29 November 2016 CTF Roundtable - Official Response
Presented by1: Randy Hewlett, Director, Financial Industries and Trusts Division, Income Tax Rulings Directorate, CRA; and
Stéphane Prud'Homme, Director, Reorganizations Division, Income Tax Rulings Directorate, CRA
Unless otherwise stated, all statutory references in this document are to the Income Tax Act, R.S.C. 1985, c. 1 (5th Suppl.) (the "Act"), as amended to the date hereof.
1 We gratefully acknowledge the following CRA personnel who were instrumental in helping us prepare for these Q&As: Vitaliy Anissimov, Mary Pat Baldwin, Mélanie Beaulieu, Dave Beaulne, Stéphane Charette, Michael Cooke, Eliza Erskine, Steve Fron, Angella Heron, Alex Ho, Judy Ho, Lena Holloway, Phil Kohnen, Jean Lafrenière, Len Lubbers, Olli Laurikainen, Alexandra MacLean, Yves Moreno, Marina Panourgias, Katie Robinson, Yannick Roulier, Louise Roy, Andrea Ryer, Suzanne Saydeh, Marc Ton-That, Grace Tu, Mark Turnbull, and Dave Wurtele.
Question 1: Application of GAAR to Transactions Involving Discretionary Family Trusts and the Application of the 21 Year Deemed Disposition Rule
A number of Canadian resident discretionary family trusts are currently approaching their 21st anniversary. Accordingly, trustees are considering planning alternatives to avoid the 21-year deemed disposition pursuant to subsection 104(4) of the Act. A common method of avoiding the 21-year deemed disposition involves the distribution of property with an unrealized gain to a Canadian resident beneficiary on a tax-deferred basis pursuant to subsection 107(2) of the Act. Where the beneficiary is a natural person, the realization of any capital gains inherent in the property distributed will be deferred and (absent a spousal rollover) realized at the earlier of the date that the individual actually disposes of the property, or the date that the individual dies. However, a distribution to a beneficiary that is a natural person in advance of the 21st anniversary of the trust may not always be the desired course of action. Where the tax-deferred distribution is instead made to a beneficiary that is another Canadian resident discretionary trust, subsection 104(5.8) of the Act would apply to prevent a deferral of the 21-year deemed disposition date. The trustees of the recipient trust would then be faced with the transferor trust’s approaching 21- year deemed disposition.
Consider a situation where a Canadian resident discretionary trust (Old Trust) that is approaching its 21st anniversary distributes property with an unrealized gain to a Canadian resident corporate beneficiary (Canco) that is wholly owned by a newly established discretionary trust resident in Canada (New Trust) on a tax-deferred basis pursuant to subsection 107(2) of the Act. Canco would be a beneficiary of Old Trust pursuant to its trust indenture.
As a result of this tax-deferred distribution to Canco, Old Trust will not hold the property on its 21st anniversary. In addition, subsection 104(5.8) of the Act should not be applicable to affect the timing of the 21st anniversary of New Trust since the property was not transferred directly from Old Trust to New Trust.
Can the CRA comment on whether it agrees with this conclusion?
The transactions described effectively result in Old Trust indirectly transferring property to New Trust on a tax deferred basis, thereby avoiding the application of the anti-avoidance provision in subsection 104(5.8) of the Act and restarting the 21-year clock. Thus, the capital gains that would otherwise be realized by Old Trust would be deferred beyond its 21st anniversary while the property continues to be held in a discretionary trust arrangement. Furthermore, the New Trust is provided with another 21 years to decide who from the potential beneficiaries will receive the property which could result in deferring the unrealized gain beyond the lifetime of the individual beneficiaries alive on the date of the Old Trust’s 21st anniversary.
Generally, it is the CRA’s view that such planning circumvents the anti-avoidance rule in subsection 104(5.8) of the Act in a manner that frustrates the object, spirit and purpose of that provision, the deemed disposition rule in paragraph 104(4)(b) and the scheme of the Act as a whole as it relates to the taxation of capital gains. It is also the CRA’s view that if a distribution is made by an existing discretionary trust to a Canadian resident corporation wholly owned by a new discretionary trust resident in Canada, it will generally be inferred that the primary purpose of such distribution is to defer the income tax otherwise applicable in respect of the 21-year deemed disposition pursuant to subsection 104(4) of the Act. The CRA has significant concerns regarding these transactions and will apply GAAR when faced with a similar set of transactions unless substantial evidence supporting its non-application is provided.
The CRA is also concerned that the proposed transactions may be repeated where the terms of New Trust are similar to those of Old Trust. Thus the realization of the capital gains inherent in the property could be deferred for several generations or indefinitely. This contravenes one of the underlying principles in the taxation of capital gains regime, which is to prevent the indefinite deferral of tax on capital gains.
The CRA is currently considering whether GAAR should apply to a situation involving a distribution from a discretionary family trust to a Canco that is wholly owned by a newly established discretionary family trust in which the deferral of capital gains is extended beyond the 21-year deemed disposition in paragraph 104(4)(b); however, the realization of the gain occurs within the lifetime of the existing beneficiaries of Old Trust.
Finally, unless substantial evidence supporting the non-application of GAAR is provided, the CRA will not provide any Advance Income Tax Ruling where such a structure is proposed to be put in place.
Question 2: Computation of safe income on discretionary dividend shares
In order to clarify the CRA’s position on the allocation of safe income on hand on circumstances commonly encountered by taxpayers, we would like the CRA to illustrate the application of the safe income exception in paragraph 55(2.1)(c) to the following hypothetical situation.
In Year 1, Holdco A and Trust B incorporated Opco as follows: Holdco A subscribed for 50 Class A common shares and Trust B subscribed for 50 Class B common shares, and the subscription price was nominal for both. Trust B is a discretionary personal trust and one of the beneficiaries is Holdco B. Holdco A is not related to and deals at arm’s length with both Trust B and Holdco B. The share articles of Opco provides that all classes of its common shares are voting, participating, entitled to discretionary dividends independent of other classes, and entitled to pro-rata sharing of net assets with other common share classes upon liquidation.
