11 October 1996 APFF Roundtable, 7M12910 - APFF ROUND TABLE

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

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

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

ASSOCIATION DE PLANIFICATION FISCALE ET FINANCIERE
ROUND TABLE ON FEDERAL TAXATION
ANNUAL MEETING
October 9, 10 and 11, 1996

INTRODUCTION

The round table provides an ideal opportunity to interact with representatives of Revenue Canada and Finance Canada. We would like to begin by thanking everyone here for their participation. It must be understood that the clarifications that emerge from these discussions are extremely useful, both to practitioners who want to know the positions of tax authorities and to those same authorities, who have a vested interest in making their positions known and thus facilitating the enforcement of the Act.

Historically, the round tables have involved a fairly large number of very specific questions to which the tax authorities have responded briefly. There was a time when the round tables, interpretation bulletins and private requests for interpretation were the only sources of the department position on a variety of situations. Now, many of these positions are available in seconds onscreen. This means that it is time to change the style of interchange at this type of event. There is a steadily increasing desire among practitioners to know, not only the position of tax authorities, but the reasons underlying the tax policies and interpretations that have led the tax authorities to adopt these positions. In other words, in addition to being aware of the tax authorities' position, today's practitioners want to understand it.

1. INTERNATIONAL TAXATION

1.1 Transfer Pricing

1.1.1 Transfer Pricing Methods

In recent years, there have been many changes to the taxation rules on transfer pricing.

First of all, the United States adopted a set of rules that appear to be largely profit-based while Canada, with a position more like that of the OECD, bases its approach to transfer pricing on transaction values. In particular, the use of the comparable profit method in the United States seems to have caused considerable distress to Canadian tax authorities.

In this context, it would be interesting to know if Canadian authorities are planning any legislative or administrative changes to Canadian transfer pricing rules in reaction to this situation. Generally speaking, are there any plans to amend the existing transfer pricing rules, or can multinational enterprises expect a period of stability in this regard on the part of Canada?

Comments by Department of Finance

The Income Tax Act includes provisions designed to ensure the reasonableness of the consideration paid in the context of certain transactions between a taxpayer and a non-resident with whom the taxpayer is not dealing at arm's length. These provisions respect the criteria for the arm's length principle established by the Organization for Economic Cooperation and Development (OECD) in what are known as the OECD Transfer Pricing Guidelines.

As you know, the OECD recently published a revised version of its Transfer Pricing Guidelines, which contains advice on questions that the OECD had not previously dealt with (e.g. profit-based methods for determining the reasonableness of the consideration paid by parties not dealing at arm's length, documentation of transactions and imposition of penalties). Generally speaking, the changes reflect changes that have occurred since the publication of the first guidelines in 1979 and, more especially, the substantive consolidation of the provisions on transfer pricing in force in the United States.

From this perspective, the Department of Finance will examine the provisions of the Income Tax Act that deal with transfer pricing (subsections 69(2) and (3)) to ensure their conformity to the new OECD guidelines. It also intends to study the guidelines in relation to the imposition of penalties for inappropriate or inaccurate transfer pricing, and the new provisions on the imposition of penalties in force in the United States, in order to determine whether or not a similar plan would be suitable for Canada.

Comments by the Department of Revenue

As most of you probably know, the OECD working group mandated to review OECD guidelines published two studies on transfer pricing. The first of these, entitled "Transfer Pricing for Multinational Enterprises and Tax Administrations" was published in 1979 and the second, entitled "Transfer Pricing for Multinational Enterprises and Tax Administrations - Three Taxation Studies" was published in 1984.

Revenue Canada and Finance Canada represented Canada on this working group from the outset. Although the main reason these OECD studies were revised was the draft American regulation on transfer pricing, some revision would have been necessary in any case as the original studies gave few specifics on the transfer pricing methods that could be acceptable in cases where the information required for the application of methods based on transaction values was not available.

Although the scope of the work to be done was extremely ambitious, the deadlines for completion of the sections of the revised report were met.

The subject matter to be covered was divided into three parts:

•  Part One:		Principles and methods
•  Part Two:		Applications
•  Part Three:	Specific subjects (e.g. permanent establishment)

The report's revised Part One, containing the most important subject matter, was published in the summer of 1994 for comments by members of the public; the final version was published in July of 1995. Part One contains a preface, a glossary of terms and seven chapters.

Chapter I reiterates the desire of OECD member countries to respect the arm's length principle as a means of establishing transfer prices. Also included are a number of general indications for application of the principle, including a detailed examination of comparability and analysis of the functions performed by the parties. Comparability of the situation being examined and external proof of the accuracy of the price are two factors that are of particular significance in the establishment of transfer prices. If the quality or quantity of products sold, the markets on which they are sold or the other conditions of sale are not essentially the same, external proof cannot be introduced unless adjustments are made to take the variation in conditions of sale into account.

It is also essential to determine the functions performed by the parties and the risks they take. It is not usually acceptable, for example, to let it be understood that a taxpayer who acts as an agent and takes no risk relating to ownership of the property in question should obtain the same return as a taxpayer who is a client and assumes the risks associated with ownership of property.

Chapter II discusses traditional transaction methods. The superiority of these methods over the profit split and the transactional net margin (TNM) methods, commonly known as "transactional profit methods" is confirmed, as the former compare the net profits of the parties. The American concept of comparable margin of profit (CMP) is not discussed as such, but the observations on TNM apply to it. Chapter II is more specific than the 1979 report on the question of the application of these methods and examples are given.

Chapter III discusses transactional profit methods and a method that does not involve the arm's length principle, i.e. "global formulary apportionment". In this latter method, the income earned by the members of a multinational group are totalled and then distributed among the countries in which the members are active using a predetermined arbitrary formula based on a combination of costs, assets, wages and sales. The OECD rejects apportionment of this kind, qualifying it as arbitrary and contrary to accepted practice and reaffirms its endorsement of the arm's length principle.

The two profit-based methods discussed to in Chapter III are methods of last resort, to be used only where traditional transaction methods cannot be applied. In our opinion, although the OECD does not state a clear preference for the transactional net margin method, the examination of the strengths and weaknesses of the two methods shows that the profit split method is clearly superior.

Examination of the TNM method point out that the method is used to determine the profit that would have been obtained in one or more controlled transactions, indicating that it must not be used in recalculating the profit earned in arm's length transactions. The guidelines establish a very high standard of comparability of the situation of the taxpayer with that of the party or parties to which the taxpayer is compared for application of the TNMM. The guidelines also require that, where market differences between two taxpayers have a significant impact on operating margin, adjustments must be made to take these differences into account. Furthermore, the OECD Fiscal Committee states its intention of supervising the use of transactional profit methods by member countries in order that the conclusions of the report may be re-examined when the information accumulated so justifies.

The TNM studied by the OECD differs from the 1992 and 1993 American versions of comparable margin of profit (CMP). In 1993, the American regulation was amended, primarily as to form. Our comments on the 1992 version of the regulation, and those of other partners in a convention with the United States and the OECD, were essentially the same as the comments on the 1992 version of the regulation. Nonetheless, the disparity between the viewpoints of the OECD and the United States has since narrowed: in 1994, the United States again amended its regulation, adding comments that essentially respect OECD views.

Many comments have been received from the public and from the Business and Industry Advisory Committee to OECD. The most important reservation expressed concerns the report's claim that TNM may comply with the arm's length principle, and that its use is not absolutely prohibited. By the way, we agree with the OECD position that it is possible, in some situations, for TNM or CMP to produce a result that conforms to the arm's length principle even if, in our opinion, such situations are extremely rare. When we were drafting our comments on the American regulation, and when the joint Revenue Canada/Finance Canada news release on transfer pricing was published on January 7, 1994, we saw that we were unable to demonstrate conclusively and, as a result, unable to state categorically, that CMP could never produce a result that would conform to the arm's length principle. Not that we think CMP is a sound method for transfer pricing, but that we are unable to prove that it could never produce a result that conforms to the arm's length principle.

This question was the subject of a lively and heated debate at the OECD. The OECD has replaced the references to CMP by references to TNM. TNM is defined as a method that enables examination of the transactional net margin earned by a taxpayer in controlled transactions relative to a given reference point. This is not simply a word game. The CMP examined by the OECD and the TNM are both methods more general in nature than the American CMP. Because of the new nomenclature, we must not infer that the OECD study deals only with the American TNM as it existed at the time the report was written. The main differences between the American CMP and the TNM are the following:

• the American CMP could replace transactional profit methods, whereas it is specified that TNM is a method of last resort;
• the American CMP could apply to all a taxpayer's transactions, whereas TNM is restricted to internal transactions;
• the American CMP did not require a high level of comparability prior to application, whereas TNM requires a very high degree of comparability, the application of which is to be closely tended by a supervisory process to be implemented and monitored by the OECD Fiscal Committee.

As we have said, the American regulation and related comments now establish clearly that the CMP is not usually as sound as transaction based methods; it is however a method of last resort (unfortunately, no distinction is made between profit splitting and CMP) and such methods require a far higher standard of comparability than previous CMP methods.

We do not see why our position on transfer pricing should be significantly changed because of the new OECD guidelines. On most of the important points and, as a result, on most of the specific points, the revised guidelines correspond essentially to the 1979 and 1984 reports. There has been no substantive revision of the basic principles on transfer pricing: the arm's length principle remains. There has been no radical change in recognition and classification of the various methods — the superiority of methods based on transaction values is reaffirmed. Profit splitting, which we use as a method of last resort when it is impossible to use methods based on transaction values, and TNM are methods that are recognized, taking into account certain reservations mentioned above. In view of these reservations, it is our opinion that TNM is a method that must only be used in exceptional situations when it is impossible to use another method, including the profit split method.

