughly corresponds to the earlier of (a) the time after the first event described in any of subparagraphs 55(3)(a)(i) to (v) of the Act that resulted from the transaction, event or series, or (b) the time before the first dividend is paid as part of the transaction, event or series.

In the situation described above, we understand that the disposition of the property in Step 2 would constitute for Corporation B a prescribed event within the meaning of paragraph 55(3)(a)(ii) in the series of transactions because it gives rise to a significant increase in the total direct interest in Filco of a person, Opco, to which the dividend recipient, Corporation B, is not related. The disposition of Opco shares in Step 4 of the series of transactions would constitute for both corporations A and B another prescribed event in paragraph 55(3)(a)(v) because this disposition results in a significant increase in the total direct interest in the dividend payer, Opco, of a person, Thirdco, which was an unrelated person before this time.

In this situation, we feel that there is a series of transactions, and that the "safe-income determination time" must be based on the series of transactions.

From this standpoint, the disposition of the property in Step 2 constitutes the first event which resulted from the series of transactions within the meaning of paragraph (a) of the definition of "safe-income determination time" in subsection 55(1) of the Act. Since the time after this first event precedes the time before a dividend is paid in Step 3 within the meaning of paragraph (a) of the said definition, we feel that the "safe-income determination time" for the series of transactions for both corporations A and B is the time after the disposition of the property in Step 2.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 15

Significant increase in interest - subsection 55(3) of the Act

In the Department of Revenue's opinion E9725615, the Department mentioned with respect to the situation described, that it felt that the redemption by a corporation (OPCO) of preferred shares of its capital stock owned by another corporation (PORTCO) would result in a significant increase in the total direct interest in OPCO of the other shareholders. The following are the facts of the situation described: PORTCO was not related to the other OPCO shareholders, but was related to OPCO. The issued capital stock of OPCO consisted of three classes of shares: one class of common shares, and classes "A" and "B" preferred shares (non-voting, non-participating, fixed redemption price). PORTCO owned 45% of the class "B" preferred shares. These shares had a nominal ACB and paid-up capital, but a substantial redemption price. The acquisition by OPCO of the class "B" preferred shares was not part of the series of transactions that included the share redemption.

The Department mentioned that, for the purposes of determining whether there had been a significant increase in the total direct interest of an unrelated person in OPCO for the purposes of paragraphs 55(3)(a)(ii) and (v) of the Act as a result of the redemption of preferred shares, the percentage of interest of the particular person in OPCO had to be determined immediately before the preferred shares were redeemed by dividing the value of the OPCO shares held by the particular person by the value of the total issued shares of the capital stock of OPCO, and comparing this percentage of interest with the percentage of the interest of the particular person determined using the same method immediately after the redemption.

Is the Department's position always the same when preferred shares have been redeemed, and more specifically, would this position change if the redeemed preferred shares were acquired by the shareholder in consideration for transferring property (other than shares of the issuing corporation) owned by the holder to the issuing corporation, and a rollover occurred in accordance with section 85 of the Act?

Response from the Department of Revenue

The Department's general position on whether there was a significant increase in the total direct interest in a corporation when preferred shares have been redeemed is set out in your question. The Department feels that the expression "significant increase in the total direct interest" used in paragraphs 55(3)(a)(ii) and (v) of the Act, as used within the context of section 55, is general enough to apply to a common shareholder of a corporation when the preferred shares of the capital stock of the corporation are redeemed.

Nonetheless, the Department does not always consider that there was a significant increase in the total direct interest of a person in a corporation for the purposes of paragraphs 55(3)(a)(ii) and (v) of the Act, when preferred shares with a substantial value are redeemed by this corporation.

For example, the Income Tax Rulings Directorate has already rendered a favourable advance ruling to the effect that there was not a significant increase in the total direct interest of a person in a corporation because preferred shares of a given corporation's capital stock were redeemed when the redeemed preferred shares were issued to a corporation that had de jure control of the given corporation in consideration for a transfer of property (other than shares of the given corporation) for which a subsection 85(1) election had been made.

Further, the Department does not usually apply subsection 55(2) to situations that are basically identical to Example 6 in the Department of Finance`s technical notes dated December 8, 1997 involving paragraph 55(3)(a). The example involves a situation where a given corporation transferred the shares of its subsidiary to a related corporation.

The Department considers, however, that there is generally a significant increase in the total direct interest of the common shareholders of a given corporation when preferred shares of the capital stock of the given corporation are redeemed and when these preferred shares were issued in consideration for the common shares of the given corporation`s capital stock as part of a reorganization of capital.