At the end of Year 2, the shares of Opco have an aggregate fair market value of $2 million and Opco’s aggregate safe income on hand was also $2 million. At that time, the following transactions occurred:
- Holdco C, a corporation related to Holdco A, subscribed for 50 Class C common shares in Opco for a subscription price of $1 million.
- Holdco D, a corporation not related to any of the above entities, borrowed $500,000 from Opco and used the funds to purchase 25 Class B common shares from Trust B. During year 3, Opco earned additional safe income on hand in the amount of $3.6 million. At the end of Year 3, Opco declares the following dividend in order to effect a significant reduction in the fair market value of Opco:
- $3 million dividend on Class C
- $2.6 million dividend on Class B (i.e. $1.3 million to Trust B and $1.3 million to Holdco D)
Trust B allocates and pays the entire $1.3 million it receives to Holdco B, whereas Holdco D repays the $500,000 it owes Opco using part of the dividend proceeds it receives. All corporations are taxable Canadian corporations.
a) Can the CRA comment on whether each of the dividends paid in Year 3 would fall outside of the safe income exception in paragraph 55(2.1)(c), and if so, how much would be re-characterized as a gain to the respective dividend recipients pursuant to subsection 55(2).4
b) Would the response be different if, at the same time as the subscription by Holdco C, Holdco A exchanged all of its Class A Opco shares on a fully tax-deferred basis under subsection 86(1) for 50 preferred shares of Opco redeemable and retractable for $1 million in aggregate, with a cumulative dividend entitlement of 1% [of the redemption amount] per annum?
c) Given the expanded scope of section 55 what are the information requirements with respect to safe income computations? For example, are detailed safe income computations essential in relatively simple case where there is a holdco / opco structure and no or limited differences in accounting versus taxable income?
CRA Response (a) and (b)
We do not believe that this type of example is, as suggested in the question we have received, representative of situations commonly encountered by taxpayers. Holdco A and its related corporation, Holdco C, have given up a portion of their collective value in Opco in favour of two unrelated persons: Trust B and Holdco D. How this is justifiable from a common business sense is not readily understandable and relevant facts are certainly missing in the example. A detailed analysis would have to be made to determine whether any of the provisions such as subsection 15(1), 56(2), 69(1), 246(1) or 245(2) could apply in these circumstances. Furthermore, we would like to point out that this type of share structure would become problematic if and when a butterfly distribution of Opco is envisaged under paragraph 55(3)(b) since it could be impossible to determine whether the butterfly distribution would qualify as a distribution under subsection 55(1) because of the uncertainty in establishing the fair market value of the shares of Opco.
As previously indicated, recent CRA comments on the allocation of safe income to discretionary dividend shares were not intended to suggest that the CRA has no concerns about the use of those shares. The CRA will study the subject and will not provide additional views until the study is completed.
CRA Response (c)
The calculation of safe income has a purpose of substantiating the claim that a dividend is not subject to the application of subsection 55(2). It is the duty of taxpayers and their representatives to use due care in making such claim, which is one of the foundations of a self-assessing system. We should note that an incorrect claim could be subject to the application of subsections 152(4), 163(2) or 239(1), depending on the circumstances.
Question 3: Agnico-Eagle Mines Decision
The Federal Court of Appeal’s (“FCA”) decision in The Queen. v. Agnico-Eagle Mines Ltd (2016 FCA 130) (Agnico-Eagle) provided a methodology to determine whether the issuer of certain foreign currency denominated convertible debentures realized a gain when the debentures were converted into shares. If we apply the methodology provided by the FCA, it would appear that an issuer of debentures could be considered to have realized a loss. Does the CRA agree that an issuer could be considered to realize a loss on the conversion and, if so, that the loss is a loss described in subsection 39(2) or an otherwise deductible capital loss?
The CRA is of the view that the decision of the FCA in Agnico-Eagle simply sets out the method to be employed in the determination of whether the issuer had made a gain for the purposes of subsection 39(2) on a conversion of convertible debentures. The CRA recognizes that in applying the FCA’s methodology to such a conversion, one might conclude that the issuer could have realized a loss. However, while the CRA accepted the methodology put forth by the FCA in the Agnico-Eagle case, the CRA is of the view that any potential loss computed based on that methodology cannot be said to have been sustained because of the fluctuation in the value of a foreign currency relative to Canadian currency. Therefore, such a loss would not be a loss described in subsection 39(2) of the Act. Furthermore, such a loss would not be a capital loss for purposes of subsection 39(1) as no property was disposed of.
Additionally, although not raised in Agnico-Eagle, the potential application of subsection 143.3(3) of the Act to the computation of any gain or loss arising on a conversion of a debenture should be considered in any similar fact situation, and could impact the application of the methodology endorsed by the FCA.
Question 4: 55(2) and Part IV tax
Assume the following facts:
1. Holdco owns all the shares of Opco. Opco is therefore connected with Holdco by virtue of subsection 186(4).
2. Holdco and Opco have the same taxation year.
3. All the transactions described below occur in the same taxation year of Holdco and Opco beginning after 2015.
4. Opco’s refundable dividend tax on hand, as defined in subsection 129(3) (“RDTOH”), is approximately $383,333.
5. Taking its RDTOH into account, Opco will pay a taxable dividend of $1,000,000 to Holdco. Opco expects to receive a dividend refund under subsection 129(1) of $383,3336 (based on the lesser of 38 1/3% of the taxable dividend paid and the RDTOH at the end of its taxation year).
6. Holdco will then pay a taxable dividend of the same amount to a shareholder who is an individual.
7. Consequently, Holdco will pay Part IV tax of $383,333 but will be eligible for an offsetting dividend refund.
8. Assume also the following:
- all transactions are part of the same series,
- no safe income can be considered to contribute to the gain, if any, on the shares of Opco held by Holdco, and
- paragraph 55(2.1)(b) applies to the dividend received by Holdco.