1.1.2 Advanced Pricing Agreements

Secondly, Canada has established a procedure for advance transfer pricing decisions. It would be interesting to know the usefulness and popularity of this new procedure to date, and the extent to which the advance decision process in Canada has been harmonized with similar procedures abroad.

Comments by Department of Revenue

Advance Pricing Agreements (APA) were implemented by Canada and a number of other countries to solve problems that face taxpayers when internal transfer prices are set. The twofold objective of a bilateral APA (BAPA) is to eliminate double taxation by taxpayers residing in Signatory States and promote voluntary compliance.

The United States officially launched their APA program in March of 1991 and included, in "Rev. Proc. 91-22", the procedures governing the program. In July of 1993, Canada officially announced the launching of its APA program. We adopted procedures and guidelines essentially the same as the American ones and published them in Information Circular 94-4, International Transfer Pricing: Advance Pricing Agreements (APA), on December 30, 1994. I would like to add that the detailed guidelines referred to in paragraph 2 of the Circular are currently in the last stages of study and are to be published shortly.

Our APA program is in its third year. It is administered by the International Tax Programs Directorate, Transfer Pricing and Competent Authority Section. We are especially satisfied with the spirit of cooperation and the good faith demonstrated by tax administrations and taxpayers with regard to APAs, and of the exceptional advantages APAs have brought to both taxpayers and tax administrations.

Since the implementation of our program, we have concluded five APAs with the United States. At the present time, we are dealing with forty-four (44) requests from taxpayers (two (2) renewals and eight (8) at the preliminary meeting stage). We expect to settle seven (7) other cases in the near future.

To date, APA requests have been submitted by related parties that do business in the United States and all but five of the agreements are bilateral.

Most of the taxpayers interested in the process have had some problems establishing transfer prices. When we are able to solve these problems in advance to our satisfaction and that of the taxpayer and any other tax administration involved, the results are extremely advantageous for all interested parties. Dealing with questions in advance is extremely useful because it makes it easier to obtain the necessary documents and explanations, something that is not always possible after a certain amount of time has elapsed.

Although most taxpayers who request APAs are large multinational corporations, we invite and encourage all smaller corporations who have interests on foreign markets to examine their individual situation and the advantages to be gained by having an APA.

The Department recognizes that establishing an APA involves expense to the taxpayer. The charges levied by the Department for an initial agreement can be as high as $20,000; however, renewal costs are far lower because all that is needed is to update an existing agreement, which takes far less time and effort. Our rule is to limit the charges levied to miscellaneous costs, and no account is taken of the time that employees devote to examining and processing APA requests. In some cases, APA related costs are as high as the possible cost of resolving transfer price related disputes through more usual channels (e.g. audit).

We also believe that interest in these agreements and requests for them will increase worldwide, inasmuch as taxpayers in Canada and other countries become more aware of the advantages to be gained thereby.

Other countries have also decided to include APAs in their services to taxpayers or broaden the field of application.

• In July 1994, Australia published its Draft Taxation Ruling on procedures governing internal APAs.
• Japan extended the application of its internal preconfirmation system.
• Mexico is making more and more of an effort to sign APAs.
• The United Kingdom has signed APAs in the context of its recourse to the competent authority process.
• The Netherlands recently announced inauguration of an APA program.
• In October of 1994, the competent authorities of the member countries of the Pacific Association of Tax Administrations (PATA) (Australia, Canada, Japan and the United States) adopted a set of common procedures for processing APAs.

1.2 Foreign Holding Companies

Most international corporate structures involve the use of holding companies resident outside Canada. These holding companies are established in jurisdictions that offer attractive tax features, for purposes that vary with the particular situation. We are seeing more and more cases where Revenue Canada attempts to attack the effectiveness of structures that involve foreign holding companies.

Two types of argument are used in such cases. Firstly, Revenue Canada uses the argument that the holding company is resident in Canada de facto, because the mind and management of the company is located in Canada. Secondly, Revenue Canada argues that the holding company is merely the agent of the Canadian corporation and that, for this reason, all the shares in the holding company must be imputed to the Canadian corporation. We would like to know in what situation the tax authorities deem the use of foreign holding companies acceptable, and in what circumstances Revenue Canada intends to contest the effectiveness of these companies? For example, what is the position of the tax authorities on structures referred to as "double dipped"?

Comments by Revenue Canada

The question of whether or not the use of foreign holding companies is acceptable for purposes of the Income Tax Act is a question of fact that can only be determined following examination of all relevant facts.

1.3 Exchange of Information

Most of the tax conventions that Canada has signed include provisions designed to facilitate the exchange of information between the countries party to these bilateral tax agreements. In the past, it appeared that such provisions in a tax agreement entailed a commitment to cooperate, and that Canadian tax authorities would provide the information requested when asked to do so by a foreign jurisdiction. However, it appears that Revenue Canada exchanges information spontaneously with foreign jurisdictions in situations that do not always involve tax fraud. We would like to know the rules of conduct followed by Revenue Canada in this matter and how Revenue Canada reconciles the general principle of confidentiality of tax information (although specific exceptions are provided in the case that concerns us) and spontaneous exchange of information with foreign jurisdictions. For example, does Revenue Canada communicate the tenor of an advance ruling to a foreign jurisdiction when it believes that some aspects of the series of transactions contemplated by the decision could be of interest to that jurisdiction?

Comments by Revenue Canada

As your question implies, Canada includes, in most of the tax agreements it negotiates, provisions designed to facilitate the exchange of information between signatory states. The article used by Canada is essentially identical to an article in the OECD Model Convention. As pointed out in the commentary on article 26 of the Model Convention, the provisions on the exchange of information are relatively broad and allow for exchange of information in three different ways.

• On request, with a special case in mind.
• Automatically, for example when information about one or various categories of income having their source in one Contracting State and received in the other Contracting State is transmitted systematically to the other state.
• Spontaneously, for example in the case of a State having acquired through certain investigations, information which it supposes to be of interest to the other State.

In the matter of the confidentiality of the information exchanged, all the articles relating to exchange of information include a provision relating to secrecy, which usually stipulates that all information be disclosed only to persons or authorities involved in the assessment or collection of the taxes covered by the Convention. Because the confidentiality of the information exchanged is guaranteed by the Convention, Revenue Canada's policy is to promote the exchange of information in all forms inasmuch as the parties can benefit from it.

Taking the preceding into account, it is not out of the question for Revenue Canada to communicate the tenor of an advance ruling to a foreign jurisdiction, if some aspects of the series of transactions may be of interest to that foreign jurisdiction.

1.4 Information Return in Respect of Foreign Affiliates

In a letter dated August 15, 1996 and addressed to the Honourable Paul Martin, Minister of Finance for Canada and the Honourable Jane Stewart, Minister of National Revenue, the Association de Planification Fiscale et Financière commented on the draft legislation made public on March 5, 1996, dealing with the new requirements for Information Returns in respect of Foreign Affiliates. The committee struck to analyze the situation expressed its awareness of the importance to Revenue Canada of having the tools required to accurately and effectively audit international transactions and structures.

The committee expressed anxiety specifically concerning draft section 233.4 of the Act and the draft Information Return in respect of Foreign Affiliates (T1134). The committee felt that these new rules placed a heavy administrative load on groups of multinational corporations and that the usefulness of the procedures could be extremely limited. The process was specifically criticized because it applies to taxpayers in general and the information requested could, in some circumstances, be difficult to obtain.

We would like to know the reasons for which the Department of Finance deemed it necessary to propose the adoption of these measures instead of introducing a more selective procedure by which taxpayers would be obliged to provide certain basic information and Revenue Canada could request additional information where necessary? We would also like to know if the Department of Finance intends to amend its initial draft on this matter.

Comments by Department of Finance

A number of reasons underlie the measures taken by the Department of Finance. Firstly, most information consists of basic data that Revenue Canada needs simply to administer the tax system of foreign affiliates. As you know, the Return in respect of Foreign Affiliates is divided into two main sections: one for foreign affiliates and the other for controlled foreign affiliates. Detailed information is required only for the latter. Furthermore, the Department of Finance needs some of the information requested, for example the summary income statement, to assess the tax policy underlying rules on foreign affiliates, not simply to compute the tax payable for the year. Finally, and this is perhaps the most important point, this situation will help the government keep a permanent watch on foreign affiliates, thus discouraging tax avoidance schemes, allow the Department of Finance to detect any breach of existing tax rules long before an audit is done, and facilitate selective audits and more efficient use of Revenue Canada audit resources.

This being said, we are aware of the need to lighten the compliance burden. This is why the Department of Finance is studying a number of mechanisms. For example, the Department is considering requiring a return of surplus accounts in respect of foreign affiliates only inasmuch as it supports the deduction claimed by the Canadian taxpayer in Canada, and to extend to 15 months after the end of the tax filer's taxation year the deadline for submitting the Information Return in respect of Foreign Affiliates. The Department is also considering exemption from the requirement to submit certain information on the form, under which a taxpayer would not be obliged to provide information he has diligently, but unsuccessfully, sought to obtain.

1.5 Definition of "Investment Business"

An investment business carried on by an affiliate is expressly excluded from the concept of active business carried on (by a corporation) for purposes of the rules governing foreign affiliates. The concept of investment business must be applied to each foreign affiliate individually. The definition of "investment business" includes a condition relating to number of employees, i.e. the corporation must employ more than five employees full time or the equivalent of more than five employees full time.