Every situation must therefore be resolved on the basis of the facts of the particular case.

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1999 APFF CONFERENCE

Question 16
Scientific Research and Experimental Development

Under subsection 127(27) of the Income Tax Act (the "Act"), a taxpayer shall add an amount to the taxpayer's tax otherwise payable under Part I of the Act under certain circumstances where a property used for Scientific Research and Experimental Development (SR&ED) is sold or converted to commercial use.

Further, provision is made in subsection 127(5) of the Act for a tax deduction otherwise payable under Part I of the Act with respect to SR&ED.

Can the tax deduction provided for in subsection 127(5) of the Act reduce the tax provided for in subsection 127(27) of the Act?

Response from the Department of Revenue

Subsection 127(27) of the Act increases the tax otherwise payable under Part I of the Act in circumstances where it applies. The Department feels that the tax deduction provided for in subsection 127(5) of the Act can reduce the tax otherwise payable to which the amount established according to subsection 127(27) of the Act was added.

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1999 APFF CONFERENCE

Question 17
Sale of a business - CPP contributions and EI premiums

When a business is acquired when assets are purchased, Revenue Canada considers that there has been a change in employers, even if all the employees are transferred without the services they provide being interrupted. As a result of this change in employers, the new employer must start deducting Canada Pension Plan (CPP) contributions and Employment Insurance (EI) premiums over again.

The fact that the employer has to start the deductions over again may, in some situations, involve significant costs.

Does Revenue Canada plan to adopt the policy announced in the 1998 Budget by the Quebec Minister of Finance concerning the Quebec Pension Plan (QPP) and ensure that an employer that immediately succeeds another employer further to the acquisition of the bulk of a business's property can be refunded the excess CPP contributions and EI premiums from a particular calendar year?

Employees can be refunded the excess paid during a calendar year when they file their federal tax return. This could, however, result in a cash flow problem for the employees. Does the Department of Finance plan to allow the employer to take the CPP contributions and EI premiums made by the employee into consideration when an employer succeeds another employer without the employee's work being interrupted further to the acquisition of the bulk of a business's property?

Response from the Department of Revenue

When a new legal entity is formed as part of the restructuring of a business, the new employer is required to start deducting Canada Pension Plan contributions and Employment Insurance premiums. It does not matter that deductions were made in this regard during the same calendar year for the employees involved.

In certain cases, the employees may have already contributed the maximum CPP/EI amounts for the year. If this happens, the employer can request administrative relief from the Department for any undue problems encountered by these employees. This type of request can be submitted to the Director of the employer's Tax Services Office.

This type of relief is not available to the employer because it is an administrative procedure that is only for employees' contributions. The fact that relief is granted in no way changes the employer's obligation to pay the employer's contributions, which are not subject to a refund.

At present, the Department of National Revenue has neither the intention nor the legislative authority to adopt the QPP policy announced by the Quebec Department of Finance concerning the CPP contributions and EI premiums of an employer that succeeds another employer further to the acquisition of the bulk of a business's property.

Response from the Department of Revenue

The Department of Finance is not the only department involved in the legislative provision development and amendment process with respect to the Canada Pension Plan and Employment Insurance.

An interdepartmental working group (Revenue Canada, Finance Canada and Human Resources Development Canada) is currently examining this problem from the point of view of employers, employees, the Canada Pension Plan and Employment Insurance.

This issue will be examined as part of a comprehensive review of various issues raised concerning these programs.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 18

Hypothecated life insurance policy

If a private corporation carrying on business in Quebec is the holder and beneficiary of an insurance policy taken out on the life, for example, of its principal shareholder, and it grants a mortgage to one of its creditors on its right to receive the insurance proceeds, article 2462 of the QCC specifies that the said hypothecation confers on the hypothecary creditor only a right to the balance of the debt, interest and accessories. Provision is further made in the article that "the hypothecation entails revocation of the revocable designation of the beneficiary ... only in respect of those amounts."

Since this type of agreement is virtually the same as the "collateral assignment" of an insurance policy under common law, can it be taken for granted that Revenue Canada's position in Income Tax Technical News No. 10 dated July 11, 1997 would also apply to this type of hypothecation, and as a result, the corporation could include the amount in question in paragraph (d)(ii) of the definition of "capital dividend account" in subsection 89(1) of the Act in the total proceeds payable under the hypothecated insurance policy?