In Holdco’s tax return for the year in which it receives the $1,000,000 of dividend from Opco, by virtue of the application of subsection 55(2), the dividend would be reported as a capital gain of $1,000,000 of which $500,000 is taxable. Thus, Holdco would report no Part IV tax on the dividend and Holdco would add to its RDTOH account an amount equal to the lesser of $153,333 (30 2/3% of $500,000) and its Part I tax otherwise payable. Holdco would only need to pay a taxable dividend of $400,000 to the individual shareholder in order to get a full refund of its RDTOH. Therefore, instead of paying a taxable dividend of $1,000,000 to the individual shareholder, could Holdco instead elect under subsection 83(2) to pay a capital dividend of $500,000 and the balance of the $500,000 available cash as a taxable dividend to the individual shareholder?
Although one should be able to self-assess under subsection 55(2) if one of the purposes under subparagraph 55(2.1)(b)(ii) is met, the application of subsection 55(2) in this situation is predicated on the actual payment of the Part IV tax and the actual receipt of the refund of such Part IV tax. In the situation described above, although paragraph 55(2)(c) deems the dividend received by Holdco to be a capital gain, the deeming has no incidence on the application of section 186 to the dividend received and, consequently, on the application of section 129 to the dividend paid by Holdco. Concluding otherwise would make the Part IV tax condition of application of subsection 55(2) redundant.
In Ottawa Air Cargo Centre Ltd v. The Queen (TCC affirmed by FCA) (2007 D.T.C. 661), the Court stated that:
In terms of the “textual” operation of subsection 55(2), the dividend amount is deemed not to be a dividend, but rather proceeds of disposition on the sale of shares. The portion of the provision in parentheses enunciates an exception to the operation of subsection 55(2), and that exception is with regard to non-refunded Part IV tax. The portion of a7 dividend for which a refund of Part IV tax is not received is not subject to recharacterization. This seems to be all the more true as the phrase “subject to tax under Part IV that is not refunded” does not sound either hypothetical or analytical. It appears to require that a procedure be followed to the letter, which leads me to believe that the requirement of an actual refund of Part IV tax is mandatory for the dividend to be recharacterized as a capital gain under subsection 55(2).
This means that Holdco would have to produce an original return and an amended return for the taxation year in which the dividend is received from Opco. The first return would report the amount of Part IV tax owing and the refund of such Part IV tax resulting from the payment of a dividend by Holdco to the individual shareholder. For the Part IV tax to be fully refunded, the taxable dividend paid to the individual shareholder has to be $1,000,000. The second return would provide adjustments resulting from the application of subsection 55(2) to the dividend received by Holdco. However, the amount of taxable dividend paid by Holdco to the individual shareholder would not change since a reduction of such amount would result in a reduction of the refund of the Part IV tax established in the original return and the application of subsection 55(2) would become applicable to a declining amount resulting from a circular calculation.
A textual, contextual and purposive interpretation of subsection 55(2) and 129(1) leads to the conclusion that Holdco’s election under subsection 83(2) in respect of the dividend paid to the individual shareholder that results in a refund of Part IV tax paid on the dividend received from Opco would not be valid as it would reduce the amount of the refund of Part IV tax resulting from the payment of a taxable dividend by Holdco and retroactively impair the application of subsection 55(2) to the dividend received from Opco.
The $500,000 increase of Holdco’s CDA resulting from the application of subsection 55(2) to the dividend of $1,000,000 received from Opco will be available to Holdco only for an election under subsection 83(2) on future dividends.
Question 5: Investment management fees for RRSPs, RRIFs and TFSAs
Investment management fees relate to services of an investment manager for providing custody of securities, maintenance of accounting records, collection and remittance of income, and buying and selling securities on behalf of the owner.
In the case of an RRSP, RRIF or TFSA, investment management fees represent a liability of the registered plan trust, and thus would be expected to be paid by the trustee using funds from within the plan. However, the CRA has a long-standing administrative policy accepting that the payment of these expenses outside of the registered plan by the plan annuitant or holder (referred to as the “controlling individual”) will not be considered to be a contribution or gift to the plan for purposes of the over-contribution rules.
Has the CRA considered whether the advantage tax rules in Part XI.01 of the Act, which have been in force since 2009 for TFSAs and 2011 for RRSPs and RRIFs, apply in this situation?
In the course of preparing an Income Tax Folio on the advantage tax rules, the CRA has reviewed the application of these rules to various fees and fee rebates in respect of registered plans. The full results of this review will be published in the Folio, which is expected in early 2017.
Of relevance to this specific question is subparagraph (b)(i) of the definition of “advantage” in subsection 207.01(1) of the Act. This provision applies where there has been an increase in the total fair market value of the property held in connection with a registered plan that can reasonably be considered to be attributable, directly or indirectly, to a transaction or event (or series) if two conditions are met:
- the transaction or event would not have occurred in a normal commercial or investment context in which parties deal with each other at arm's length and act prudently, willingly and knowledgeably; and
- one of the main purposes of the transaction or event is to benefit from the plan’s taxexempt status. It is the CRA’s view that an increase in value of the property of a registered plan has indirectly resulted from the plan’s investment management fees being paid by a party outside of the plan.
This increase in value of the property of the registered plan would likely constitute an advantage by virtue of this provision. Our reasons are twofold:
- it is not commercially reasonable for an arm’s length party to gratuitously pay the expenses of another party; and
- there is a strong inference that a motivating factor underlying the transaction is to maximize the savings in the plan so as to benefit from the tax exemption afforded to the plan.
As a result, the plan’s controlling individual could be subject to advantage tax of 100% of the amount of fees paid.
To avoid the adverse tax consequences from the application of the advantage tax rules, any existing arrangements in which investment management fees are charged directly to the plan’s controlling individual will have to be changed so that the fees are charged to the registered plan. Should there be insufficient cash in the registered plan to pay the expense immediately and this gives rise to an overdraft, there wouldn’t be any adverse tax consequences.
The CRA is working with the investment industry in identifying the different types of fee structures and the application of the advantage rules to these structures. We appreciate that this review and the application of the advantage rules to these structures will require a period of transition so that the investment industry can review how registered plan fees are processed. To give the investment industry time to make any system changes that may be required, the CRA will defer applying this position until January 1, 2018.
Investment management fees that are reasonably attributable to periods ending before 2018 may be paid by either the registered plan or the controlling individual with no adverse tax consequences. Where the controlling individual pays the fees, paragraph 18(1)(u) of the Act will apply to deny the individual a deduction in computing income for the payment (as with any registered plan fees).
