13 June 2017 STEP Roundtable
This provides the written questions that were posed, and summarizes the oral responses provided by CRA, at the Annual STEP Canada CRA Roundtable held in Toronto on 13 June 2017. The presenters from the Income Tax Rulings Directorate were:
Steve Fron, Manager, Trust Section II, Financial Industries and Trusts Division
Marina Panourgias, Senior Rulings Officer, Trust Section II, Financial Industries and Trusts Division
The questions were orally presented by Michael Cadesky and Kim G. C. Moody. Steve Fron cautioned that they were only providing preliminary oral answers, and that the audience should await the written answers, which were released on October 11, 2017, and are linked at the foot of each oral-response summary. The titles have been modified by us.
Q. 1 - Para. (b) of “specified corporate income”
The inclusion of paragraph (b) in the definition of specified corporate income (“an amount that the Minister determines to be reasonable in the circumstances”) in subsection 125(7) creates significant uncertainty in the application of the small business deduction rules. This kind of administrative discretion by the Minister over the determination of an amount, outside of the realm of valuation and arm’s length price, appears to be without precedent in the context of the Income Tax Act. Can the CRA advise on how the Minister intends to exercise its administrative discretion in relation to this proposed provision, and in what circumstances would it do so?
Steve Fron. The definition of specified corporate income of a corporation for a taxation year in s. 125(7) is determined as the lesser of the two amounts in paras. (a) and (b). Para. (b) is the amount that the Minister determines to be reasonable in the circumstances.
The Department of Finance Explanatory Notes indicate that the Minister could determine a lower amount than the para. (a) amount to be the reasonable amount if, for example, the higher para. (a) amount includes income that it is reasonable to consider to be attributable to, or be derived from, income that would not be eligible for the small business deduction.
What is reasonable or not in the circumstances remains a question of fact that can only be made once all the relevant facts of a particular situation are known and have been fully considered. The CRA will only be able to provide specific examples once it has had the opportunity to fully consider specific fact situations involving a taxpayer’s computation of income otherwise determined under subpara. (a)(i) of the definition of “specified corporate income.”
Q. 2 - GAAR and capital distribution to Canco beneficiary
At the 2016 CTF Annual Tax Conference Roundtable, the CRA indicated that it was considering whether the general anti-avoidance rule (“GAAR”) in subsection 245(2) should apply to a situation involving a distribution from a discretionary family trust to a Canco the shares of which are held by a newly established discretionary family trust, thereby avoiding the 21-year deemed disposition that would have otherwise applied if the property had not been distributed by the first trust. Has the CRA made a determination in respect of this matter, and, if so, what are the factors relevant to this determination?
(a) Indefinite deferral
Steve Fron. At the 2016 CTF Annual Tax Conference, the CRA provided its views on the application of GAAR to this scenario, where there was a distribution of property by a discretionary family trust ("Old Trust") to a Canadian-resident corporate beneficiary (Canco), the shares of which were held by a newly-established discretionary trust resident in Canada ("New Trust"). That was all done on a tax-deferred basis pursuant to s. 107(2) in order to avoid the 21-year deemed disposition pursuant to s. 104(4)(b).
I will begin by relaying the response at the 2016 CTF Conference. The transactions described effectively resulted in Old Trust indirectly transferring property to New Trust on a tax-deferred basis, thereby avoiding the application of the anti-avoidance provision in s. 104(5.8) 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 continued to be held in a discretionary trust or arrangement. Furthermore, the New Trust is provided with another 21 years to determine who, from among the potential beneficiaries, will receive the trust 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 s. 104(5.8) in a manner which frustrates the object, the spirit, and the purpose of that provision, the deemed disposition rule in s. 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 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 s. 104(4).
The CRA has significant concerns regarding such 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 regime for the taxation of capital gains, which is to prevent the indefinite deferral of tax on capital gains.
(b) Tracked deferral
At the 2016 CTF Roundtable, CRA also indicated that it was considering the application of GAAR to another situation, whereby the realization of the capital gains inherent in the distributed property would not be deferred beyond the lifetime of the existing beneficiaries at the time of the 21st anniversary of Old Trust. This other arrangement effectively proposed to avoid having the 21-year deemed disposition under s. 104(4) apply to Old Trust on the basis that the deferral of the realization event, i.e. the death of the individual beneficiary, would be consistent with that achieved by a deferred rollover of property to a Canadian resident individual beneficiary pursuant to s. 107(2). However, the trust property would continue to be held indirectly in a discretionary trust.
The CRA has concluded its review of this situation, and it is the CRA’s view that this planning would effectively permit taxpayers to circumvent the anti-avoidance rule in s. 104(5.8) in a manner which frustrates the object, the spirit and the purpose of that provision, as well as the deemed disposition rule in paragraph 104(4)(b), and the scheme of the Act as a whole.
It is the CRA’s view that the object, spirit and purpose of these provisions is that the realization of gains on property in a discretionary family trust should occur every 21 years. There are specific situations provided for in the Act to which the 21-year deemed disposition rule does not apply. In our view, the Act does not contemplate any deferral beyond the 21-year period while property is directly or indirectly held in a discretionary trust. Therefore, this second situation raises the same concerns as the situation described at the 2016 CTF Annual Tax Conference.
As a result, the CRA will not provide any advance income tax ruling where such a structure is proposed to be put in place unless substantial evidence supporting the non-application of the GAAR is provided.