A situation could arise in which, for legal or business purposes, it is necessary to divide some operations among a number of affiliated firms. For example, in the field of real estate, it may be preferable to arrange things so that each sister company owns a separate building. In this type of situation, the affiliated firms as a group may employ more than five full-time employees. Conversely, no single firm could meet the requirements of the condition and be considered to employ more than five full-time employees or the equivalent of more than five full-time employees. Does the Department of Finance intend to apply corrective measures to this situation? How does Revenue Canada intend to administer the situation?

Comments by Department of Finance

The definition of "investment business" in subsection 95(1) of the Act means that the income of some businesses carried on by a foreign affiliate are included in computing its income from property. There are exceptions to this definition, relating to certain types of specified businesses of the affiliate conducted principally with persons with whom the affiliate deals at arm's length, if it is established that the business of the affiliate meets the condition described in paragraph (b) of the definition relating to number of employees. This condition must be met by the affiliate for each one of its businesses, to establish that the business is actively carried on by the foreign affiliate. This requirement entails a minimum level of activity to establish whether or not a business is a business actively carried on by the foreign affiliate. There are no plans to amend the definition of "investment business" with a view to relaxing the minimum requirement any more than new subparagraph 95(2)(a)(i) of the Act relaxes it. When it is established that the business conducted by the affiliate is a business carried on actively, certain activities of the business may be exercised within another company to which the affiliate is related without tainting its income from an active business. Examples 5 and 6, reproduced below, from the explanatory notes to the revised draft legislation published January 23, 1995, illustrate the application of subparagraph 95(2)(a)(i) of the Act in circumstances that apply to the field of real estate.

EXAMPLE 5

Facts

A corporation resident in Canada has two foreign affiliates which it controls throughout the year - FA1 and FA2.

FA1 carries on the active business of leasing property at arm's length and has 20 employees.

FA2 is a wholly owned subsidiary of FA1 with no employees and was formed by FA1 for business reasons to hold a single high risk lease that was negotiated and executed by the employees of FA1 in the conduct of the business of FA1.

FA2 earns leasing income of $100 which would otherwise qualify as income from property.

Application of Subparagraph 95(2)(a)(i)

The leasing activity of FA2 is directly linked to the active business activities of FA1 since it was negotiated by the employees of FA1 in the conduct of the business of FA1 and can be considered to be an extension of the business of FA1. The leasing activities of FA2 resulting in the property income are dependent upon the active business activities of FA1 and would not have taken place but for the active business activities of FA1.

If FA1 had earned the leasing income of FA2, the income would be income from the active leasing business of FA1.

The corporation resident in Canada, FA1 and FA2 are related throughout the year.

The $100 of FA2's income derived from the leasing activities is included in its income from an active business rather than its income from property.

FA2 has no property income and $100 of active business income.

EXAMPLE 6

Facts

A corporation resident in Canada has two foreign affiliates which it controls throughout the year - FA3 and FA4.

FA3 carries on the active business of developing real estate for sale and has 30 employees.

FA4 is a wholly owned subsidiary of FA3 and is used by FA3 to develop and sell a real estate property that but for the risk involved would have been developed and sold by FA3. The activities of FA4 are managed by employees of FA3. FA4 carries on no other activities and earns a profit of $200 on the sale of the property.

Application of Subparagraph 95(2)(a)(i)

The development and sale of the real estate property by FA4 is an activity that is directly linked to the active business activities of FA3 and can be considered to be an extension of the active business of FA3.

If FA3 had earned the leasing income of FA4, the income would be income from the active business of FA3.

The corporation resident in Canada, FA3 and FA4 are related throughout the year.

The $200 of income derived by FA4 from the development and sale of the real estate property is included in its income from an active business rather than its income from property.

FA4 has no property income and $200 of active business income.

Comments by Department of Revenue

A business conducted by a foreign affiliate is not an "investment business" where the condition in paragraph (b) of the definition of "investment business" in subsection 95(1) of the Act is met.

The Department of Revenue applies paragraph (b) of the definition of investment business as it is written. The number of employees test applies corporation by corporation and for each of a corporation's businesses. For purposes of the "equivalent of more than five employees full time" test, subparagraph (b)(ii) of the definition allows some services rendered to a foreign affiliate by the employees of a corporation related to the said foreign affiliate to be considered, but allows for no other grouping of the employees of a number of affiliates.

2. STOP LOSS RULES

2.1 Amendments to subsection 112(3) and following of the Act

On April 26, 1995, subsections 112(3) and following of the Act were amended in draft legislation. Under former subsection 112(3), the loss arising from the disposition of a share by a corporation was diminished by the total of all amounts received on the share unless the corporation owned the share 365 days or longer, and the corporation and persons with whom the corporation was not dealing at arm's length did not, at the time the dividend was received, own in the aggregate more than five percent of the issued shares of any class of the corporation from which the dividend was received.

The dividends that diminished the loss are:

(1) the taxable dividends deductible in virtue of section 112 or subsection 138(6) (for life insurers) unless a tax on the dividend paid on the designated surplus has been paid (Part VII before March 12, 1977);

(2) capital dividends (subsection 83(2) of the Act); and

(3) life insurance capital dividends (former subsection 83(2.1) of the Act repealed on May 23, 1995).

The most important amendment to subsection 112(3) is that it now applies to individuals. This amendment reduces the attraction of estate planning that involves, under subsection 164(6) of the Act, using a capital loss sustained by the estate when a share is redeemed (e.g. under a repurchase agreement) to offset the capital gain arising to the deceased.

Grandfathering rules are included to exclude certain dispositions of shares from the mechanism in subsections 112(3) and following of the Act. Specifically, these rules do not apply in the following cases:

(1) the shares are owned by a taxpayer on April 26, 1995 and are disposed of pursuant to an agreement in writing made before April 27, 1995;

(2) a corporation was a beneficiary of a life insurance policy on the life of a taxpayer on April 26, 1995 and the proceeds of the policy were intended to be used to redeem the shares owned by the taxpayer on April 26, 1995, and the redemption occurs pursuant to an agreement in writing made before 1997;

(3) the shares are held by a taxpayer on April 26, 1995, a disposition of the shares by the taxpayer's estate before 1997;

(4) on April 26, 1995, a taxpayer's estate owns the shares and the estate's first taxation year ends after April 26, 1995, and a disposition of the shares by the estate occurs before 1997;

(5) a disposition of shares owned by a spouse trust on April 26, 1995 if the disposition occurs after the death of the beneficiary spouse and before 1997.

The Notice of Ways and Means Motion of June 20, 1996 answers some of the questions concerning these grandfathering rules. However some points require further clarification.

2.1.1. Roll-Over of Shares by virtue of Subsection 85(1) or Section 85.1 of the Act

Subsection 57(11) of the Notice of Ways and Means Motion, which deals with the applicability of the grandfathering rules, specifies that a share acquired in exchange for another share in a transaction to which section 51, 86 or 87 of the Act applies is deemed to be the same share as the other share, thus making the grandfathering rules eligible following corporation reorganizations.

Why does the Department of Finance continue to ignore exchanges of shares in virtue of sections 85 and 85.1 of the Act? A taxpayer who holds a share on April 26, 1995 could disqualify himself from the grandfathering rules by transferring the share to a holding company.

Comments by Department of Finance

You ask why the provisions of subsection 57(11) of the Notice of Ways and Means Motion, in virtue whereof shares may be exchanged for purposes of the transitional provisions (grandfathering rules) that apply to the amendments to subsections 112(3) to (3.2), do not apply to shares exchanged for other shares under section 85 or 85.1 of the Act.

The Department is aware that a taxpayer may transfer his shares to his holding or investment company in such a way that the economic substance of the taxpayer's initial participation in the share capital remains essentially unchanged. As a result, we will recommend that the shares acquired as part of a transaction to which section 85 applies be contemplated in subsection 57(11).

Conversely, shares acquired as part of a transaction targeted in section 85.1 in exchange for shares that would be further contemplated by the transitional provisions will not benefit from these transitional provisions. For example, if a shareholder exchanges shares that he owned on April 26, 1995 for other shares as part of a transaction contemplated in section 85.1, the disposition of these other shares would be subject to the section 112 rules on minimization of losses. In the Department's view, section 85.1 is designed to allow tax deferral where there is an exchange of shares as part of an arm's length sale of shares in the corporation acquired. Unlike transactions contemplated in section 85, most transactions contemplated in section 85.1 significantly change the taxpayer's participation in share capital. It would not be advisable to broaden the application of transitional provisions in these circumstances, since the economic interest of the holder may change substantially due to the presence of a third party.

2.1.2. Sole Shareholder

Access to the grandfathering rules depends to a great extent on the existence of an agreement in writing that existed on April 26, 1996 and specified redemption of shares. A shareholder agreement is obviously a written agreement, one that enables shareholders that are partners in a business to grandfather their estate planning.

This situation is not equitable vis-à-vis sole shareholders, who obviously have no shareholder agreement. What is the Department of Finance's view on this problem?

Specifically

-Can a will that specifies that the deceased's shares are to be redeemed be interpreted as an agreement in writing?

-If, under company by-laws, shares must or can be redeemed, is this an agreement in writing?

-Does the simple fact that the by-laws state that a share is redeemable at the pleasure of the holder be used to prove that the shares are redeemed in accordance with an agreement in writing?

Comments by Department of Finance

You note that, in virtue of specific transitional provisions in subsection 57(10) of the draft legislation, a taxpayer's shares must be disposed of in accordance with an agreement in writing. More specifically, there are two separate transitional rules that may apply when an agreement in writing exists.