Question 6: Section 84.1: Poulin v. The Queen and Turgeon v. The Queen
On June 14, 2016, the Tax Court of Canada (the “Court”) released its decision in the cases of Ghislain Poulin v. The Queen (“Poulin”) and Herman Turgeon v. The Queen (“Turgeon”)(2016 TCC 154, heard on common evidence). These cases involve two unrelated shareholders, both of whom attempted to extract corporate surplus as a capital gain to which they could claim the capital gains deduction by selling shares of a subject corporation to a holding corporation owned and controlled by another employee/shareholder of the subject corporation. The Court determined that section 84.1 did not apply in Poulin as Mr. Poulin and the holding corporation dealt at arm’s length; whereas, the Court determined that section 84.1 did apply in Turgeon as Mr. Turgeon and the holding corporation did not deal at arm’s length.
a) Could CRA please comment on what it regards as the differentiating factors identified by the Court in this decision?
b) Does this decision impact CRA’s view of employee buyco arrangements? If so, how? And, if not, why not?
c) What is CRA’s view of a share sale identical to Mr. Turgeon’s except the holding corporation benefits from its involvement via dividends on the shares it purchased? The benefit is real in that such dividends are in addition to subsequent share redemption amounts received by the holding corporation and used to pay off debt owed to the original vendor of shares. Would CRA’s view differ if the holding corporation was compensated for its involvement otherwise than by dividend?
The issue raised in this case stems from the sale of frozen preferred shares in the context of a reorganization of the corporate structure of Les Constructions de l’Amiante Inc. (“Amiante”), the purpose of which was twofold: 1) to implement the departure of Mr. Poulin; and 2) to integrate a key employee of Amiante, Mr. Hélie, into its share structure.
As such, Mr. Poulin sold his freeze shares of the capital stock of Amiante to a corporation (“Gestion Turgeon”) controlled by Mr. Turgeon. In turn, Mr. Turgeon sold his freeze shares of the capital stock of Amiante to another corporation (“Gestion Hélie”) controlled by Mr. Hélie. Both individuals declared a taxable capital gain on the sale and claimed the capital gains deduction pursuant to subsection 110.6(2.1).
Based on all of the evidence, the Court was of the view that Mr. Poulin wanted to leave Amiante, selling his interest in it at the best price and under the most optimal possible conditions — one of which was to benefit from his capital gains deduction. On the other hand, Gestion Turgeon wanted to acquire the shares of Amiante held by Mr. Poulin, which allowed Mr. Turgeon to ultimately control Amiante.
In the case of Mr. Poulin, the Court concluded that section 84.1 did not apply since the parties did not act in concert without separate interests and, consequently, were dealing at arm’s length. In view of the above, the CRA generally agrees with the Court when it acknowledges that “[t]he fact that Mr. Poulin and Mr. Turgeon had structured the transaction such that Mr. Poulin could benefit from his capital gains deduction does not mean that the parties acted in concert without separate interests.”2
However, the Court pointed out that this possibility is not limitless: “That being said, while it is completely acceptable for an entrepreneur to want to benefit from tax relief available to them, it is, however, necessary to ensure that the method used is permitted.”3. As such, the Court held that Mr. Turgeon and Gestion Hélie acted in concert, without separate interests and, consequently, were not dealing at arm’s length.
The CRA is and has always been of the view that the question as to whether unrelated persons are dealing at arm’s length at any particular time is a question of fact that requires a review of all the facts and circumstances surrounding a specific situation.
In this regard, the mere fact that an employee/shareholder, such as Mr. Poulin, wants to dispose of all his shares of the capital stock of a corporation to an employee buyco which wants to acquire them, is not sufficient to conclude that these taxpayers deal with each other at arm’s length.
Indeed, in a particular situation it could be established that the employee/shareholder and the employee buyco are acting in concert, without separate interests. For example, it could be established that, as is the case with Gestion Hélie, the employee buyco: assumes no economic risks associated with its involvement in the transaction; does not benefit from acquiring the shares of the capital stock of the operating corporation; has no interest other than to enable the employee/shareholder to realize a capital gain and claim the capital gains deduction; and has no role independent of the employee/shareholder or the operating corporation. In short, the facts of a particular situation could support the position that the employee buyco is only involved in the transaction as an accommodating party for the benefit of the employee/shareholder. In closing, where taxpayers intend to carry out transactions to which section 84.1 may apply, we recommend that they obtain an advance income tax ruling beforehand.
2 Ghislain Poulin v. The Queen and Herman Turgeon v. The Queen, 2016 TCC 154, at paragraph 81.
3 Ibid. at paragraph 90
Question 7: Assessment Procedure Under the General Anti-Avoidance Rule
Our understanding is that the GAAR Committee must approve any reassessment invoking the general anti-avoidance rule (“GAAR”) under section 245 prior to such reassessment being made. However, it appears that taxpayers have had different experiences in terms of matters going before the GAAR Committee. In some cases a matter has gone to the GAAR Committee prior to the taxpayer receiving a proposal letter regarding a proposed assessment. In other cases some taxpayers have been reassessed under GAAR without the GAAR Committee first having reviewed the matter, contrary to our understanding set out above. Taxpayers would appreciate greater transparency as to how the GAAR Committee operates from a procedural perspective. Can the CRA comment on what procedures must be followed before a taxpayer can be reassessed under GAAR? Specifically:
a) Can the CRA comment on the process followed for GAAR Committee referrals at the proposed assessment stage?
b) Can a GAAR reassessment be made without the file being brought to the attention of the GAAR committee?
c) If the response to (b) is yes, can the reassessment only be made if the transactions being reassessed and the resulting tax benefit are similar to those involved in another file that has gone before the GAAR Committee, or can the CRA reassess under GAAR without ever having taken the matter to the GAAR Committee?
d) Do the answers to (b) or (c) change if GAAR is the alternative, as opposed to the primary, assessing position?
e) Do taxpayers have to be informed prior to a file being referred to the GAAR Committee so that they have the ability to make representations to the GAAR Committee?
f) Can the CRA comment on the composition of the GAAR committee? Specifically, how many individuals from the CRA, the Department of Finance, and the DOJ sit on the GAAR Committee, how often are the positions rotated, and does membership change based on the topic before the committee?