Response from the Department of Revenue

The Department mentioned in Income Tax Technical News No. 10 that the proceeds in excess of the adjusted cost basis of a life insurance policy assigned as collateral for a loan is included in the capital dividend account of the debtor when the proceeds are paid to a creditor if the debtor is still the beneficiary of the policy.

We feel that this position does not apply when the proceeds of a life insurance policy are paid to a creditor because a mortgage was granted on this policy under the second paragraph of article 2462 of the QCC. In a case such as this, the creditor, not the debtor, receives, as beneficiary, the proceeds not exceeding the balance of the debt.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 19

Evaluation of shares after death

When a corporation agrees to guarantee that all or part of its liabilities will be reimbursed by taking out a life insurance policy on the life of one of its shareholders, but the holder and beneficiary of the insurance policy is the corporation's creditor (the premiums are however paid by the former), is it possible when the shareholder dies to apply the rule provided for in subsection 70(5.3) of the Act when calculating the fair market value of the shares that were held by the shareholder immediately before the shareholder's death? The life insurance policy is not the corporation's property, but the insurance proceeds will reduce its liabilities and increase the value of shares. Further, will the settlement of the debt under these circumstances give rise to the application of section 80 of the Act?

Response from the Department of Revenue

Under paragraph 70(5)(a) of the Act, a deceased taxpayer is deemed to have disposed of the taxpayer's shares in a corporation and received proceeds of the disposition thereof equal to the fair market value of the property immediately before the death. Provision is made in subsection 70(5.3) of the Act that the fair market value of the shares immediately before the death shall be determined as though the fair market value of a life insurance policy were the cash surrender value of the policy at that time. Based on these provisions, we feel that subsection 70(5.3) applies even if the creditor is the holder and beneficiary of the life insurance policy under the circumstances described.

Section 80 will not apply in the situation described provided that the debt was paid in full.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 20

Beneficiary corporation under a trust

At the 1998 APFF Conference, certain authors recognized that not only was it possible under the Quebec Civil Code, but it was also useful, for a corporation to be the beneficiary under an inter vivos trust. Taxpayers are increasingly using trusts because of their many benefits (flexibility, confidentiality, protection of assets). The Act does not seem to be clearly adapted to this reality, particularly with respect to the following issues.

Part IV tax

When a corporation ("PORTCO") is the sole beneficiary under an inter vivos trust, which is a personal trust (as defined in subsection 248(1)), and which owns shares of the issued share capital of another corporation ("OPCO"), PORTCO does not own the OPCO shares, and there is no provision in the Act to deem that PORTCO holds OPCO shares for the purposes of the Act. However, provision is made in the proposed amendment to paragraph 251(1)(b) of the Act in the legislative proposals on trusts announced by the Minister of Finance on December 23, 1998, that a beneficiary under a trust is deemed not to deal at arm's length with the trust. Thus, OPCO would be related to PORTCO under paragraph 186(4)(a), if the trust owned more than 50% of OPCO's issued share capital (having full voting rights under all circumstances) because OPCO would be deemed to be controlled by PORTCO under subsection 186(4). OPCO is a private corporation within the meaning of subsection 89(1) of the Act.

If, instead, the trust owned 40% of each class of OPCO's issued share capital, OPCO would not be related to PORTCO, and the latter would be subject to Part IV tax on the dividends designated to it by the trust.

Questions

1. Does the Department of Revenue agree with these conclusions?

2. Would the Department of Revenue have the same view if there were other income and/or capital beneficiaries under the trust, these other beneficiaries were individuals related to PORTCO under subsection 251(2) of the Act, and the dividends received by the trust are designated by the trustees to PORTCO?

3. Does the Department of Finance plan to amend section 186 of the Act to enable such corporations as PORTCO in the second situation described above (that is, when the beneficiary corporation under the trust is not related to the payer corporation under paragraph 186(4)(a) of the Act) to receive, through a trust, dividends on which Part IV tax is not charged?

Capital dividend account

When a personal trust earns a capital gain from the disposition of capital property, subsection 104(21) allows the trustee to designate a taxable capital gain to a beneficiary under the trust. However, according to paragraph (a)(i)(A) of the definition of "capital dividend account" ("CDA") in subsection 89(1) of the Act, a corporation must have earned a capital gain, not just a deemed taxable capital gain, in order for a gain to be included in calculating the CDA. Further, subsection 104(21) applies for the purposes of sections 3 and 111 of the Act, not for the purposes of sections 83 and 89.

When a corporation pays a capital dividend to a trust and the trustees designate the capital dividend to a corporation that is a beneficiary under the trust, it seems that the capital dividend amount is not included in calculating the CDA of the beneficiary corporation under the trust.