Q. 3 - Dual-resident estate and Art. IV(4)
Under U.S. law, when a U.S. citizen dies, their estate may be considered a U.S. estate under U.S. domestic law. However, such an estate may also be considered a Canadian resident estate pursuant to where the central management and control of the estate resides. Under paragraph 4 of Article IV of the Canada-US Tax Convention (the “Convention”), the Competent Authorities shall by mutual agreement endeavour to settle the question of residency.
a) Has the CRA ever used Article IV(4) in order to settle this question?
b) Can the CRA tell us what factors are considered by the competent authority when settling the issue?
c) Where a U.S. trust is deemed to be a resident of Canada under the provisions of subsection 94(3) of the Act, is it possible to rely on Article IV(4) of the Convention?
d) Can the CRA provide an example of a “mode of application”?
(a) Dual residence requests
Marina Panourgias. In respect of your first question, the Canadian Competent Authority has received very few requests to resolve the dual-residence of a trust or estate with the U.S. competent authority. However, as a result of the 1999 Budget, where it was first announced that significant changes would be made to section 94 of the Act, the competent authority of Canada did receive a number of requests seeking its views on the dual-residence in respect of deemed resident trusts.
(b) Residence factors
When determining whether a trust or estate is a resident of Canada for purposes of the Act, the CRA will apply the criteria that are outlined in the Income Tax Folio on the Residence of a Trust or Estate.
It is generally the CRA’s view that the residence of a trust or estate is a question of fact to be determined according to the circumstance in each case. Of course, it is always important to note that the Supreme Court of Canada clarified that, for the purposes of the Act, a trust resides where the central management and control of the trust actually takes place – so where the trust or estate is also considered to be a resident of the U.S. under the U.S. domestic law, the Canadian competent authority will consider all the surrounding facts on a case-by-case basis to determine the strength of the trust’s ties to Canada relative to the U. S.
In addition to the factors that are listed in the Income Tax Folio on the Residence of a Trust or Estate, some of the factors that the competent authority will consider are:
- the residence of the settlor;
- the residence of the beneficiaries;
- the type and location of the trust property; and
- the reason that the trust was established in a particular jurisdiction.
This is not an exhaustive list. Each case could warrant different considerations based on its particular fact situation, and it may be settled differently.
(c) Resolution of dual residence
The use of foreign trusts to hold capital and earned income is a concern for many countries in the world. A primary concern for Canada is that these arrangements could result in the deferral or avoidance of Canadian tax on income that would otherwise be subject to tax in Canada.
Following the 1999 Budget, the Canadian competent authority conducted extensive consultations with other CRA stakeholders and the Department of Finance and there were discussions with representatives of the competent authorities of Canada and the US in order for Canada to explain its concerns in respect of these situations.
S. 4.3 of the Income Tax Conventions Interpretation Act, which came into force in 2010, clarifies that, under Canadian law, a trust that is deemed to be resident in Canada pursuant to subsection 94(3) of the Act will be considered to be a resident of Canada for the purposes of applying a particular treaty.
Where the deemed resident trust is also considered to be a resident of another country pursuant to that country’s domestic tax legislation, the trust could be considered to be a resident of both contracting states, and may request competent authority assistance pursuant to paragraph 4 of Article 4 of the Treaty to endeavor to settle the question of dual-residence, and to determine the mode of application of the Treaty.
In this context, it is generally the Canadian competent authority’s position that it would not be appropriate to cede on the Canadian residency of a trust that is deemed to be resident in Canada when it is in the course of negotiations with the competent authority of the other contracting state. This policy reflects the view that the tests of residency under s. 94 of the Act are neither inferior nor subordinate to any other tests of residency – but we understand that the competent authority of the other contracting state could be equally reluctant to cede the residence on a trust that they believe to be otherwise resident in their own jurisdiction. Given that s. 94 anticipates providing full relief for any foreign taxes paid by the trust, we understand that the legislation does not contemplate the other country giving up its right to tax the income from non-Canadian sources. Thus, it is the Canadian competent authority’s expectation that the negotiation of these cases, with the question of settling the dual residence for a deemed resident trust, will generally not be possible or advisable.
Paragraph 4 of article 4 of the Treaty does not require the competent authorities to come to a common understanding on the dual-residence of a trust or estate. The provision contemplates that the result may be dual residence for a trust, where the countries cannot settle the question. That being said, the Canadian competent authority does believe that determining the mode of application of the treaty can still proceed in respect of the deemed resident trust, even though the question of residency has not been settled.
(d) "Mode of application"
The competent authority’s position is that the Treaty should be applied to a deemed resident trust to avoid any unexpected double-tax. Once income tax returns have been filed in Canada, the Canadian competent authority will accept requests from trusts that are deemed resident in Canada seeking relief from double tax. That relief could be provided unilaterally or the Canadian competent authority may enter into negotiations with the other contracting state with a view to avoiding any double tax that remains after the application of section 94.
Q. 4 - US taxes of Grantor Trust beneficiary
A Canadian resident individual (Mr. C) who is a citizen of the United States (U.S.) settles a revocable living trust for the benefit of himself and his family members. The trust is factually resident in the U.S. (i.e., the trust is resident in the U.S. for U.S. income tax purposes and the central management and control of the trust resides in the U.S.).
The trust property includes certain real estate interests situated in the U.S. and marketable securities from which the trust earns U.S. source property income.