The GAAR Committee was established to provide advice on the application of the GAAR in the Income Tax Act (Canada) and the Excise Tax Act, to ensure that the GAAR is applied consistently. The role of the GAAR Committee is to provide recommendations in respect of the application of GAAR to: (i) proposed transactions for which advance income tax rulings are requested, and (ii) transactions under review by audit.
GAAR Committee Composition
Historically, the Chair and co-secretaries have always been from the Income Tax Rulings Directorate (CRA). They organize, coordinate and facilitate all meetings. The directors of all four divisions within the Income Tax Rulings Directorate are invited to and usually attend all GAAR Committee meetings.
The GAAR Committee is an Ad Hoc committee composed of representatives from: (i) the Income Tax Rulings Directorate (CRA); (ii) the Legislative Policy Directorate (CRA); (iii) the Abusive Tax Avoidance and Technical Support Division of the International and Large Business Directorate (CRA); (iv) the Department of Finance; (v) the Department of Justice; (vi) Legal Services (a group from the Department of Justice dedicated to providing the CRA with legal support). Although some representatives attend all meetings, others vary depending on the subject matter being discussed at the meeting.
Audit/GAAR Reassessment Process
The audit process for GAAR issues is essentially the same as the process for any audit issue, except that advice is obtained from the Abusive Tax Avoidance and Technical Support Division in Headquarters (“Headquarters”) and, where applicable as described below, the GAAR Committee. Headquarters’ role is to review files where a Tax Service Office (“TSO”) is considering the application of the GAAR as a primary or alternative assessing position. The stage at which the TSO sends a proposal letter to a taxpayer on a file involving the GAAR depends on the circumstances.
The TSO will generally review the particular facts of each file to establish the purpose of the transactions and determine if any of the transactions is an avoidance transaction. Where the transactions under audit are similar to situations previously considered by the GAAR Committee and resulted in a recommendation to apply GAAR, generally the TSO will proceed with the proposal letter and obtain the taxpayer’s representations. The TSO will subsequently refer the matter to Headquarters with the taxpayer’s representations (if any), to obtain its recommendation.
Where the TSO reviews the particular facts of a file and determines that the matter has not been previously considered by the GAAR Committee, and the GAAR is likely the primary position, the TSO will refer the matter to Headquarters prior to the issuance of a proposal letter. In this circumstance, the TSO will generally only proceed with the issuance of a proposal letter if it obtains the recommendation of Headquarters on the application of the GAAR. Headquarters will generally in turn refer the matter to the GAAR Committee for consideration.
Headquarters might sometimes recommend not to proceed with a GAAR reassessment without consulting with the GAAR Committee in circumstances where Headquarters believes that there are no grounds to consider the application of the GAAR. However, Headquarters may still submit the case to the GAAR Committee to obtain their recommendation. Any submission received from the taxpayer or the taxpayer’s representatives are forwarded, in their entirety, to Headquarters and, where applicable, the GAAR Committee. Thus taxpayers should be assured that when the application of the GAAR is considered, all their arguments will have received careful consideration.
Question 8: 55(2) Fundamental Principles – Is cash a “property” for purposes of clause 55(2.1)(b)(ii)(B)
Is cash considered to be property for purposes of the application of clause 55(2.1)(b)(ii)(B)?
Subsection 55(2) and the concept of cost are cornerstones of the corporate taxation system. Subsection 55(2) essentially negates the effect of the dividend deduction under subsection 112(1) when such deduction is not warranted.
The underlying principle of subsection 112(1) is to eliminate duplication of tax on income moving through a corporate chain by exempting the income from additional corporate tax when it was already subject to tax in another corporation. Concurrently, property that is received by a shareholder as a dividend generally has, by virtue of subsection 52(2), a cost equal to the fair market value of the property. The cost ensures that the value of the property that was included in income as a dividend under paragraph 12(1)(j), even if offset by a corresponding deduction under subsection 112(1), does not get included in income a second time when the property is disposed of. The concept of cost reflects the fact that the value of the dividend was included in the income of the dividend recipient under paragraph 12(1)(j). The cost ensures that only the future increase in the value of the property is taxed. Therefore, the concept of cost shares with subsection 112(1) the objective of preventing the duplication of tax paid by corporations.
When a dividend, in the form or cash or any other type of property, is paid from income that has been subject to tax in the hands of the dividend payer, the dividend will normally be a safe income dividend. If so, it is appropriate for the corporate shareholder to obtain a deduction under subsection 112(1) in respect of that dividend in order to avoid the duplication of tax paid by corporations. As explained above, the cost to a shareholder of the cash or any other type of property received as a dividend is equal to its fair market value on the basis that the dividend was included in income.
When a dividend is paid from a source that has not been subject to tax in the hands of the dividend payer, the dividend will normally not be a safe income dividend. Such dividend might be paid from borrowed cash, from share subscription proceeds or from any source of untaxed income. The role of subsection 55(2) is to question whether one of the purposes of the payment or receipt of such dividend, amongst any other objectives, is to significantly reduce the fair market value of a share or to increase the cost amount of property of the dividend recipient. If so, the scheme of the provision is that such dividend should not be tax-free. The scheme of subsection 55(2), amongst other objectives, is to preserve the integrity of the corporate tax system by prompting an inclusion in income where there is an increase in the cost of property of the dividend recipient when such increase in cost has not been taxed in the hands of the dividend payer or the dividend recipient and when a purpose of effecting such increase exists. Such inclusion results from the recharacterization of the dividend as proceeds of disposition or as a capital gain.
The concept of cost and subsection 55(2) share the objective of preventing the duplication of corporate tax while ensuring that tax is paid on an amount of cash or other property received in the form of a dividend, where such dividend is not supported by income that was subject to tax in the hands of the dividend payer. The scheme of the Act generally does not allow for an increase in cost where no tax is paid on the corresponding gain. For example, if a corporate shareholder transfers a property it owns (other than shares of the corporation) to the corporation or to another person, a taxable gain will be realized if the cost amount of the consideration received on the transfer is greater than the cost amount of the property transferred. Thus, there is a lack of tax integration where a corporate shareholder receives a property on a payment of a dividend that is not taxable but the cost of the property received is greater than the amount on which tax is paid by either the dividend payer or the corporate shareholder.