Questions

1. Does the Department of Revenue feel that a capital gain earned by a trust and a capital dividend received by a trust, that are designated to a corporation that is the beneficiary under the trust, are not included in calculating the corporation's CDA?

2. Would the Department of Revenue have the same view if there were other income and/or capital beneficiaries under the trust, these other beneficiaries were individuals related to the corporation, and the capital dividend or capital gain was designated by the trustees to the corporation?

3. Does the Department of Finance plan to amend the Act to allow the capital gains of a trust and the capital dividends received by a trust that are designated to beneficiary corporations under trusts to be included in calculating the corporations' CDAs?

Income earned or realized by a corporation after 1971

An inter vivos trust that is a personal trust owns shares of a corporation. Shortly before the disposition of the shares by the trust to an unrelated person (within the meaning of paragraph 55(3.01)(a) of the Act), the corporation pays a taxable dividend on these shares, the amount of which is the earned income on hand from the trust's shares. The purpose of the dividend is to significantly reduce the portion of the capital gain which, without the dividend, would have been realized by the trust when it disposed of the shares after paying the dividend. The trustees designate the dividend to a corporation that has always been the sole beneficiary under the trust. This designation occurs in accordance with the provisions of the trust agreement. Subsection 104(19) of the Act applies to the dividend. The beneficiary corporation under the trust is entitled to a deduction under subsection 112(1) for the dividend.

Questions

1. Does the Department of Revenue feel that subsection 55(2) of the Act does not apply to the disposition of the shares?

2. Would the Department of Revenue have the same view if there were other income and/or capital beneficiaries under the trust, these beneficiaries were individuals related to the corporation, and the dividend was designated by the trustees and paid to the corporation?

Response from the Department of Revenue

Part IV tax

For the purposes of our response, we have presumed that the proposed amendments to paragraph 251(1)(b) of the Act as part of the legislative proposals on trusts announced by the Minister of Finance on December 23, 1998 were adopted as proposed.

The Department agrees that OPCO would be related to PORTCO under paragraph 186(4)(a) of the Act if the trust owned more than 50% of OPCO's issued share capital (having full voting rights under all circumstances) because OPCO would be controlled by PORTCO under subsection 186(2). The Department feels that OPCO would not be related to PORTCO if the trust owned only 40% of each class of OPCO's issued share capital, and if no other person with which PORTCO was not dealing at arm's length owned PORTCO shares.

PORTCO would be subject to Part IV tax on a taxable dividend received by the trust from OPCO and designated by the trust to PORTCO under subsection 104(19), if OPCO is not related to PORTCO and PORTCO is entitled to a deduction for the dividend under subsection 112(1).

The Department cannot provide a general opinion on the application of section 186 in situations where there would be other income and/or capital beneficiaries under the trust, and the dividends received by the trust would be designated by the trustees to PORTCO.

Capital dividend account

The Department feels that the provisions of the Act do not allow a Canadian-controlled private corporation that is the beneficiary under a trust to increase its capital dividend account by the non-taxable portion of capital gains realized by the trust and capital dividends received by the trust, even if the capital gains and capital dividends are distributed to the beneficiaries.

A capital dividend received by a trust does not constitute a dividend received by a beneficiary under the trust. No provisions in the Act allow a capital dividend received by a trust and distributed by the trust to a beneficiary to remain a capital dividend for the beneficiary. The non-taxable portion of a capital gain realized by a trust cannot be included in the capital dividend account of a beneficiary even if subsection 104(21) applies, because provision is made in subsection 104(21) that the beneficiary is deemed to have realized a taxable capital gain, not a capital gain.

The different facts presented in Question 2 obviously change nothing in this regard.

Income earned or realized by a corporation after 1971

When subsection 104(19) applies to a taxable dividend received by a trust for a share of the capital stock of a corporation and designated to a beneficiary under the trust, the dividend is deemed for the purposes of the Act (except for Part XIII) not to have been received by the trust and constitutes a taxable dividend received from the corporation by the beneficiary under the trust. Consequently, this presumption applies for the purposes of section 55 of the Act.

The disposition of the shares by the trust constitutes a prescribed transaction under paragraph 55(3)(a)(iii) because the disposition is to an "unrelated person", that is, a person to whom the corporation which is the beneficiary of the trust (to which the dividend was designated by the trust) is not related.