As the trust is a “grantor trust”, it is disregarded for U.S. tax purposes. Accordingly, Mr. C reports all income earned by the trust on his U.S. income tax return and pays the related U.S. income tax. However, the trust is a trust for Canadian income tax purposes, and is not an arrangement that is deemed not to be a trust as described in subsection 104(1). Further, as Mr. C is a “resident contributor” to the trust, as defined in subsection 94(1), the trust is deemed to be resident in Canada for certain purposes of the Act by virtue of subsection 94(3). As a result, the trust is subject to Canadian income taxation on its worldwide income.
Since Mr. C pays the U.S. income tax in respect of the trust’s U.S. source property income each year, the trust cannot claim a foreign tax credit under section 126 as the trust does not pay the U.S. tax. Similarly, the trust cannot claim a deduction under subsection 20(12) in respect of the tax paid by Mr. C. To deal with the mismatch of foreign income and foreign tax paid, the trustee has suggested two possible alternatives to effectively transfer the foreign source property income to Mr. C. Under the first alternative, the trust can make all of its income payable to Mr. C in the tax year and make a subsection 104(22) designation such that the income retains its character as U.S. source income in Mr. C’s hands. Second, instead of having the trustee allocate the trust income to the beneficiaries, Mr. C can elect to have subsection 94(16) apply to himself and the trust. As Mr. C is the sole contributor to the trust, the application of subsection 94(16) will result in the trust’s income being attributed to Mr. C.
Could the CRA comment on the availability of the foreign tax credit and the deductions under subsections 20(11) and 20(12) under each of these alternatives?
Steve Fron. We originally received this question as a technical interpretation request, and we thought it was interesting enough to pass along for the Roundtable.
For the purposes of this discussion, let us further assume that Mr. C has no other US-source income, and the US tax paid by Mr. C is in accordance with the provisions of the Canada-US Treaty, and is therefore not refundable to him.
First, let us deal with the income being distributed out by the trust. The question refers to the trust making a s. 104(22) designation. That would probably be the normal course of action for a trustee of a resident, or deemed resident, Canadian trust. The trustee might make the designation under s. 104(22) where the trust reports the foreign income and the foreign tax paid, and wishes to pass the foreign income and foreign tax through to the beneficiaries so that they can claim the foreign tax credit in their returns.
However, in this situation, it is relevant that s. 94(3)(a) deems the US trust to be resident in Canada only for the purposes of the provisions listed in subparas. (i)-(x). As s. 108(5) is not included in the provisions contemplated in s. 94(3)(a), s. 108(5) does not impact the territorial source of the income. The territorial source is a question of fact, taking into account all the surrounding circumstances.
Assuming the trust is factually resident in the US, as long as it pays or makes payable the trust income to Mr. C in the year, an amount included in Mr. C’s income pursuant to s.104(13) would be considered to be US-source income – and we assume this throughout the rest of the answer.
As Mr. C has paid the US tax, he may claim the foreign tax credit in respect of the tax paid, subject to the conditions and calculations in s. 126(1). In effect, an s. 104(22) designation is not needed in this case in order to be eligible for a foreign tax credit.
Ss. 20(11) and (12)
Generally, the s. 20(11) deduction is with respect to foreign tax in excess of 15% of the income of an individual from property, other than real property, outside Canada. Pursuant to s. 108(5), except as otherwise noted in Part I, a beneficiary’s income from a trust is deemed to be income from a property that is an interest in a trust, and not from any other source. This deeming changes the nature of the income and, as a result, Mr. C should be able to claim a deduction under s. 20(11).
Any amount deductible under s. 20(11) will reduce the amount of the non-business income tax paid by Mr. C for the purposes of calculating his foreign tax credit in s. 126(1), and determine the amount deductible under s. 20(12).
S. 20(12) allows a taxpayer who is resident in Canada to deduct, in computing income for a taxation year from a business or property, non-business income tax paid to a foreign government in respect of that income. As noted, s. 108(5) applies to deem any amount included in Mr. C’s income under s. 104(13) to be his income from a property that is an interest in a trust.
It is our view that a deduction may be claimed under s. 20(12) in respect of US income tax paid by Mr. C in respect of the trust income that was paid or made payable to him by the US grantor trust in the year. Any amount claimed as a deduction under s. 20(12) will, of course, reduce the amount of business income tax paid by him for purposes of the foreign tax credit.
Where Mr. C elects, as described in the definition of “electing contributor” in s. 94(1), to have s. 94(16) apply to himself and the trust, the amount of the trust income that is required to be included in Mr. C’s income is determined by the formula in s. 94(16)(a).
As Mr. C is the only contributor to the trust, the fraction A/B in that formula equals one, so that he reports 100% of the income earned by the trust. (While electing to have 94(16) apply may seem attractive, as it results in income being attributed to the contributor without there being an actual income distribution by the trust, it is worth noting that the election itself is not revocable.)
S. 94(16)(b) provides that the income required to be included in the electing contributor’s income is deemed to be income from a source in Canada, subject to the amount designated under paragraph (c). S. 94(16)(c) provides that, for purposes of (c), (d), and s. 126, where certain conditions are met, the trust’s income from a source in a country outside of Canada is deemed to be income of the electing contributor from that source.
Thus, Mr. C can claim the foreign tax credit under s. 126(1), in respect of the foreign income that the trust designates under s. 94(16)(c). As para. (c) does not apply for purposes other than those set out in that provision, pursuant to s. 94(16)(b) Mr. C’s income under s. 94(16)(a) remains sourced to Canada for the purposes of s. 20(11). As a result, Mr. C cannot claim a deduction under s. 20(11).