Property is defined in subsection 248(1) as including money, unless a contrary intention is evident. As explained above, the scheme of subsection 55(2) is to consider cash as property. Note that cash received on the payment of a dividend that was subject to the application of subsection 55(2) can then be used to purchase any other property or additional shares in the dividend payer which, in the latter case, results in an increase in the cost amount of shares held by shareholder in the dividend payer.
Question 9: BEPS Action Item 13
Will the CRA’s expectations of the “reasonable efforts” that a taxpayer must make to determine and use arm’s length transfer prices include the preparation of transfer pricing documentation that is consistent with the recommendations from the OECD in Action 13 of the BEPS initiative (i.e. Master File and Local File transfer pricing documentation)?
The CRA considers that BEPS Action Item 13 has been dealt with by the introduction of proposed section 233.8 of the Act relating to Country-by-Country Reporting. The “reasonable efforts” requirement is based on the legislation contained in section 247 of the Act, in particular the requirement to produce “contemporaneous documentation” in accordance with subsection 247(4). Proposed section 233.8 has no direct relation to section 247 and does not include a specific requirement to produce a “local file” or “master file”. As such, the CRA has not altered its criteria regarding whether a taxpayer has made reasonable efforts to determine and use arm’s length transfer prices.
Question 10: U.S. LLPs & LLLPs
At the 2016 Society of Trust and Estate Practitioners (“STEP”) and the International Fiscal Association (“IFA”) CRA Roundtable, the CRA announced that it considers Florida and Delaware limited liability partnerships (“LLPs”) and limited liability limited partnerships (“LLLPs”) to generally be corporations for the purposes of Canadian income tax law. As part of this announcement, the CRA offered administrative relief to existing LLPs and LLLPs that meet certain criteria such that the CRA would accept their treatment as partnerships for the purposes of the Act.
The position will affect certain U.S.-based LLPs and LLLPs, with many partners, which carry on business in Canada. They are unable to qualify for the administrative relief provided because, for business reasons, they cannot convert to LPs. They are generally prepared to begin filing as corporations in future years, however, amending all previous years’ returns for all individual partners would be impractical if not impossible.
Would the CRA consider allowing these entities to file as a corporation on a go-forward basis while leaving its previous years’ partnership/partner filings unchanged?
The CRA has established an internal working group to study compliance issues related to LLPs and LLLPs. It is being led by members of the audit branch, specifically the International Tax Division (“ITD”) of the International and Large Business Directorate of the International, Large Business and Investigations Branch. Some questions and submissions have already been received by officials of the CRA and have been brought to the attention of members of the working group. The ITD is open to a prospective approach whereby prior filings would, in certain circumstances, be allowed to stand, and welcomes submissions from taxpayers and their representatives in this regard. Submissions should be sent by February 28, 2017 to the following mailbox: DELAWAREFLG@cra-arc.gc.ca.
One must keep in mind that Canada’s tax system is one of self-assessment and taxpayers are expected to know the law and properly comply with it. CRA resources are available to taxpayers when they have doubts as to their filing positions, but the CRA can’t be considered to have16 assented to taxpayer filing positions indirectly through so-called “negative assurance”. In other words, a taxpayer that files incorrectly cannot assume that the return will not be reassessed if the CRA later discovers the error, even if the return was originally assessed as filed, or a prior return containing the same error is statute-barred.
Question 11: Computation of Earnings for a Disregarded U.S. Limited Liability Company
In its response to Question 9 posed at the 2011 IFA Conference, the CRA indicated that a disregarded U.S. limited liability company (LLC) that is a foreign affiliate of a Canadian taxpayer and that has a single member which is a regarded U.S. corporation should compute its “earnings” in accordance with subparagraph (a)(i) of the definition of “earnings” in subsection 5907(1) of the Regulations. Despite the fact that such an LLC would not itself be required to compute its profits pursuant to U.S. tax law, and that such a computation would only be made for purposes of computing the member’s tax liability, the CRA considered this to be sufficient to bring the scenario within the scope of the above-mentioned provision. The CRA further stated the following:
If the CRA encounters a Canadian corporation that has attempted to inflate the surplus balances of a foreign affiliate that is a US limited liability company by computing its “earnings” in accordance with the Act and ignoring discretionary deductions, the CRA may challenge the taxpayer's filing position…
a) In light of subsection 5907(2.03) of the Regulations, which was enacted in 2013 and which requires an affiliate that computes its “earnings” in accordance with Canadian tax law to claim all discretionary deductions to the maximum extent possible, does the position set out above still accurately reflect the CRA’s view? That is, is it still the CRA’s view that a disregarded LLC that is resident and carrying on an active business in the United States should compute its “earnings” under the U.S. rules?
b) Would the answer change if the LLC had one or more members which were not regarded U.S. resident corporations?
CRA Response (a)
The view of the CRA regarding the interpretation of the definition of “earnings” in subsection 5907(1) of the Regulations (hereinafter referred to as the “Earnings Definition”) has changed as a result of the context provided by subsection 5907(2.03) of the Regulations. The CRA is now of the view that the “earnings” from a U.S. active business of a U.S.-resident, single member LLC that is disregarded for U.S. tax purposes and that is a foreign affiliate of a corporation resident in Canada should be computed in accordance with subparagraph (a)(iii) of the Earnings Definition. The change in the CRA’s position is effective for the first taxation year of the LLC for which subsection 5907(2.03) has effect, that year being the LLC’s first taxation year ending after August 19, 2011.17
The CRA recognizes that subsection 5907(2.03) does not contemplate a scenario where the “earnings” of a foreign affiliate are computed under subparagraph (a)(i) of the Earnings Definition in one taxation year and under subparagraph (a)(iii) of the Earnings Definition the next taxation year. However, for the purposes of such a transition, the CRA is prepared to accept that paragraph 5907(2.03)(b) applies under this scenario and that the deductions claimed in preceding taxation years in computing the LLC’s “earnings” under subparagraph (a)(i) of the Earnings Definition were “deductions…actually claimed under the Act”.