Firstly, the new section 112 rules on minimizing losses do not apply to the disposition of shares owned by the taxpayer on April 26, 1995 and where the disposition occurred in accordance with an agreement in writing made before April 27, 1995. This rule aims to soften the impact of the new rules where a taxpayer is obliged to dispose of his shares under an existing agreement before April 27, 1995. In a case like this, the taxpayer will probably be substantially, or completely, unable to take the impact of the new rules into account. A disposition made in accordance with a will, company by-laws or the terms and conditions of a share redeemable by mutual agreement or at the pleasure of the holder, is not considered made in accordance with an agreement in writing. In a case like this, the shareholder would usually be able to reorganize his business to take the new section 112 rules on minimizing losses into account.

Secondly, the new rules do not apply when a taxpayer's shares are disposed of to the issuing corporation and the corporation was the beneficiary of a life insurance policy on the life of the taxpayer or his spouse on April 26, 1995 and the proceeds of the policy were intended to be used to purchase shares. In virtue of this rule, a shareholder who had not made an agreement in writing on April 26, 1995 may, in spite of the rules on minimizing losses, produce a capital loss if he agrees in writing to dispose of shares to the benefit of the corporation before 1997. Furthermore, we propose extension until the end of March 1997 of the deadline for making an agreement in writing of this kind. To this end, an agreement in writing between a corporation and its sole shareholder could be contemplated by the transitional rules.

3. GENERAL ANTI-AVOIDANCE PROVISION

Subsection 245(2) of the Act specifies that, where a transaction is an avoidance transaction, the tax consequences to a person shall be determined as is reasonable in the circumstances in order to deny a tax benefit that... would result... from that transaction. In this regard, a transaction is an avoidance transaction if it results in a tax benefit, unless it is reasonable to consider that the transaction was undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit. By exception subsection 245(4) of the Act further specifies that a transaction that it is reasonable to consider as not, directly or indirectly, resulting in abuse in the application of the provisions of the Act as a whole, is not contemplated by this general anti-avoidance rule.

Since the anti-avoidance rule was adopted, taxpayers and tax authorities have had some difficulty understanding the scope of the concepts of "tax benefit" and "abuse" in the provisions of the Act.

Revenue Canada, in Information Circular 88-2 of October 21, 1988 and Supplement 1 of July 13, 1990, makes use of examples to express its view on situations that result in abuse in applying the provisions of the Act.

In paragraph 7 of Supplement 1 to the Information Circular, Revenue Canada gives its interpretation of the acceptable limits of a transaction involving the declaration of a dividend by a corporation resident in Canada to be paid to the parent corporation resident in the United States. In the example, Revenue Canada appears to consider that a dividend exceeding the amount of the "gain realized" by the Canadian corporation following the acquisition of shares by the American parent corporation would be an abuse under the provisions of the Act as a whole.

Furthermore, in paragraph 25 of the Information Circular, the Department confirms its intention to apply the provisions of the anti-avoidance rule to counteract dividend stripping transactions aimed at converting assets of a corporation to capital gains, where specific anti-avoidance rules are designed to prevent this type of transaction are avoided.

In some cases, Revenue Canada will apply the general anti-avoidance rule in order to treat as a dividend a capital gain realized at the time of a sale of shares; in other cases, the rule will be used to consider a capital gain a dividend paid to non-resident shareholders. The interpretation process used by Revenue Canada with regard to such operations can lead to confusion.

In this context, could the Department clarify the following points?

3.1 Application of Tax Conventions

In the context of applying the general anti-avoidance rule with regard to a dividend stripping transaction to a shareholder not resident in Canada, a transaction not clearly contemplated by a specific anti-avoidance provision, does Revenue Canada intend to assign importance to the application of the bilateral tax conventions binding Canada and its foreign partners?

Comments by Department of Revenue

Where specific anti-avoidance provisions are not applicable to a transaction or series of transactions that results in tax abuse, the general anti-avoidance provision may be applied even before taking tax conventions into account. The principle according to which a country may apply a general anti-avoidance provision in domestic tax law is recognized by OECD (Organization for Economic Cooperation and Development) member States.

The right to apply the general anti-avoidance provision is implicit in article 29 A, paragraph 7 of the Canada-U.S. Income Tax Convention. This provision mentions the fact that the preceding provisions of this article apply only for the purposes of the application of the Convention by the U.S. shall not be construed as restricting in any manner the right of a Contracting State to deny benefits under the Convention where... to do otherwise would result in an abuse of the provisions of the Convention.

The technical notes on the subject issued by the U.S. Treasury in relation to the recent protocol (ratified March 17, 1995) to the Tax Convention states that the anti-avoidance provisions of the Contracting State are added to the anti-avoidance provisions of the Convention concerning the selective use of tax conventions ("Treaty Shopping"). Canada may thus call upon the general anti-avoidance provision to redefine transactions on the basis of their true nature.

3.2 Determination of the "Tax Benefit"

With regard to the determination of a tax benefit for purposes of applying the general anti-avoidance provision, does the Department consider that an advantage of this kind exists as soon as a taxpayer follows a procedure other than the procedure that would be the least fiscally advantageous in the circumstances, or is the Department attempting rather to establish an acceptable "benefit in relation to a yardstick"?

Comments by Department of Revenue

The Department has no criteria for establishing whether or not a given stituation entails a tax benefit. Each case is resolved on the facts, specifically taking into account the substance of the transactions.

When it is advisable to determine whether or not a series of transactions would result in a benefit taxable for purposes of subsection 245(3) of the Act, the Department must compare the tax consequences of that series of transactions with the tax consequences one would expect if the series of transactions were undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit. This series of hypothetical transactions would include only transactions motivated for purposes other than obtaining the tax benefit.

Comparison of an actual series of transactions and a hypothetical series of transactions is frequently difficult. There may be a number of ways of achieving the targeted business ends using the series of transactions in question, none of which entails any avoidance transaction. An example follows.

U.S. Co
100%

Canco

100%

Barbadesco

Canco has surplus liquidity arising from its business. It incorporates Barbadesco and pays the subscription price of Barbadesco shares with this surplus liquidity. Barbadesco loans the funds to U.S. Co with interest. U.S. Co uses the funds in an active business.

Suppose Barbadesco makes the loan in the context of a business that it carries on in Barbados and that Barbadesco is resident in Barbados; the interest income of Barbadesco would be included in exempt earnings and exempt surplus under articles 5907(1)(b) and (d) and subarticle 5907(11) of the Income Tax Regulations and subparagraph 95(2)(a)(ii) of the Act. The exempt surplus may be paid to Canco by means of a dividend free from Canadian tax by virtue of paragraph 113(1)(a) of the Act (these consequences result from consolidation of the draft amendments into the regulations as they now stand).

Supposing there were no purpose other than a tax benefit for the incorporation of Barbadesco, Revenue Canada would compare the tax consequences resulting from the series of transactions with the tax consequences of the series of transactions that would be expected to produce the business results of the series of transactions actually carried out, if Barbadesco were not incorporated.

In the hypothetical series, U.S. Co would borrow the money, with interest, in order to use it in its active business. This money would come from the profits earned by Canco. In our opinion, if Barbadesco were not incorporated, Canco would loan the surplus funds to U.S. Co and earn interest income on which it would be taxed in virtue of Part I. The loan itself would be taxable in the hands of U.S. Co in accordance with subsection 15(2) of the Act. Consequently, Canco's tax benefit is represented by the Part I tax that would have been payable and was avoided on the interest income, and the U.S. Co tax benefit is represented by the Part XIII tax that would have been payable, taking into account application of subsections 15(2), 214(3) and 212(2) of the Act, which was avoided.

It is important to stress that there may be many ways to achieve business ends through a series of transactions. Each situation must be analyzed on the basis of the facts. The above comments aim only to illustrate the usual approach for determining whether or not a tax benefit exists for purposes of subsection 245(2) of the Act; they do not represent exhaustive analysis of the application of the general anti-avoidance rule, specifically the question of whether or not there is abuse of the Act for purposes of subsection 245(4).

3.3 Surplus Stripping Transactions

The Department is considering applying the general anti-avoidance provision to surplus stripping transactions that circumvent the specific anti-avoidance provisions contemplated in the Act to this effect. In some cases, Revenue Canada has appeared to apply the general anti-avoidance rule to reconsider the tax impact of transactions that were contemplated by specific anti-avoidance rules such as those contemplated in sections 84.1 and 212.1 of the Act. Could the Department confirm its policy in this regard?

Comments by Department of Revenue

Depending on the circumstances, the Department may apply the general anti-avoidance rule even if a specific anti-avoidance provision was otherwise applicable to a transaction or series of transactions. For example, the Department can apply section 245 of the Act if a taxpayer undertakes an avoidance transaction for the purpose of not being subject to a specific anti-avoidance provision.

For example, consider a taxpayer who, to avoid application of section 84.1 of the Act, takes measures to avoid meeting the conditions for application of the provision. To do so, the taxpayer carries out a reorganization of capital under subsection 86(1) of the Act with the aim of converting voting shares of the corporation involved in the transfer into non-voting shares to avoid the transferred corporation being related to the purchaser.

3.4 Ambiguity in the Wording of the Act

Is the Department considering using the general anti-avoidance provision to rectify what it views as "ambiguity" in the wording of specific anti-avoidance provisions?

Comments by Department of Revenue

It is obvious that the legislator cannot foresee all the avoidance strategies that may be used by taxpayers, and specific anti-avoidance provisions can certainly not circumvent all improper strategy. If it is possible to conclude that a transaction or series of transactions is not subject to a specific anti-avoidance rule because of its particular wording (which could be considered ambiguity in wording), and that it should have been in accordance with the spirit and plan of the act (in other words, the transaction is improper), it is our opinion that we should consider the possibility of applying subsection 245(2) of the Act; for example, where a taxpayer uses an avoidance transaction to avoid application of a specific anti-avoidance provision.