Finally, Mr. C may claim a deduction under s. 20(12) in respect of the US income tax he paid in respect of the income attributed to him under s. 94(16)(a). Any amount claimed as a deduction will, of course, reduce the amount of non-business income tax for the purpose of the foreign tax credit.
Q. 5 - Safe income allocation to discretionary shares
At the 2016 CTF Annual Conference, the CRA indicated that it was conducting a study of how safe income on hand should be allocated for corporations that have issued shares that are entitled to discretionary dividends, and when a dividend disproportionate to the respective pro rata interest is declared on such shares. Can the CRA provide an update on this study?
Steve Fron. We are still looking at this issue. We did make a comment at the 2016 CTF Annual Tax Conference, which I will reiterate: our previous comments on the allocation of safe income should not be taken as implying that the CRA does not have any concerns about safe income being allocated to discretionary dividends shares. The other thing that we said at the CTF Conference is that we really were not willing to provide additional comments until we have provided our review which, as noted, we have not completed.
Q. 6 - GAAR re basis step-up under s. 55(3)(a)
In CRA document #2015-0610681C6, the CRA indicated that it would seek to apply GAAR to a transaction that relies on paragraph 55(3)(a) to artificially create or unduly preserve ACB. The CRA listed the below as an example of such transaction:
“A note or other property (other than assets owned by the dividend payer at the beginning of the series that includes the redemption) received by a dividend recipient as consideration for a redemption of shares in a reorganization that is exempt under paragraph 55(3)(a) is used by a person to generate ACB that is significantly greater than the ACB of the shares that were redeemed.”
We see the CRA applying this principle in CRA document #2015-0604521E5, which describes a reorganization where a promissory note was issued to Holdco on a share redemption and the promissory note was subsequently transferred to Newco as a capital contribution. The deemed dividend arising on the share redemption would not be subject to subsection 55(2) if paragraph 55(3)(a) applied. Since the amount of the promissory note was higher than the ACB of the redeemed shares and the amount of the promissory note increased Holdco’s ACB of the shares of Newco, the CRA viewed these transactions to have artificially increased the ACB in the hands of Holdco and indicated that it would seek to apply the GAAR for Holdco’s reliance on paragraph 55(3)(a).
Can the CRA confirm that a subsequent transaction to ‘use’ the note or other property (including cash) received as consideration for a share redemption, such as the transfer of the note to Newco in CRA document #2015-0604521E5, is a necessary trigger for a GAAR determination with respect to paragraph 55(3)(a)? In other words, could the receipt of a note or other property with ACB higher than the ACB of the redeemed shares in itself cause the GAAR to apply?
Marina Panourgias. One of the roles of subsection 55(2) is to question whether one of the purposes of the payment or the receipt of the dividend that is not derived from income that was subject to tax is to significantly increase the cost amount of property of the dividend recipient. If that is the case, then that dividend should not be tax-free.
Where a purpose to increase the cost amount of property of the dividend recipient exists, GAAR would be triggered, and it is irrelevant whether the cost amount has been used in a series of transactions that includes the dividend.
Q. 7 - S. 55(2) and pipeline planning
An individual dies and leaves in his or her estate a holding company (H1) with an investment portfolio. A capital gain is recognized by the deceased. The estate then structures a pipeline type transaction where the shares of H1 are transferred to H2 and the estate receives a note. Later, the shares of H1 held by H2 are redeemed or purchased for cancellation. Now that subsection 55(2) applies when there is a purpose of reducing fair market value or increasing cost amount, does this mean that the provisions could apply to deem a capital gain to result? Would the estate have a carryover of the safe income of the deceased or would the starting safe income to the estate be nil?
Marina Panourgias. We assume that the ACB of the shares of H1 to the estate is equal to the fair market value of the shares at the time those shares are transferred to H2 and at the time of the redemption of those shares.
Because there would be no capital gain if those shares were disposed of for fair market value proceeds immediately before the redemption, the redemption of shares of H1 would not result in a reduction of any gain. Also, the purpose test in s. 55(2.1)(b)(ii) does not apply to a dividend that is deemed to be received under s. 84(3).
In this situation, the dividend deemed to be received on the redemption or purchase for cancellation would not be subject to subsection 55(2).
This is different from situations where we consider that there was an attempt to artificially create or unduly preserve ACB in a reorganization that would be exempt under either s. 55(3)(a) or 55(3)(b), and that would frustrate the object, spirit and purpose of s. 55(2). Here, the cost amount of the property is the same before and after the redemption, and the reduction of the fair market value of the shares being redeemed does not result in any deductible loss to H2. The CRA would not seek to apply GAAR in this situation.
There is also no carry over of safe income, since the safe income has already been crystallized in the ACB of the shares..
Q. 8 - Art. IV and XXVI: Single-member disregarded U.S. LLC
Consider a single-member disregarded U.S. limited liability company (“SMLLC”) whose member is a resident of Canada. If the mind and management of the SMLLC resides in Canada, Canadian domestic income tax law would treat the SMLLC as a corporation resident in Canada. Since the SMLLC is not liable for U.S. income tax, the SMLLC is not a resident of the U.S. for purposes of applying the Canada-US Tax Convention (the “Convention”). As such, paragraph 3 of Article IV of the Convention cannot be relied on to tie-break the SMLLC to the U.S. Accordingly, the SMLLC would be required to file a T2 corporate income tax return and report its worldwide income, including any U.S. source income. This is the case, even though any such U.S. source income would also be subject to U.S. income tax in the hands of the member of the SMLLC. Moreover, the SMLLC would not be entitled to claim any foreign tax credit for the U.S. income tax paid by its member. Assume that, for the purposes of the question, the U.S. source income is taxable in the U.S. on the basis that it is business income earned through a permanent establishment in the U.S.