CRA Response (b)
The CRA’s position is the same where the LLC is treated as a disregarded entity for U.S. tax purposes, regardless of the status of its member for U.S. tax purposes. However, the CRA’s position differs for a U.S.-resident LLC that has two or more members and that is treated as a partnership for U.S. tax purposes. If such LLC carries on an active business in the U.S and is required for U.S. tax purposes to compute its income to determine the partners’ distributive shares, it is the CRA’s view that the LLC must compute its “earnings” under subparagraph (a)(i) of the Earnings Definition in accordance with the income tax laws of the U.S.
Question 12: Support for U.S. Foreign Tax Credit claims
At the 2016 STEP Canada Roundtable, the CRA commented on its recent policy of requiring taxpayers to obtain official transcripts from U.S. federal, state, and municipal tax authorities in order to support foreign tax credits that were claimed in respect of U.S. tax paid. In its response, the CRA announced that a taxpayer who is unable to provide a copy of a notice of assessment, transcript, statement, or other document from the applicable foreign tax authority would be allowed to support its foreign tax credit claims by providing bank statements, cancelled cheques, or official receipts.
a) The IRS does not issue NOA’s like the CRA and there is no online taxpayer portal. It takes much longer to get an IRS account statement than the allotted 30 days even if a 30 day CRA extension is applied for, and barring obtaining IRS power of attorney (difficult to be granted) the IRS statement must be requested by the taxpayer. Has the CRA considered reaching out to the IRS on this matter to streamline the process of obtaining verification of credits claimed.
b) Where a taxpayer performs its employment duties in a large number of U.S. states and municipalities (e.g. professional athletes), it may be very laborious and cumbersome to obtain transcripts or official notices or statements from each of the states and municipalities. Some states and municipalities are very slow to or are incapable of confirming tax payments. Sometimes, no conventional proof of payment are available since the applicable U.S. tax is withheld directly from the taxpayer’s wages.
Would the CRA accept U.S. Form 1040-NR showing a deduction against the U.S. federal tax owed for state tax paid as satisfactory support for the amount of U.S. state tax claimed as foreign tax credit?
CRA Response (a)
The following information was provided in the 2016 STEP Canada Roundtable document (2016-0634941C6).
It is recommended that taxpayers and their representatives not wait until CRA asks for supporting documents before requesting them. According to the IRS website "Most requests will be processed within 10 business days". If a request for the account transcript is made promptly, there would be a reduction or elimination of issues related to the timeframe for submitting a copy if the CRA asks for documentation.
Based on our findings, the IRS has a very structured process for requesting tax account transcripts online or through the mail using Form 4506-T. Information about requesting transcripts from the IRS is available on their website at https://www.irs.gov/Individuals/Get-Transcript-FAQs. In addition, the majority of the U.S. states have an online system which allows the taxpayer to print his/her “account statement” which would confirm the taxpayer’s final tax liability.
At this time, the CRA has not communicated with the IRS on this matter. The CRA will take your suggestion under consideration.
CRA Response (b)
The Canadian FTC is dependent on a confirmed final tax liability with the foreign tax authority and the supporting documents requested are proof of that confirmed final tax liability.
Acceptable supporting documents for individuals reporting U.S. source income are as follows:
- a completed Form T2209, Federal Foreign Tax Credits, for each country to which foreign taxes were paid;
- federal, state, and municipal tax returns and all associated schedules and forms;
- a federal account transcript;
- an account statement or similar document from the state and municipal tax authority;
- all information slips (W-2, 1042-S, 1099); and
- any other document that may be needed to support the claim.
If a joint return is filed with a spouse or common-law partner, also provide a breakdown by income type (for example, interest, dividends, capital gains), country, and recipient. As indicated in the 2016 STEP Canada Roundtable document (2016-0634941C6), if you are unable to provide a copy of the Account transcript from the IRS or the account statement or similar document from the state or municipal tax authority, the CRA will accept proof of payment made or refund received which “…may be in the form of bank statements, cancelled cheques, or official receipts. The following information has to be clearly indicated:
- that the payment was made to or received from the applicable foreign tax authority;
- the amount of the payment or refund;
- the tax year to which the payment or refund applies;
- the date that the amount was paid or received. Note: If you are submitting photocopies of a cancelled cheque, you will need to copy both sides of the cheque unless the front has been micro-encoded by the banking institution.” It should be noted that proof of payment made or refund received only replaces the requirement for a copy of the account transcript, account statement, or similar document, all other documents listed above still need to be provided in support of the claim.
Question 13: ECE/Class 14.1
Proposed subparagraph 13(38)(d)(iii), contained in the Notice of Ways and Means Motion tabled on October 21, 2016 (formerly subsection 13(37)(d)(iii)), provides that if no taxation year of a taxpayer ends immediately before January 1, 2017, and such taxpayer would have had a particular amount included in computing the taxpayer’s income from a business for the particular year because of paragraph 14(1)(b) (as that paragraph applied immediately before that day), the taxpayer will be able to elect that an amount equal to the particular amount is to be included in computing the taxpayer's income from its business for the particular year. One of the conditions set out in the preamble of proposed subsection 13(38) is that this subsection will apply only if a taxpayer has incurred an eligible capital expenditure (ECE) in respect of a business before January 1, 2017. In a situation where a taxpayer has disposed of all of its business in a straddle year but before January 1, 2017, and the intangible business assets disposed of only include internally generated goodwill with no cost, will the CRA consider that subparagraph 13(38)(d)(iii) can apply in this context although the taxpayer has not incurred an ECE in respect of a business before January 1, 2017?
Where a taxpayer’s only intangible asset is internally-generated goodwill with no cost, that taxpayer cannot be said to have made or incurred an ECE in respect of the business. As such, the taxpayer would not meet the requirements of the election in subparagraph 13(38)(d)(iii). It is our understanding that this result is consistent with tax policy.
Question 14: Distribution of Income by an Estate to a Residual Beneficiary
Often a Will is drawn up that is quite simple and uncomplicated, providing minimal specific instructions to the chosen administrator. Such a Will typically directs the Executor to pay the debts and expenses of the deceased, makes specific bequests of property and finally specifies what is to be done with the residue of the estate.