The Department feels that subsection 55(2) of the Act would not usually apply in the situation described above concerning subsection 55(2), if the dividend paid by the corporation to the trust and designated by the latter to another corporation, which has always been the sole beneficiary under the trust, corresponds to earned income on hand from the shares owned by the trust.

The Department cannot provide an opinion on the application of subsection 55(2) in a situation where there would be other income and/or capital beneficiaries under the trust, where these beneficiaries would be individuals related to the beneficiary corporation under the trust, and where the dividend would be designated to the corporation and paid to it, without knowing all the details of a particular situation.

Response from the Department of Finance

Part IV tax

First of all, we must indicate the scope of the proposed amendment to paragraph 251(1)(b) of the Act, as set out in the legislative proposals on trusts published by the Department of Finance on December 23, 1998. According to the proposed amendment, a taxpayer and a trust are deemed not to deal with each other at arm's length if the taxpayer, or any person not dealing at arm's length with the taxpayer, is beneficially interested in the trust. The Department is afraid that from a tax policy standpoint, the proposed amendment is too general in its original form. This is why we will recommend that the proposed rule apply only to "personal trusts", as defined in subsection 248(1) of the Act. Consequently, the Part IV repercussions we discussed will apply only to personal trusts.

With regard to the possibility of easing the rules on the direct control described in paragraph 186(4)(b) of the Act, the Department is aware that trusts could be used to consolidate assets in order to exceed the "related" persons threshold, and thus avoid Part IV tax. As a result, the Department does not plan to recommend a new rule that would consider the shares of a corporation held by a trust as being directly held by the beneficiaries under that trust for the purposes of Part IV.

Capital dividend account

The Department of Finance is aware of Revenue Canada's interpretation that a capital dividend received in accordance with subsection 104(20) of the Act cannot be included in the capital dividend account of a beneficiary corporation. We agree with this interpretation, which is in accordance with the relevant tax policy. However, this and Question 7 will have to be examined together.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 22

Non-resident trusts

Provision is made in subsection 94(1) of the ITA that a non-resident trust is subject to FAPI provisions if it acquires property from a person residing in Canada, except if, among other things, this person is an individual who has not resided in Canada for more than 60 months.

The proposed amendments to the rules on foreign trusts in the 1999 Federal Budget require, among other things:

• that where a Canadian resident transfers property to a non-resident trust, the trust being created be treated as being resident in Canada and be taxed on all of its undistributed income. The proposed rules would apply whether or not the trust has a Canadian-resident beneficiary.
• that the proposed changes also deal with the distributions from trusts. Distributions out of current income of the trust would be taxed in the hands of the beneficiaries. As well, distributions out of any previously untaxed accumulated income of the trust would be subject to tax.
• that the following trusts be excluded from the application of the proposed rules; there are three types of trusts to be excluded, including: non-resident trusts set up prior to immigrants' arrival in Canada, for a five-year period after immigration.

Can the Minister of Finance specify whether this exception is only for non-resident trusts set up by immigrants before their arrival in Canada or whether it excludes the "concept" of non-resident trusts for immigrants set up before or after their immigration to Canada?

Response from the Department of Finance

The Department of Finance has already been asked this question. We are examining it in connection with preparing the budgetary proposal implementation legislation. We plan to publish a draft version of the legislative amendments later in the year. We recognize, however, that principle-based arguments can be made in favour of exempting non-resident trusts set up after an immigrant has become a Canadian resident.

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 23

Termination of a trust

Under article 1296 of the Quebec Civil Code, a trust is terminated by the expiry of the term or the fulfilment of the specified condition. Provision is made in article 1297 of the Quebec Civil Code that when the trust is terminated, the trustee must deliver the property of the trust to those entitled to it. Consequently, when a trust is terminated, there is a period of time between when the trust is terminated and when the property is delivered to the beneficiaries during which the trustee controls the property. When does the trust cease to exist from a taxation standpoint?

Response from the Department of Revenue

On Page 12 of the T3 Guide and Trust Return, the paragraph entitled Final Return covers the termination of a trust. This paragraph reads, in part, as follows:

"Final return

If you wind up a testamentary trust, the taxation year will end on the date of the final distribution of the assets. If you wind up an inter vivos trust, you may want to file a final return before the end of the trust's taxation year."

ROUND TABLE ON FEDERAL TAXATION
1999 APFF CONFERENCE

Question 24

Civil penalties for misrepresentation of a tax matter by a third party

Two new civil penalties were proposed in the last federal budget for third parties that make false statements. The first would apply mainly to promoters and professionals involved in tax shelters and tax planning arrangements. The second penalty, which would apply to a person involved in making or counselling the filing of false returns, raises more questions because it involves the everyday work of tax preparers.