Pursuant to paragraph 1 of Article XXVI of the Convention, a person may approach the competent authority of the Contracting State of which the person is a resident, if the person considers that the actions of one or both of the Contracting States result in taxation not in accordance with the provisions of the Convention. Although the member of the SMLLC and the SMLLC are distinct taxpayers in the eyes of Canadian income tax law, they are one and the same from the perspective of U.S. income tax law. It could be viewed that, from the U.S. perspective, the member is double-taxed on the same U.S. source income: the member’s U.S. source income is taxed once under U.S. income tax law, and the same income is taxed again under Canadian income tax law also in the hands of the member (since the SMLLC is disregarded from the U.S. perspective).
Does the Convention provide relief from double taxation in the circumstances described? Would the answer be the same for U.S. LLPs or LLLPs?
Steve Fron. We agree that paragraph 3 of Article 4 of the Treaty does not apply in the circumstances described, with the result that the single-member LLC would be subject to tax in Canada as a resident. In determining any relief from double taxation in the form of a deduction against Canadian income tax payable, i.e. a foreign tax credit, paragraph 2 of Article XXIV of the Treaty confirms that any deduction against Canadian income tax payable is subject to the provisions of the Act.
In the circumstances described, the CRA agrees that s. 126 of the Act does not allow for the US income tax paid by the member of the single member LLC to be credited against the Canadian income tax payable by the SMLLC itself. However, relief from double-taxation may be available to the member in the form of a deduction under s. 20(12) of the Act or, to the extent that the U.S. income tax paid by the member is not deducted under s. 20(12), and the member has income from a source in the US, that that member could claim a foreign tax credit against their own Canadian income tax otherwise payable.
Regarding paragraph 1 of Article XXVI, it is our view of the circumstances described that there is no taxation that is not in accordance with provisions of the Treaty. Accordingly, Art. XXVI(1) does not help.
We think the answer would be the same for a U.S. LLP or LLLP which is treated as a fiscally transparent entity for purposes of US income tax law and as a corporation for purposes of Canadian income tax law. At the 2017 International Fiscal Association Annual Conference the CRA provided an update on the deliberations of its internal working group, which is studying compliance issues related to Florida and Delaware LLPs and LLLPs arising from its 2016 announcement that it would generally consider such entities to be corporations for purposes of Canadian income tax law.
We note that the double-taxation described in the scenario could be avoided entirely by the SMLLC if it elects to be taxed for US income tax purposes as a traditional C-corporation. It is our understanding that such an election would result in the SMLLC being liable for US income tax and thus to be a resident of both Canada and the US - and then, pursuant to subparagraph 3(a) of Article 4 of the treaty, the SMLLC would be deemed to be a resident only of the US.
Alternatively, if the SMLLC is eligible to, and does, elect to be taxed as an S-corporation after it elects to be taxable as a C-corporation, it is the CRA’s understanding that it would be subject to pass-through taxation for U.S. income tax purposes like a typical disregarded US LLC. However, the member may be able to request competent authority assistance pursuant to paragraph 5 of Article XXIX of the Treaty. It is our understanding that there are numerous conditions that an SMLLC would have to meet in order to be eligible to elect to be treated as an S-corporation. One such condition is that the SMLLC must have no non-resident alien shareholders. Therefore, in the situation described, the Canadian resident member would have to be resident in the US, i.e. a dual resident, or U.S. citizen.
Q. 9 - Art. XXIX(5) – Qualified Subchapter S Corp. Sub
Under paragraph 5 of Article XXIX of the Canada-US Tax Convention (the “Convention”), the Competent Authority of Canada may agree to allow a Canadian-resident shareholder of a United States S Corporation to apply the following rules for Canadian tax purposes with respect to the period during which the agreement is effective:
a) the corporation shall be deemed to be a controlled foreign affiliate of the person;
b) all the income of the corporation shall be deemed to be foreign accrual property income;
c) for the purposes of subsection 20(11) of the Income Tax Act, the amount of the corporation’s income that is included in the person’s income shall be deemed not to be income from a property; and
d) each dividend paid to the person on a share of the capital stock of the corporation shall be excluded from the person’s income and shall be deducted in computing the adjusted cost base to the person of the share.
The cumulative effect of these rules synchronizes the recognition of income in Canada with that of the US and allows the shareholder to claim a foreign tax credit in respect of the amount of US tax paid on his or her share of the S Corporation’s income. However, paragraph 5 of Article XXIX of the Convention does not apply automatically. It only applies to a shareholder of an S Corporation who requests and enters into an S Corporation Agreement with the Canadian Competent Authority. Additionally, if the shareholder has an interest in more than one S Corporation, a separate S Corporation Agreement is required for each corporation. This was recently confirmed by the CRA at the 2015 STEP CRA Roundtable.
Can the CRA comment on the situation of an S Corporation that holds the shares of a qualified subchapter S Corporation subsidiary (“QSSS”). A QSSS is a wholly-owned subsidiary of an S Corporation for which a separate U.S. tax election is made to treat it as a pass-through entity. In such situation, is the Canadian-resident shareholder of the S Corporation required to enter into two separate S Corporation Agreements: one with respect to the parent S Corporation and the other with respect to the QSSS? Or would the S Corporation Agreement for the parent S Corporation automatically cover the QSSS?