3.5 Determination of the "Tax Consequences"

When the tax consequences to a person with a view to suppressing the tax benefit resulting from an avoidance transaction contemplated by the general anti-avoidance provision are being determined, is it Department policy to establish these tax consequences in such a way as to minimize the tax burden to the taxpayer?

Comments by Department of Revenue

Subsection 245(2) specifies that, in an avoidance transaction, the tax consequences to a person shall be determined as is reasonable in the circumstances in order to deny a tax benefit that... would result, directly or indirectly, from that transaction or from a series of transactions that includes that transaction.

As mentioned above, no specific criteria have been established for determining whether or not a tax benefit exists in a given situation and what should be the tax consequences to the taxpayer(s) involved. Each case must be handled on the basis of the particular facts; however, our prior comments on determining tax benefit give a good idea of the Department's overall approach to the matter.

4. MISCELLANEOUS

4.1 Land in Inventory

Pursuant to the decision in Friesen (95 DTC 5551), the Supreme Court of Canada confirmed that a parcel of land held principally for the purpose of reselling could be valued at its fair market value when this is lower than its cost to the taxpayer in compliance with subsection 10(1) of the Act. Incidentally, a taxpayer could write down lands in inventory and claim a loss even if no sale transaction had taken place.

In Friesen, the litigation addressed several items, including Revenue Canada's claim that subsection 10(1) was applicable only to an active business and did not apply to an "adventure in the nature of trade", namely an isolated speculative venture that falls within the definition of "business" in subsection 248(1) of the Act.

News Release of December 20, 1995 and Notice of Ways and Means Motion of June 20, 1996

On December 20, 1995, after Revenue Canada's position was overturned by the Supreme Court of Canada in Friesen v. Canada, Finance Canada issued a news release designed to restrict inventory write-downs to fiscal years that had ended before the date of the release, and for which an income tax return had not been produced, to avoid being snowed under by amended returns. In all other cases, subsection 10(1) would no longer apply to property held as an adventure in the nature of trade. This position has been included in the Act in the new subsections 10(1) and 10(1.01), contained in the Notice of Ways and Means Motion of June 20, 1996.

4.1.1 Details Concerning Adventures in the Nature of Trade

The distinction between a business and an adventure in the nature of trade has been of minor interest until recently because subsection 248(1) of the Act treated them almost the same. Indeed, for the purposes of subsection 248(1) of the Act, an "adventure in the nature of trade" was excluded from the definition of a "business" only for the purposes of the following provisions:

paragraph 18(2)(c):interest on debt or property taxes paid in respect of land;

section 54.2:shares obtained in exchange for assets used in a business;

subsection 95(1): foreign accrual property income;

paragraph 110.6(14)(f): capital gains exemption.

Case law has given us little information about the distinction between the two concepts. Practitioners would therefore appreciate more details concerning property that could be written down under new subsection 10(1) of the Notice of Ways and Means Motion of June 20, 1996.

Specifically,

What criteria will be used by the Department to distinguish property in a business's inventory that constitutes an adventure or concern in the nature of trade from property in a business's inventory that is not an adventure or concern in the nature of trade?

As adventures in the nature of trade are usually isolated and speculative ventures, can a taxpayer who owns many parcels of land consider these parcels property in the inventory of a business which is not an adventure or concern in the nature of trade?

Do these parcels of land have to be batched together?

Does the write-down permitted under new subsection 10(1) apply only to construction businesses?

Is the Department's view that a taxpayer may hold parcels of land in inventory as part of a business that is not an adventure or concern in the nature of trade and at the same time principally operate another unrelated business?

Must a taxpayer necessarily have sold parcels of land in the year in question (which may be problematic in view of the economic situation)?

Comments by Department of Revenue

General

The pending amendments to subsection 10(1) in the Notice of Ways and Means Motion tabled in the House of Commons on June 20, 1996, provide that the rules allowing property in inventory to be valued at the cost at which the taxpayer acquired the property or its fair market value, whichever is lower, applies only to computing a taxpayer's income from a business that is an adventure or concern in the nature of trade.

A further pending amendment to subsection 10(1) requires businesses that have valued inventory property at an amount that is less than the acquisition cost for a given year, thus raising the cost of the property sold, to revalue the inventory at the lower of fair market value or acquisition cost at the end of a subsequent taxation year, which may reduce the cost of the goods sold during this subsequent year.

The new pending subsection 10(1.01) provides that property in the inventory of a business that is an adventure or concern in the nature of trade be valued at the taxpayer's acquisition cost.

As you mentioned, the pending amendments to section 10 of the Act were made primarily because of the Supreme Court decision in the Friesen case.

To obtain a proper understanding of the scope of the amendments made as a result of the Friesen decision, we feel that it is important to review the facts of this case.

In January 1982, the appellant and several others bought a parcel of land, located in the city of Calgary, which was registered in the name of a college which held it on behalf of the group of investors. The parcel of land was purchased with a view to reselling it at a profit. A portion of the expected profits was to be paid to the college and other organizations in the form of charitable donations, with the rest to be shared by the members of the group of investors. However, in the years that followed, the land declined significantly in value and the mortgage was foreclosed in 1986.

The land was vacant, and had remained completely untouched (i.e. no services or infrastructure had improved the land) and it had not generated any income during the period of tenure. Moreover, even though it was a one-time operation, the investors, particularly Mr. Friesen, were not inexperienced in speculative real estate operations.

In view of these facts, the Supreme Court judges were unanimous in concluding that the real estate operation constituted an adventure or concern in the nature of trade and was therefore a "business" within the meaning of subsection 248(1) of the Act.

In a factual situation like the one in the Friesen case, it is clear that the new subsection 10(1.01) of the Act as set out in the Notice of Ways and Means Motion would apply and generally prevent an investor from writing down any loss in value between the time of purchase and the time of sale.

Furthermore, although the very concept of a concern in the nature of trade was developed to distinguish buying and selling operations of a business nature from which business income is generated, from those that have to do with capital property, our view is that the usefulness of the distinction between an adventure or concern in the nature of trade and the carrying on of a business is relevant with respect to a variety of factors, including the application of subsection 39(4) of the Act (election concerning disposition of Canadian securities) (cf Federal Court of Appeal decision in Vancouver Art Metal Works Ltd. v. Her Majesty the Queen, 91 DTC 5643, in which the Court made the distinction between a situation in which an investor holds securities or engages in a concern in the nature of trade from that in which an investor operates a business); or to determine whether a corporation is a "small business corporation" for the purposes of the capital gains deduction provided in subsection 110.6(2.1) of the Act; or yet again to determine when a business corporation began operations (cf interpretation bulletin IT-364 of March 14, 1977).

Specific Criteria

The Department has not developed any specific criteria to distinguish property in a company's inventory which is not an adventure or concern in the nature of trade from property in inventory held as part of an adventure or concern in the nature of trade. Each is a question of fact that can only be determined after a review of the specific circumstances of the case.

However, in interpretation bulletin IT-459 of September 8, 1980, the Department sets out the main criteria established by the courts for determining whether a specific transaction constitutes an adventure or concern in the nature of trade, including the taxpayer's behaviour, the nature and quantity of property and the taxpayer's intention.

Paragraph 3 of IT-459 mentions that although an adventure or concern in the nature of trade is included in the definition of the term "business" in section 248 of the Act, it does not necessarily mean that a taxpayer who is engaged in an adventure or concern in the nature of trade is "carrying on" a business or has "carried on" a business. It further notes that when these expressions are used in the Act, a determination is made based on the degree of activity and each situation must be considered in the light of its own particular facts.

According to paragraph 1 of IT-459, a person who habitually does a thing that is capable of producing a profit is carrying on a trade or business.

Paragraph 2 of IT-459 states that where such a thing is done only infrequently, or possibly only once, rather than habitually, it is still possible to hold that the person has engaged in a business transaction if it can be shown that he has engaged in an "adventure or concern in the nature of trade".

Determining whether property belongs in the inventory of a business other than an adventure or concern in the nature of trade or is held as part of a concern in the nature of trade, could essentially be resolved by analyzing the organizational structure of an operation, the extent and variety of the activities of this operation and its continuity over time, in other words by determining whether a business is carried on by the taxpayer. Major J., for the majority, made the following comments in Friesen, which appear to us to be useful in this connection:

First, I do not accept the argument that s. 10(1) applies only to those who "carry on a business". A specific judicial interpretation has evolved for the phrase "carry on a business". That phrase is used in the Income Tax Act and is useful for determining the residence of a taxpayer (see s. 253). Once again if Parliament had intended to restrict the ambit of s. 10(1) to taxpayers which carry on a business it would have done so. I can do no better on this point than to quote with approval the response of Rip T.C.J. to this argument in Bailey, supra, at p. 1330:

Subsection 10(1) directs a property to be valued "for the purpose of computing income from a business". The phrase does not contemplate computing income only from carrying on a business, as suggested by counsel for the respondent. The phrases "carrying on a business" and carried on a business" are found in several provisions of the Act: see, for example, paragraph 2(3)(b), and subsections 115(1) and 219(1). "To carry on something," stated Jackett P. in Tara Exploration (and Development Co. v. M.N.R., 70 D.T.C. 6370), page 6376, "involves continuity of time or operations such as is involved in the ordinary sense of a `business'". When this expression "carry on" is used in the Act, Parliament describes a continuity of time or operations with respect to the factual situation contemplated by the particular provision. Such continuity is not required in subsection 10(1) and its addition to that provision would add nothing to that provision's ordinance.