All practitioners understand that this type of penalty will discourage the "aggressive" advisor who knowingly encourages taxpayers to file false returns. This is a "motherhood" issue. However, tax advisors are concerned about how Revenue Canada will interpret the concept of "circumstances amounting to gross negligence". The example provided in the budget documents is unclear and is so general that it could prompt organized accounting firms to stop preparing certain tax returns (particularly for individuals) or to increase their fees so that taxpayers will have to fill out their own returns. Now, it has been shown, that taxpayers who do business with organized accounting firms have a higher rate of compliance with the Act.

In the example provided in the budget documents, Accountant X receives a box of receipts and prepares a business expense claim. Accountant X deducts the $5,000 cost of the taxpayer's family vacation, and is liable for a penalty and criminal charges may be laid against him/her. In practice, this can occur in many ways:

(a) The accountant knows that they are the taxpayer's personal expenses and the accountant advises the taxpayer that he/she nonetheless deducted them from his/her income, in which case the penalty would probably apply.

(b) The accountant prepares a summary of expenses or has an employee prepare it without questioning the nature of these expenses, which is what the taxpayer wanted when he/she asked him/her to prepare a tax return, not verify every item. Must the accountant verify every item on the expense claim even if the taxpayer did not ask him/her to?

(c) The accountant questions the taxpayer about the merits of each of the expenses and the latter tells him/her that they are business expenses. Is the accountant required to dispel any doubt he/she may have about the client's statements, even if he/she was not asked by the client to do so?

Can the Department of Finance comment on the concept of gross negligence in each of the foregoing cases, particularly in light of the representations made to it by various tax practitioners?

The following questions are also for the Department of Finance and involve the scope of this initiative.

(d) The text of the proposed penalty is similar to that for the penalty in subsection 163(2) of the current Act. To what extent will the application of both penalties be inter-related? For example, will the application of subsection 163(2) automatically result in the application of the new penalty? Can the taxpayer claim that he/she relies completely on his/her accountant so that only the professional will be penalized?

(e) Public accountants have their own standards on the amount of work that they must do for each item. In particular, when preparing a statement accompanied by a "Notice to Reader", the public accountant informs all users of the statement, including the tax department, that the findings were compiled without verifying the completeness or authenticity of the amounts. Even in the case of statements accompanied by an auditor's report, the latter's task is to inform users if he/she discovers fraudulent activity, not to detect it. Will the tax authorities take the limits of the public accountant's terms of reference into account when applying the new penalty?

(f) To what extent will the new penalty apply to the valuation of property? Will the professional necessarily have to ensure that the taxpayer did enough work to justify what he/she establishes to be the fair market value of a property?

(g) Finally, will guidelines be published by Revenue Canada in an information circular on the application of these penalties when they are implemented?

Response from the Department of Finance

The concerns raised in this question involve the initially proposed gross negligence standard. After the 1999 budget was tabled, Department of Finance staff met with representatives of tax specialist organizations to discuss the issues raised by the proposed gross negligence standard.

The tax specialists wanted to ensure that they will not be liable, under the proposal, to a civil penalty for involuntary errors or justifiable differences of opinion. The 1999 budget proposed the gross negligence standard specifically because it deals, on the one hand, with this completely legitimate concern about involuntary errors or justifiable differences of opinion, and on the other, guarantees that people involved in otherwise culpable conduct do not shirk their responsibilities. There is a considerable difference between "gross negligence" and "involuntary error".

In light of the recommendations of professional organizations, another approach was, however, proposed. Instead of the gross negligence standard, a culpable conduct criterion is proposed. A person will have culpable conduct if he/she acts intentionally, shows indifference as to whether the Income Tax Act is complied with or shows a wilful disregard of the law. A "good faith" exception is also proposed, that is, a tax specialist who prepares or fills out a return on behalf of a taxpayer will not be deemed to have acted under circumstances leading to culpable conduct for the sole reason that he/she relied, in good faith, on the information provided by the taxpayer in question. These recommendations appear in the draft legislation made public in September 1999.

From an administrative standpoint, Revenue Canada will seek the views of the private sector when developing guidelines for applying the provisions governing penalties for third parties providing misleading information on tax matters. Private sector tax specialists will be consulted as part of Revenue Canada's periodic examination of the application of the provisions governing the penalties. Finally, a penalty will be assessed only after a Revenue Canada Head Office review has been completed.

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