Steve Fron. The answer to the question at the 2015 IFA Roundtable in respect of an S-corporation agreement, provides some background in respect of making an S-corporation agreement, and the Canadian income tax implications.
It is our understanding that, when an S-corporation elects, under the Internal Revenue Code, to treat one of its subs as a Qualified Subchapter S Subsidiary [“QSSS”], the sub is no longer treated as a separate corporation under the Code, and items of income and deduction are treated as those of the S-corporation.
The template S-Corporation agreement used by Canadian competent authority provides that the income of the S-Corporation that is deemed to be foreign accrual property income, and which is provided in Art. XXIX(5)(b), is to be determined in accordance with the Code. On that basis, if the shareholder of an S-Corporation in the circumstances described has entered into an S-Corporation agreement with the competent authority, the income of the S-Corporation, as computed under the Code, which will include the income of the subsidiary, is deemed to be foreign accrual property income. If that is the case, there is no need for the Canadian shareholder to enter into a separate S-Corporation agreement with respect to the subsidiary.
Q. 10 - Trustees' payment of children's expenses
Where a trust pays an expense for the benefit of a beneficiary, is the beneficiary required to direct and concur with the payment of the disbursement on the beneficiary’s behalf in order for the payment to be deductible to the trust pursuant to subsections 104(6) and (24), and included in the beneficiary’s income pursuant to subsection 104(13)? For example, a father who is the trustee of a discretionary family trust takes his children (who are beneficiaries of the trust) out for dinner. The father itemizes his children’s expenses, reimburses himself out of the trust funds for the meal expense incurred on behalf of the trust beneficiaries, and issues T3 slips to each child.
According to the CRA’s comments in ITTN 11, Payments Made by a Trust for the Benefit of a Minor Beneficiary, (September 30, 1997), this arrangement is acceptable for expenses paid on behalf of minor children. However, we are aware of similar situations which the CRA has recently audited and proposed to reassess because a beneficiary did not direct and concur with such payments incurred on their behalf. Can the CRA advise as to whether there has been a change in policy from ITTN 11?
Marina Panourgias. We would first like to note that all previously archived Income Tax Technical News documents, including ITTN 11, were cancelled and removed from the CRA website in 2012. Going forward, all relevant technical content from these documents and Income Tax Interpretation Bulletins will be communicated using Income Tax Folios.
With respect to trust payments made to a third party for the benefit of a minor beneficiary, or to a parent as reimbursement for expenses made for the benefit of that beneficiary, ITTN 11 outlined three requirements for such payments to be considered to be deductible from the trust income, and included in the beneficiary’s income:
- the trust must exercise discretion, pursuant to the terms of the trust or the will, to make the amount of the trust income payable to the child before the payment is made;
- notification to the parent of the exercise of the discretion, along with the parent’s direction to pay the amount to the appropriate person, must occur, or;
- the payment must be made pursuant to the parent’s request and direction, where the parent was advised of that discretion; and
- it is reasonable to consider that the payment was made in respect of an expenditure for the child’s benefit.
It would be inappropriate to comment on a particular audit situation involving a specific taxpayer, so we can only offer some general comments.
The determination of whether the requirements in ITTN 11 have been met can only be made on the completion of a review of all the relevant fact, including the terms of the trust. It is possible, after such a review, that the CRA might conclude that those requirements have not been met. In a situation where a trustee seeks to deduct such an amount from the income of the trust, and to have that amount included in the income of the beneficiary, the onus of proof is presumed to lie with the taxpayer.
In addition to the requirements in ITTN 11, the comments of Bonner TCJ in Degrace Family Trust, which was released after ITTN 11, are also helpful. At para. 5, Bonner TCG stated:
Assuming, without deciding, that payment of trust funds to a trustee and expenditure of such funds by the trustee for the benefit of a beneficiary may constitute payment to a beneficiary within the meaning of subsection 104(24) of the Act, the expenditure by the trustee must clearly be made by the trustee in his or her capacity as trustee for a purpose which is unequivocally for the benefit of the beneficiary.
Guidance from this decision was also applied in a 1999 technical interpretation, where it was noted that, in the case of a payment from a discretionary trust to a parent representing a reimbursement of household expenditures, the onus of proving that the payment was for the child’s benefit is not met when the household expenditures are basically totaled and divided by the number of family members in order to determine the child’s share. It was also noted that, when it comes to household expenditures, it would be very difficult for the trustee to substantiate that the payments are unequivocally for the child’s benefit. It was further noted that the comments relating to household expenditures would apply in respect of any kind of expenditure made by the trust.
Finally, note that ITTN 11 was published about 20 years ago, and a lot has changed since then. The CRA intends to review the commentary in ITTN 11 to evaluate its continued validity, and may provide an update if that is deemed appropriate.
Q. 11 - Spousal rollover and substituted property
As a consequence of the death of a taxpayer, and where certain conditions are met, subsection 70(6) allows property held by the deceased immediately before the death, to be transferred to a trust described in paragraph 70(6)(b) on a tax-deferred "rollover" basis. This provision requires, inter alia, that the property has vested indefeasibly with the spousal trust within 36 months of the taxpayer’s death.