My colleague Iacobucci J. accepts the fact that s. 10(1) applies to an adventure in the nature of trade. However, he would restrict the use of the valuation method in s. 10(1) to stock-in-traders and those who "carry on" a business. This effectively prevents s. 10(1) from being applied to an adventure in the nature of trade since by definition an adventurer in the nature of trade is neither a stock-in-trader nor does he "carry on" a business.

(1995) 3 S.C.R. 103, pp. 134,135 and 136

Number of Land Parcels in Inventory

The number of land parcels held by a taxpayer is one of the factors to consider in determining whether or not he is carrying on a business. On the other hand, owning several such parcels is not of itself decisive because, following an analysis of the specific facts and circumstances of a situation, the Department could consider that a business is not being carried on in the situation because it deems, for example, that each parcel of land has been acquired separately as a concern in the nature of trade or that each of the parcels of land is held as part of a series of isolated transactions, or that the acquisition of all such land parcels is an isolated event.

Likewise, a taxpayer who owns a very large number of land parcels could hold an inventory of land parcels of a business which is not an adventure or concern in the nature of trade if, for example, he carries out other activities with respect to these land parcels on an ongoing or constant basis.

Subdivision of Lots

Subdivision alone may be a factor that indicates that the land is not capital property or that the parcel of land has been converted into inventory property. However, our view is that this factor is not of itself decisive in determining whether or not a parcel of land is in the inventory of a business that is an adventure or concern in the nature of trade.

Paragraph 24 of interpretation bulletin IT-218R gives the example of the filing of a subdivision plan in which the selling of lots thereunder does not in itself affect the status of the gain notwithstanding that such a subdivision may enhance the value of such land. Thus a gain on the sale of farming or inherited land will remain a capital gain if an examination of all other facts, both before and after subdivision, establishes this to be so. However, paragraph 24 also indicates that where the taxpayer goes beyond mere subdivision of the land into lots and installs improvements such as watermains, sewers or roads, or carries on an extensive advertising campaign to sell the lots, the taxpayer will be considered to have converted the land from a capital property into a trading property.

Likewise, the fact that land has not been subdivided does not necessarily mean that it is held by a business which is an adventure or concern in the nature of trade. For example, a taxpayer may carry on a land development and reselling business and hold the non-subdivided land as an integral part of this business's inventory.

A Business Other than A Construction Business

The rules allowing taxpayers to value land in inventory at the cost at which the taxpayer acquired the property or its fair market value, whichever is lower, as provided in subsection 10(1) of the pending amendment, are for computing income derived from any business that is not an adventure or concern in the nature of trade.

Our view is that the rules provided in subsection 10(1) of the pending amendment could apply to a taxpayer who holds land in inventory as part of a business that is not a construction business provided that the business is not an adventure or concern in the nature of trade. Such could be the case, for example, for a dealer who habitually purchases and sells lots or for a taxpayer who develops and resells lots.

Unrelated Businesses

A taxpayer could hold land in inventory as part of a business that is not an adventure or concern in the nature of trade, even though he engages principally in another unrelated business.

This is in keeping with the Department's position as stated in paragraph 1 of interpretation bulletin IT-459, which reads as follows:

It is a general principle that when a person habitually does a thing that is capable of producing a profit, then he is carrying on a trade or business notwithstanding that these activities may be quite separate and apart from his ordinary occupation. An example is that of a dentist who habitually buys and sells real estate.

No Sale During Year

If the land is property in an inventory of land parcels held by a business that is not an adventure or concern in the nature of trade, the taxpayer may use the valuation method provided in subsection 10(1), even though he may not have sold any land during the course of the year.

Comments by Department of Finance

Details Concerning Undertakings in the Nature of Trade

The Department of Finance did not intend to change the meaning of the expression "adventure or concern in the nature of trade" in the recent pending amendments to section 10. Revenue Canada must therefore interpret the Income Tax Act.

4.1.2 Section 1801 of the Regulations

4.1.2.1 Section 1801 of the Regulations and Friesen

Moreover, section 1801 of the Income Tax Regulations ("the Regulations") was amended to remove the option allowing taxpayers to value their property in inventory at cost or at fair market value as of January 16, 1987, from which time taxpayers are required to value inventories in compliance with Regulation 1801 (fair market value) or in accordance with subsection 10(1) of the Act (at cost or fair market value, whichever is lower). Thus all taxpayers who did not follow Friesen's lead are mistaken and the Department of Finance, in its December 20, 1995 news release, is maintaining an incorrect application of the Act.

Comments by Department of Finance

Details Concerning New Release of December 20, 1995 and the Notice of Ways and Means Motion of June 20, 1996

A qualification is required with respect to the application of the pending amendments to the Act following the Supreme Court decision in the Friesen case. These amendments of course apply to the taxation years ending after December 20, 1995, but they also apply to taxation years ending before December 21, 1995, unless the deadline for filing a return for such a year falls after December 20, 1995 or if the taxpayer has already claimed a loss for such a write-down in his return or if there is an objection or an appeal for the year in question (ending before December 21, 1995). The Supreme Court decision will therefore only apply under very limited circumstances (i.e. years ending before December 21, 1995) and only taxpayers whose filing deadline for the last taxation year fell after December 20, 1995 will be eligible to apply the decision, along with taxpayers who had claimed such a write-down in an income tax return filed before December 20, 1995 or in an objection or appeal made before this date. The proposed amendments thus restore the earlier practice, namely not allowing the write-down of property held in an adventure in the nature of trade. There will thus be only a brief and very limited hiatus during which the Friesen judgment will be applicable, and virtually the only taxpayers who will be able to benefit from the situation are those who have already written down their property. Taxpayers who have not followed Friesen's practice are therefore reassured and the Act has been amended to comply with Revenue Canada practice.

4.1.2.2 Tax Audit

The practical considerations that led the Department of Finance to take this position are understandable. On the other hand, could Revenue Canada adopt two stances, or measures, if a taxpayer engaging in an adventure in the nature of trade were to decide, for a year in which he is entitled to write down his land inventory, not to write it down and adopt the same position forced upon the majority of Canadian taxpayers, even though the position is in conflict with the previous subsection 10(1) of the Act, particularly if the taxpayer were to deem that taking such a position could provide him with a tax advantage at a future date (a coming increase in the income tax rate, loss carry-over, etc.).

In other words, could Revenue Canada, during an audit of a taxation year prior to the news release, force the application of the former subsection 10(1) and write down the property of a taxpayer held in an adventure in the nature of trade even though the news release of December 20, 1995 denies this position to the taxpayer.

Comments by Department of Revenue

In an audit, the Department will generally not value property held in an adventure or concern in the nature of trade lower than its cost to the taxpayer for the taxation years for which returns were filed before December 21, 1995.

4.1.3 The Mara Properties Case

Still in connection with land in inventory, the Supreme Court of Canada confirmed in Mara Properties (96 DTC 6309) that the cost of property in the inventory of a subsidiary could be transferred to the parent company upon the winding up of the subsidiary under paragraph 88(1)(d) of the Act and that the nature of the property in question was not altered by doing so.

The dispute in the Mara Properties case had to do with the fact that the taxpayer (a real estate development company) had acquired the shares of a company, which owned land, that it had wound up this company and immediately resold the land in question at a loss. The Federal Court of Appeal had determined that the land had not been acquired in the normal course of business and was not part of the inventory of the parent company.

4.1.3.1 Department of Finance Response

Does the Department of Finance intend to respond to this decision by amending paragraph 88(1)(d) of the Act or by any other amendment of the Act?

Comments by Department of Finance

The Supreme Court of Canada judgment in Mara Properties is very short and simply indicates that the Supreme Court agrees with the conclusions (but not the rationale) of the Tax Court of Canada and the dissenting judge, MacDonald J., of the Federal Court of Appeal. The Court did not say that the property distributed by the parent company under section 88 retained its character as inventory under all possible circumstances (or even as a general rule), but it did take the trouble to say that it was strictly in the circumstances of this case that the property retained its character as inventory. We recall that Kempo J. of the Tax Court of Canada had deemed in this case that the parent company, like the subsidiary, were both real estate developers and that therefore there was nothing to prevent the parent company from deducting the deemed cost thereof under section 88 and the realization of a paper loss that was deductible in computing benefits from the business. The Federal Court of Appeal had refused to allow a loss in computing the business income to Mara because the land in the inventory thus acquired was not truly part of Mara's inventory according to the Court (indeed, the land inventory could not give rise to a real business transaction because there was no expectation of profit: the deduction (and the loss) were strictly tax-driven and could not generate any benefit under section 9. The Court of Appeal therefore determined the roll-over of the indicated cost could not give rise to a loss against business income. MacDonald J. dissented, preferring to follow Kempo J.'s line of reasoning. He too concluded that the property distributed by the subsidiary to the parent company should be combined with the parent company's property and that as both were real estate developers and had land inventories, these land inventories should be merged.

The Department of Finance thus understands that determining the character of the property acquired by a parent company from a subsidiary under section 88 is an issue of fact that will depend on the specific circumstances of each case. There is no rule stating that the character or nature of property rolled over is automatically preserved by simply applying section 88. It is possible that under different circumstances, the roll-over loses its status as inventory property and gives rise to a capital loss (or gain) in the hands of the parent company, depending on whether it is appropriate to consider the transaction as a capital transaction rather than an income transaction.