Where during the administration of an estate, taxable income is generated yet all debts and specific bequests have been paid, can the Executor pay or make payable this taxable income to the residual beneficiaries, such that the amount of this taxable income would be considered payable, under subsection 104(24) of the Act, for the purposes of subsections 104(6) and 104(13)?
For purposes of our response, it is assumed that the scenario we are addressing involves an estate that arises on and as a consequence of a death that occurs after 2015.
While the issue of whether a deduction pursuant to subsection 104(6) of the Act will ultimately depend on the terms of the Will and any other laws that impact the administration of the estate, in our view, the following key concepts will be useful in determining how to treat testamentary gifts4 for tax purposes:
1. Where there is no indication in the Will from which assets the gift is to be paid, generally the Executor can make the payment as they wish as long as they act impartially (the evenhand rule), they follow the classification of gifts (and, as is noted in the question posed, they have paid the liabilities of the testator and the estate). The residue of the Estate can include income and the residue of an estate is not necessarily comprised only of after tax amounts.5 Accordingly, in such instances, the income of the estate may be paid or made payable to a residual beneficiary, and a deduction pursuant to subsection 104(6) may be taken by the estate (if no other provision of the Act prohibits such a deduction).
2. However, depending on the wording of the Will, after the debts and specific bequests of the estate have been paid, the Executor may be required to pay the taxes owing on the income generated by the Estate and distribute the after tax “residue” to the residual beneficiaries. In such cases distributions to residual beneficiaries could not be considered to be income payable to a beneficiary for purposes of subsections 104(6) and 104(13).
Accordingly, the estate would be precluded from claiming a deduction under subsection 104(6) in respect of the distribution. Instead, the income would be taxed in the estate, and the residual beneficiaries would receive capital distributions, comprised of after tax paid capital of the estate.
It should also be noted that, pursuant to subsection 104(7.02), no deduction may be claimed under subsection 104(6) by the estate in regard to a gift in respect of which an amount is deducted under section 118.1 of the Act in computing income for any taxation year of the testator.
4 Testamentary gifts are bequests (gift of personalty), devises (gift of real property) and legacies (gifts of money or money equivalents). Bequest and legacies are classified in four main classes: specific, general, demonstrative and residuary. Devises only have three classes: general, specific or residuary. The distinction between the types and classed of gifts is important to determine the order in which the assets are available to pay the testator’s debts and whether the gift adeems or abates. A specific gift adeems when its subject matter is not in the estate at the testator’s death whereas abatement is the pro rata reduction of gifts where there is insufficient funds in the estate to pay the debts and gifts in full. See Oosterhoff on Wills and Succession, Seventh Edition 2011, starting at page 525.
5 “A gift of residue is a gift of that part of the testator’s estate which he or she has not specifically disposed of. Hence, it includes all his or her property after pecuniary, general, demonstrative and specific gifts are satisfied (IBID at page 536).
Question 15: The New Small Business Deduction Provisions
There appears to be an anomaly in these new provisions, perhaps best illustrated by an example. Assume we have two corporations, Opco and Rentco. They are owned by the same person or group of persons, and as such are associated. Opco carries on an active business, and does not earn “specified partnership income” or “specified corporate income”. Rentco owns the real estate from which Opco operates, and earns net rental income of $150,000 from this activity. This income is deemed active business income by Subsection 129(6). The corporate group has under $10 million of taxable capital.
The Present Law
On an annual basis, Opco and Rentco file Schedule 23 to allocate 30% of their business limit to Rentco, and 70% to Opco. Rentco claims the small business deduction (SBD) on $150,000 of income, and Opco claims the SBD on $350,000 of its income.
The Proposed Law
Under the proposed changes, for fiscal years commencing after March 21, 2016, enabling Rentco to continue claiming the SBD on $150,000 per year will require the following steps:
a) Continuing to allocate 30% of the annual $500,000 business limit to Rentco, in accordance with subsection 125(3). This will leave Opco with a $350,000 business limit. This is unchanged.
b) Opco and Rentco must jointly elect an assignment of $150,000 of Opco’s SBD limit to Rentco, as these payments are “specified corporate income”. This assignment is required by subsection 125(3.2), and will be filed on a prescribed form yet to be released. Pursuant to subsection 125(3.1), the amount assigned to Rentco will be subtracted from Opco’s business limit as computed in accordance with subsection 125(3).22 In combination, then, it appears that Rentco may continue to claim SBD on $150,000, but that Opco will be restricted to $200,000 of income, as its business limit of $350,000 (determined in accordance with subsection 125(3)) will be reduced by $150,000 in accordance with subsection 125(3.1).
If 100% of the business limit is allocated to Opco under subsection 125(3), it would continue to have access to SBD on $350,000 of its income, but the assignment to Rentco would not result in Rentco having access to the SBD, as its business limit computed in accordance with Subsection 125(3) would be nil.
Can the CRA confirm that this is the manner in which they interpret the proposed legislation?
The anomaly described in this question was based on the previous version of the draft legislation, released on July 29, 2016, and the Department of Finance was made aware of it.
On October 21, 2016, the Department of Finance tabled revised legislation (The Notice of Ways and Means Motion), which included, inter alia, new subsection 125(10) of the Income Tax Act, which is intended to address the above-described anomaly. New subsection 125(10) provides a computational rule regarding certain amounts that a corporation receives from another corporation to which the corporation is associated and that may be eligible for the small business deduction under subsection 125(1).
Generally speaking, in the above situation, under new subsection 125(10), the $150,000 of income that Rentco receives from Opco would be excluded from the definition of specified corporate income (i.e., it will continue to be treated as active business income of Rentco pursuant to subsection 129(6)), provided the following conditions are met:
(a) The $150,000 is income from an active business of Rentco from the provision of services or property to another associated corporation (i.e., Opco); and
(b) The $150,000 was not deductible by Opco in respect of an amount included in Opco’s income that is:
(i) referred to in any of clauses 125(1)(a)(i)(A) to (C); or
(ii) reasonable to consider as being attributable to or derived from an amount referred to in clause 125(1)(a)(i)(C).