Suppose the will of a deceased taxpayer provides that certain assets are to be transferred to a spousal or common law partner trust. Before doing so, and while property of the estate is being administered, certain property might change or be substituted by the Estate. For example, shares might be converted from one class to another. If so, is the spousal rollover still available? If not, does the gain recognized on the tax return of the deceased have to be amended?
Marina Panourgias. At the 2015 APFF conference, the CRA commented on whether the rollover under s. 70(6) would apply if the executor of an estate disposed of the property of the estate and transferred the proceeds or property substituted for those proceeds to a spousal trust created under the will of the deceased.
In that response, it was noted that the spousal rollover applies on a property-by-property basis, and the spousal trust must receive the same property that is deemed to have been disposed by the deceased taxpayer immediately before his or her death. Any property substituted for the property held by the deceased taxpayer would not qualify for the spousal rollover, because the language in s. 70(6) does not refer to substituted property.
The CRA also noted that it is a question of fact and law whether a particular property has been transferred or distributed to a spousal trust, and vested indefeasibly in the spousal trust within the required timeframes in order for the conditions under s. 70(6) to be met. This can only be determined following a review of the applicable law, the jurisprudence, the will, and all other relevant documents and circumstances in respect of the particular property.
Turning back to the example here, which involves a reorganization of the shares, the determination of whether s. 70(6) could apply depends on whether the shares of the deceased taxpayer, at his or her death, were considered to have been transferred to, and vested indefeasibly in, the spousal trust prior to that reorganization.
Thus, similarly to our comments at the APFF, this is a question of fact and law, and further information would be required to make that determination. If it is determined that the shares were not transferred or distributed to the spousal trust, or not vested indefeasibly in the spousal trust before that reorganization, the shares would not be eligible for the spousal rollover in s. 70(6). If that is the case, then s. 70(5) would apply, and the deceased taxpayer would be deemed to have disposed of those shares immediately before death, and would realize a capital gain or loss that would need to be reported on the individual’s terminal income tax return.
Q. 12 - T3 reporting re s. 75(2) trust
As most trust and tax practitioners know, subsection 75(2) of the Income Tax Act will attribute trust income, losses, capital gains and capital losses to the contributor / settlor if certain conditions are met. The 2016 T3 Guide (T4013) states the following:
Certain related amounts, including taxable capital gains and allowable capital losses from that property or the substituted property, are considered to belong to the contributor during the contributor's life or existence while a resident of Canada. The trust must still report the amount on the trust's T3 return and issue a T3 slip reporting the amount as that of the contributor of the property.
While the recommended approach to report the amount of the attributed income is certainly a good practical approach, it may not be consistent with the law. Subsection 104(6) will only provide a deduction against trust income for amounts paid or payable to the beneficiaries which requires the issuance of a corresponding T3 slip to the recipient beneficiaries. In many cases, however, the terms of the trust that is affected by subsection 75(2) will not have any amounts paid or payable to the contributor / settlor and ultimately the taxation of the applicable amounts in the contributor / settlor’s hands is only because of subsection 75(2) and not subsection 104(6). Accordingly, when preparing the accounting records for the trust, the subsection 75(2) attributed amounts are not recorded as being paid or payable to the contributor / settlor since the facts of the particular case will often not require the actual payment of such amounts to the contributor / settlor. Given such, many practitioners do not agree that a T3 slip should be issued to the settlor and, instead, the attributed amounts should simply be recorded as an elimination of the applicable reported amounts on the T3 return and a subsequent direct reporting by the contributor / settlor. Can the CRA comment on this approach please?
Steve Fron. We addressed a similar question at the 2006 STEP Roundtable, and I will relay a few of those comments to you.
As you know, the T3 return is an income tax and an information return, and it serves to report not only information with respect to the reporting trust, but also information such as that affecting the taxation of persons, beneficiaries or settlors having some connection to the trust.
Consistent with this is the additional requirement for the trust to issue T3 slips to persons whose own income tax requirements may be affected by arrangements involving the trust. These persons include those to whom an amount is attributed from the trust under one of the statutory attribution rules. The information provided under these mechanisms is necessary for the proper administration of the tax system.
These specific reporting requirements are imposed by s. 204 of the Income Tax Regulations. The statutory power to promulgate this regulation is not limited to s. 150 of the Act, which speaks directly to the requirements for income tax returns – it is also found in s. 221 of the Act. S. 221 contains a broad range of prescribing powers, including powers to promulgate regulations imposing requirements to file information returns.
Therefore, given the nature of the T3 reporting return as both a return of income and an information return, the statutory requirement (as per Reg. 2014) to file a T3 return exists where the trustee has control of, or receives, income, gains, or profits in the trustee’s fiduciary capacity. This would be the case even if the trustee computes nil income for the trust for tax purposes, and this would be a circumstance where the trust has no income for tax purposes because s. 75(2) applies to recognize amounts as those of another person for tax purposes.
These comments remain relevant, and they are supported by the law. It is important to note that, when considering the issue as noted in the 2016 response, the filing requirements of a trust are not confined only to a return of income; the Regulations also impose the information filing requirement.
The analysis, as to how to report the income attributed under s. 75(2) to the contributor or settlor, cannot be based solely on whether or not a deduction pursuant to s. 104(6) is applicable. In other words, it does not hinge on whether s. 75(2) amounts were paid or payable to the beneficiaries of the trust..