One may rightly ask whether, in spite of the technical and apparently automatic nature of section 88, whether it would not be natural to recognize that this section should sensibly apply only to the actual winding up of operations effected in real reorganizations for reasons other than tax-driven ones. This would mean that using section 88 in such a context (the pre-orchestrated transfer of a loss belonging to a third party for the purpose of tax avoidance) would run contrary to the intent and spirit of section 88, which is intended simply as a rule to ease authentic corporation reorganizations, and not to encourage loss transfers. We also find it regrettable that the analysis of this case was not done in the light of the taxation policy underlying the loss limitation rules in the context of a corporate reorganization as reviewed in Duha Printers, 96 DTC 6323. In this case, the Federal Court of Appeal had rejected a strategy to acquire losses through reorganization (merger) with a view to using the losses incurred by a third and therefore "foreign" party to the acquiring corporation. The Court submitted an excellent analysis of the principles governing loss limitation. Hence it remains possible, in appropriate circumstances, that an application of section 88 whose objective is to bypass these fundamental principles could be denied as running counter to the intent and spirit of the act as a whole.

For all of these cogent reasons, the Department of Finance does not at this time intend to amend section 88 of the Act.

4.1.3.2 Revenue Canada's Position

In addition, what would be Revenue Canada's position in the following case?

Land parcels are acquired by a corporation as an adventure in the nature of trade. One of the shareholders, a limited company carrying on a construction business, has as part of its assets a considerable inventory of land. This shareholder acquires all the shares of the company and winds it up in a context similar to that in which Mara Properties did so, but instead of selling the land, keeps it. These parcels of land, which were initially acquired as part of an adventure in the nature of trade are, after the winding up, part of an inventory. Would this taxpayer be justified in valuing the land at fair market value and, if it wished to do so, to write them down?

Comments by Department of Revenue

Subsection 10(10) as amended in the Notice of Ways and Means Motion tabled in the House of Commons on June 20, 1996 (notice of motion) provides that at the end of the tax year for a corporation preceding the acquisition of control, any property in the inventory of a business which is an adventure or concern in the nature of trade is to be valued at the lower of the acquisition cost or fair market value at the end of the year. After this, the acquisition cost of the property to the corporation is deemed to be equal to the lower of these amounts. For the purposes of our reply, we have assumed that the pending amendments to subsection 10(10) will be passed and that the taxation years covered by the question are the years ending after December 20, 1995.

Assuming that control over the company (Company A) that owns the parcels of land as an adventure or concern in the nature of trade has been acquired, the latent loss on the land is realized by Company A in the taxation year ending immediately before the acquisition of control. If Company A realizes a loss other than a capital loss for its taxation year ending immediately prior to the acquisition of control, the use of this loss by the parent company (Company B) could be subject to the restrictions provided in subsection 88(1.1) of the Act.

Even though the expression "an adventure or concern in the nature of trade" is included in the definition of the term "business" in section 248, this does not necessarily mean that a taxpayer engaged in an adventure or concern in the nature of trade is "carrying on" a business, as noted in paragraph 3 of interpretation bulletin IT-459. Among other things, the degree of activity must be examined, and each situation must be considered in the light of its own particular facts. The requirement referred to in subparagraph 88(1.1)(e)(i) to the effect that the business must be carried on by the parent company may not be met, depending on the circumstances.

The proceeds of the disposition of land for Company A and the land acquisition cost for Company B under paragraphs 88(1)(a) and (c) of the Act are the deemed cost for Company A pursuant to subsection 10(10).

Subsequent to winding up, Company B could value the land at the lower of acquisition cost and fair market value under subsection 10(1) of the Act, because all the property in its inventory is held as a business that is not an adventure or concern in the nature of trade.

4.2 Paragraph 18(1)(l) of the Act Obsolete

Meals at Golf Clubs

Revenue Canada has amended the response to question 5, concerning meals at golf clubs, from the Round Table discussions on federal taxation presented at the 1995 APFF convention . In its amended response, the Department confirmed a technical interpretation on the subject concerning the term "facilities" used in paragraph 18(1)(l) of the Act. Thus the term "facilities" includes a golf club dining room, meaning that the cost of a meal, when taken together with other golfers, is not deductible under paragraph 18(1)(l) of the Act.

Paragraph 18(1)(l) of the Act

Although justified in 1971, at a time when there were more hunting and fishing camps owned by private companies, paragraph 18(1)(l) has lost its usefulness over the years, particularly since the introduction of section 67.1 of the Act on expenses for food, etc., limiting the allowable deduction for food, beverages and entertainment consumed in a business setting to 50 percent.

Paragraph 18(1)(l), section 67.1 and Revenue Canada's technical interpretation concerning meals at golf clubs have caused situations for taxpayers that are, to say the least, inequitable.

Thus:

- a taxpayer who plays a round of golf with clients and invites them to dine that evening in the club dining room cannot deduct anything. If they dine at a restaurant in town, 50 percent is deductible;

- if the same taxpayer plays golf with clients and then dines in the club dining room with other clients, he cannot deduct anything. Here again, if he went to a restaurant he could deduct 50 percent;

- moreover, if instead of inviting his clients to play a round of golf, he takes them to a sports event (hockey, tennis), 50 percent of everything, including meals, is deductible;

- if a taxpayer holds a Christmas party for all employees, he can deduct all expenses under the exception provided in paragraph 67.1(2)(e) of the Act, even if the dinner is in the dining room of a golf club;

- on the other hand, if a taxpayer holds a golf tournament for all his employees, he cannot deduct anything.

What does the taxation department have against golf? Does it want to dictate what forms of recreation we should enjoy? Would it not be more equitable to repeal paragraph 18(1)(l) of the Act or limit it to the cost of a hunting or fishing camp or to the share in a private golf club and allow section 67.1 to provide equitable treatment to all meal expenses. What does the Department of Finance think of this?

Comments by Department of Finance

In its 1966 report, the Carter Commission noted the importance of doing just that to the greatest extent possible, to ensure that no taxpayer could deduct personal consumption expenses, making only expenses incurred with a view to deriving profit deductible. The report treated entertainment expenses separately from other expenses involved in the use of recreational facilities, including a lodge, a hunting or fishing camp, a yatch or a golf club.

The report recommended allowing entertainment expense deduction only insofar as they were for reasonable business purposes, and solely within prescribed limits. It further recommended that if this approach became impossible to apply, or if abuse of the system were to become problematic, that all entertainment expenses were to be considered a taxable benefit to the beneficiary, whether such a person were an employee, client or shareholder, or subjecting them to a special tax as the supplier of the benefit.

As for expenses in recreational facilities like the above, the report recommended either taxing the whole amount of the benefit as beneficiary income, or subjecting the beneficiary to a special tax payable by the supplier of the benefit. This recommendation was implemented as part of tax reform, but in an amended version, which prohibited the deduction of the expenses covered in paragraph 18(1)(l).

At the beginning, the recommendation concerning entertainment expenses was not acted upon, and these expenses remained fully deductible provided that they were made with a view to deriving income, until the introduction of section 67.1 as part of the 1987 tax reform. Limiting the amount of such deductible expenses to 50 percent stemmed from the same concerns that led to the initial recommendation by the Carter Commission, which was intended to limit such expenses to the prescribed amounts.

As we were saying above, the distinction from the tax policy standpoint between a recreational facility like a golf course or a fishing camp, and an ordinary hotel, is that any business outlay tied to the use of such recreational facilities will inevitably be accessory or subordinate to the recreational and personal nature of the fishing or the golf activity. On the other hand, the recreational character of expenses incurred by a business in a hotel is probably subordinate to the business purpose of an activity such as holding a meeting or a conference. Even though the distinction may sometimes yield debatable results, it remains a reasonable compromise designed to ensure that businesses assume their fair share of the tax burden, and to prevent ordinary taxpayers from subsidizing the deduction by businesses of entertainment expenses that are altogether discretionary.

4.3 Relocation of Employees

Recent case law, particularly since the Splane decision (92 DTC 6021) tends to identify a principle with respect to employee relocations according to which a payment made by an employer to an employee transferred to another city constitutes a taxable benefit only if the net worth of the employee's assets are increased thereby. Thus when an employee is given compensation to allow him to purchase a comparable but more expensive house in another city, the compensation is taxable because the house constitutes an asset that has increased the employee's net worth (Phillips, 94 DTC 6177). If the employee is compensated because of an increase in the interest rate (Splane, 92 DTC 6021) or an increase in the amount of interest paid because of a house that is more expensive (Hoefele et al., 95 DTC 5602), such payment does not increase the taxpayer's net worth and does not constitute a taxable benefit.

Our questions are as follows:

4.3.1 To the Department of Finance

Is it likely that the amendments to the Act will set out the procedure to be followed with respect to determining the taxable benefit in the event of employee relocations?

Comments by Department of Finance

In your question, you claim that recent case law identifies a principle to the effect that payments made by an employer to an employee for a transfer to another city are not treated as taxable benefits because the net worth of the employee's assets or asset base is not thereby increased. You derive this principle from the Splane case, in which the Federal Court of Appeal concluded that periodic reimbursements of an increase in mortgage interest rates incurred for a move from Ottawa to Edmonton was not a taxable benefit within the meaning of paragraph 6(1)(a) of the Act because such reimbursements did not improve his economic situation but merely compensated the employee's losses owing to less favourable interest rates on his mortgage in Edmonton. You interpreted the Phillips case similarly, concluding that a lump sum reimbursement of $10,000 paid to an employee transferred from Moncton to Winnipeg to compensate him for higher living costs was a taxable benefit because the amount in question was not to compensate the employee for a loss incurred, but to subsidize the purchase of a new home that would increase his net worth. Lastly, you based yourself on the Court of Appeal decision in Hoefele et al., which determined that a reimbursement by the employer of increased mortgage interest expenses, based on the difference between the cost of selling the Calgary home and the estimated cost of an equivalent home in Toronto, was not a taxable benefit because the taxpayer was not enriching himself because of the reimbursement but simply maintaining his financial position.

You asked us whether it is likely that the Department of Finance will introduce legislation to determine the taxable benefit for employee transfers.