Q. 13 - TFSA share trading
Subsection 146.2(6) of the Income Tax Act provides that if a TFSA “carries on one or more businesses” then Part I tax is payable on its business income. We are aware that this has been a focus for CRA audit and reassessment activities targeting taxpayers who actively traded securities in their TFSA. Can the CRA provide an update on the result and its future intention on its activities in respect of this area? Also, does the CRA have any plans to educate the public on what the acceptable limits are on securities trading to prevent a TFSA account from being considered to be carrying on a business?
Steve Fron. The CRA is committed to maintaining compliance-presence on high-risk TFSA transactions to ensure that the provisions of the Act are respected. To date, the CRA has reassessed more than $75 million in additional taxes resulting from audits of TFSAs.
In 2016, CRA released a Folio entitled “qualified investments, RRSPs, RESPs, RRIFs, RDSPs, and TFSAs.” The Folio provides information on tax consequences of a registered plan taking on a securities-trading business. I think the key paragraph in the Folio is 1.87, which states:
The determination of whether a particular taxpayer carries on a business is a question of fact that can only be determined following a review of the taxpayer’s particular circumstances. Interpretation Bulletin IT-479R, Transactions in Securities, sets out factors developed by the courts that are relevant in determining whether transactions in securities constitute carrying on a business. While there is nothing unique in applying these general principles to securities trading that occurs within a registered plan, several exceptions apply so that certain business activities will not give rise to adverse tax consequences.
Back to our question on TFSAs specifically, it is our view that there really is not anything unique to TFSAs when determining whether transactions and securities constitute carrying on a business. As such, we do not have any plan to provide any further guidance specific to TFSAs on this issue.
Q. 14 - Dedicated Telephone Service
The Income Tax Rulings Directorate recently confirmed at the 2017 CPA-BC & CRA Roundtable the CRA’s plan to introduce a new dedicated telephone service (DTS) for income tax service providers, which was originally announced in Budget 2016. Under a three-year pilot project beginning in July, 2017, the DTS will initially be offered to certain Chartered Professional Accountants in Ontario and Quebec. The DTS is intended to provide participants in the project with access to experienced CRA staff who can help with more complex technical issues.
Can the CRA provide an update on this pilot project?
Marina Panourgias. Last Monday, there was a soft launch of the new dedicated telephone service, where Rulings officers assigned to the new service began to accept calls from 500 registrants that were provided early access. The response so far has been positive. In the coming weeks, access to the service will be gradually expanded until 3000 participants are registered.
The registration is open to CPAs in Ontario and Quebec who are in public practice as sole proprietors or in groups of up to three professional partners or shareholders.
CPA Ontario and CPA Quebec began to contact eligible participants with information on how to register for the service beginning back in April. Registrations are still ongoing, and will continue to be accepted under the pilot project on a first-come, first-serve basis, until 3000 participants are registered. If the three-year project is successful, the DTS might be expanded nationwide, and to more income tax service-providers, on a permanent basis.
To give a bit more background, participants of the dedicated phone service will benefit from having telephone access to experienced staff within the CRA who can provide guidance on more complex income tax issues. The service is intended to be a technical resource for those that are in the business of preparing income tax returns, but the service is not intended to be a problem-resolution line in respect of specific taxpayer issues, so the DTS officers will not have access to taxpayer accounts.
The DTS is not intended for specialized tax professionals who provide complex tax-planning services. These advisors should continue using the existing advance income tax rulings or technical interpretation services to address their needs.
Q. 15 - Registration of Tax Preparers Program
On January 17, 2014, the Minister released a proposal to introduce the Registration of Tax Preparers Program (RTPP) which is a registration system for tax preparers who prepare tax returns for a fee, and requested input from taxpayers, tax preparers and other stakeholders. Can the CRA comment on the input it has received, and the status of this proposal?
Marina Panourgias. The Registration of Tax-Preparers Program, or RTPP, was original announced as part of the CRA’s three-point plan to improve voluntary compliance for small- and medium-sized businesses. The RTPP was designed as a registration system for tax-preparers who prepare individual or corporate income tax returns for a fee. The overall objective of the program was to work closely with the tax-preparer community to prevent frequent and re-occurring mistakes in the filing of income-tax returns.
The CRA launched a public consultation process on the RTPP in January 2014 to gain a better understanding of the business needs of tax-preparers and the impact of the registration process, and to solicit input from all stakeholders. The tax-preparer community provided valuable input into the proposed program. Generally, tax-preparers expressed a desire to continue working closely with the CRA, and the overall results of the consultations was that the RTPP should be designed to minimize additional red tape, to emphasize a collaborative and preventative approach to addressing non-compliance, and to enhance services that would serve to reduce non-compliance.
Taking into consideration the input of stakeholders, the CRA further pursued its analysis of the legislative system requirements needed to implement the RTPP. This analysis has shown that, to be effective, the program as originally proposed would require significant investments that no longer align with the CRA’s priorities.
However, the goals of the RTPP continue to be relevant to an effective tax administration, which is the value and importance of working with stakeholders to prevent common errors, and to improve long-term compliance. The CRA is now considering other options that would serve to implement the objectives of the proposed RTPP, through existing programs and initiatives, at lower cost.
With the collaborative and educational approach, that includes leveraging programs like the liaison officer initiative, and the dedicated telephone service pilot, as well as its current partnerships with various associations and other stakeholders, the CRA believes that it can achieve the objectives of the RTPP in a more cost-effective manner.
Going back to the public consultations – if anyone is looking for more information, a detailed analysis of that consultation has been posted on the CRA website.