We are not convinced that one can henceforth conclude, as you appear to, that case law has completely determined this issue. Incidentally, you may be aware that the Supreme Court of Canada last August denied permission to appeal the Court of Appeal decision in Hoefele et al. At any rate, I believe that the issue of concern to the government in these cases is that of knowing to what extent paragraph 6(1)(a) of the Act is applicable, even when there is no increase in the net worth of the assets of an employee receiving the reimbursement. In an article which appeared in the spring Tax Journal (1996), Vol. 44, No. 1, Brian Arnold and Jinyan Li claimed that the Court of Appeal was wrong in denying the application of 6(1)(a) of the Act to reimbursements for relocation expenses paid to employees. Because such expenses are clearly personal expenses for these employees, it would be more appropriate, they argue, to treat these amounts as taxable benefits. Any reimbursement by an employer of personal expenses would inevitably improve the employee's economic situation when compared to other employees who incur such losses but who are not granted a reimbursement, or who receive higher pay as compensation (horizontal equity). Thus according to the authors, most case law since Ransom is mistaken, precisely because it has refused to admit that there may be a taxable benefit when there is compensation for an economic loss by the employee rather than a net economic gain. According to them, paragraph 6(1)(a) is very broad and in no way supports the idea that reimbursement of removal expenses be excluded. The authors further claim that the fundamental error by our courts stems from the application of the principle that all income must be measurable in cash and positive. The original sin thus goes back to Lord Macnaghten in a British case, Tennant v. Smith (in which he stated: a person is chargeable for income tax... not on what saves his pocket but on what goes into his pocket). This dubious principle was rejected by the British legislator and, given the scope of paragraph 6(1)(a) of the Act, has no reason to exist in Canada either.

The Department of Finance has followed this matter very closely, even though no decision has yet been taken. In spite of the Supreme Court of Canada's refusal to grant leave to appeal in Hoefele et al., it is to be hoped that this matter will eventually be reviewed by our courts in the appeal of the Tax Court of Canada decision in Pezzelato or Gernhart.

4.3.2 To Revenue Canada

What will Revenue Canada's attitude be towards cases in which employees are relocated in the light of this case law. As conclusions on the matter in recent years have not been clear, employers have been in some doubt concerning how to apply paragraph 6(1)(a) of the Act in employee relocations. Will Revenue Canada take a hard line with respect to the years during which uncertainty remained with respect to employees (taxable benefit, interest, etc.) and employers (penalties for failing to make source deductions, etc.)?

Comments by Department of Revenue

As mentioned in income tax Technical News, No. 6, in February 1996, the Department accepts that payments made to offset a difference in interest rates, where an employee incurs a higher interest rate on a mortgage as a result of an employer-requested relocation as was the case in Splane, the mortgage interest rate differential payments for the remaining term of the mortgage are not taxable.

However, the Department has sought leave to appeal the Hoefele et al. decision to the Supreme Court of Canada. This request was denied on August 22, 1996 by the Supreme Court. The Department shall therefore apply the Federal Appeal Court's decision in this case, namely that a subsidy for mortgage interest rates to compensate an employee for the higher cost of living in the city to which he is being relocated will not be considered taxable under paragraph 6(1)(a) of the Act in circumstances identical to those in Hoefele et al.

Where the Splane or Hoefele et al. decisions are inapplicable because the facts of a specific situation are different, our department will consider benefits granted in a relocation to constitute a taxable benefit to the beneficiary in all instances in which the Department is of the opinion that an economic gain has been granted to the beneficiary.

4.4 RRSP Investment in Private Corporations

Connected Shareholder Concept

Subsection 4900(12) of the Regulations allows a trust governed by an RRSP to own shares in a small business corporation provided that the annuitant of the RRSP is not a connected shareholder immediately after the time the property was acquired. A connected shareholder means a shareholder who at the specified time directly or indirectly owns at least 10 percent of the shares of a given category in a corporation or any affiliated company, unless the shareholder has no non-arm's length ties with the corporation and the total reported cost of the shares of the corporation or affiliated corporation of which he is or is deemed to be an owner is less than $25,000.

4.4.1 Arm's Length A Question of Fact

Let us assume that two shareholders each own 50 percent of the shares in a corporation. If these two shareholders were to act together in making transactions with the corporation, Revenue Canada could invoke paragraph 251(1)(b) of the Act, which states that whether or not people are dealing at arm's length is a question of fact. Thus if the RRSPs of these two shareholders each invested $24,000 in shares of the corporation, could Revenue Canada consider these two shareholders connected because of such a question of fact?

Comments by Department of Revenue

Determining whether or not two unrelated persons are dealing at arm's length at any given time is a question of fact. When two shareholders together hold equal numbers of all the shares in circulation of a private company, the Department generally considers them to be acting together in a way that gives them control over the company.

However, our view is that although two unrelated shareholders may together control the corporation does not automatically mean that there is non-arm's length dealing between them and the corporation immediately after their RRSP has acquired shares in this corporation.

Likewise, merely because two shareholders are using their respective RRSPs to acquire shares in the corporation is not of itself a sign that they are not dealing at arm's length with the corporation immediately after such acquisition. This is a question of fact and the Department will examine all the facts and circumstances immediately following such an acquisition to determine whether there is non-arm's length dealing between the shareholders and the corporation. If the shares held in the RRSP perform unusually well, it could be a sign that the shareholders have common interests and are therefore not dealing with the corporation at arm's length.

Comments by Department of Finance

The rules governing investment by RRSPs and RRIFs in small business corporations are designed to strike a balance between the integrity of the taxation system in contributing to retirement savings and the benefits of providing an additional source of funds for these small businesses.

In terms of fiscal policy, there are two major reasons for the $25,000 limit and the requirement that shareholders deal at arm's length with the corporation for the purpose of investing in private corporate shares through RRSPs and RRIFs.

First of all, if there were no such restrictions in the rules governing RRSPs and RRIFs for private corporations, we are afraid that excessive yields on such investments would become unduly inflated to benefit from the tax deferral available for income accumulating on assets held in an RRSP or RRIF.

Secondly, if a person's only RRSP holdings consisted of shares in his businesses, his retirement security would be completely tied to his business, which could require the government to provide more support to this person following his retirement. This would be contrary to the underlying overall policy of the taxation system to provide incentives to retirement savings, by encouraging people to save for their retirement.

4.4.2 Loan Financing

The $25,000 limit applies only to the cost amount for the corporation shares. If in the previous example, the shareholders had financed their corporation by means of an interest-free loan of $100,000 each with no repayment terms, while subscribing to only a nominal number of shares, the $25,000 limit would not be a problem for them. If, on the other hand, they had financed their corporation by subscribing to $100,000 each in preferred shares, they are considered designated shareholders. Did the Department of Finance anticipated this inconsistency?

Comments by Department of Finance

We admit that the $25,000 limit applies only to the cost amount for a corporation's shares and does not cover the cost of loans made to the corporation. Subsection 4900(12) of the Income Tax Regulations is designed to be an incentive to equity investment. That being the case, it would be unfair and overly strict from a fiscal policy standpoint to require that such debts be included in computing the $25,000 limit.

Disallowing debt investment in private companies for the purpose of RRSPs and RRIFs may, however, be justified because interest payments made by a corporation are generally deductible in computing income, unlike dividends on shares, which are not. This means that existing concerns about the possibility of improper tax planning in connection with debt investment compared to equity investment are that much greater in the context of RRSPs and RRIFs.

4.4.3. Concerns with regards to Subsection 4900(13) of the Regulations

Subsection 4900(13) of the Regulations adds that a share in a small business corporation purchased by an RRSP held by a trust shall cease to be and shall not thereafter be a qualified investment for the trust if an amount is received (including a dividend) in respect of the share by the trust, and that under the circumstances, it is reasonable to consider the amount to be in respect of the acquisition of goods from or services provided by the issuer. This subsection is of concern for a shareholder who is also an employee of the corporation. It is not unusual for shareholders in a small corporation, in particular when the corporation is just starting up, to receive very little in salary.

In such cases, if the corporation were to pay dividends to the trust governed by the RRSP, could subsection 4900(13) disqualify the investment because the dividend partly covers services rendered previously that were not paid for equitably?

More generally speaking, would the salaries of all shareholders who are employees have to be reviewed each year in comparison to the market to avoid an unexpected application of subsection 4900(13) of the Regulations?

What does Revenue Canada think?

Comments by Department of Revenue

Determining whether an amount received by a trust governed by an RRSP in connection with a share can reasonably be considered in respect of full or partial payment for services provided by the issuer of the share or the person related to the issuer, is a question of fact.

Subsection 4900(13) does not allow an employee to pay part of the remuneration to which he is entitled into his RRSP. Moreover, the Act does not require under any circumstances that a salary be paid.

One cannot conclude simply from the fact that a startup corporation pays little salary that subsection 4900(13) of the Regulations applies. Factors such as cash flow, requirements of financial institutions or other creditors, salary policy, and the policy on reinvestment in corporate shares need to be considered to determine the reasons why low salaries are being paid.

For example, where employees who perform tasks similar to those performed by employee-shareholders whose shares are held in an RRSP are better paid than the latter and the difference is compensated for in that year or subsequently through the payment of dividends, subsection 4900(13) of the Regulations may apply.

Moreover, where the only employee or employees of a corporation are shareholders, the salary paid should normally be comparable to a salary paid to non-shareholder employees with due regard to the above-mentioned factors. If this is not the case and, as mentioned earlier, the difference between the two is compensated for in the year or a future year through the payment of dividends, subsection 4900(13) of the Regulations may apply.

Comments by Department of Finance

The income tax system may, to a certain degree, discourage a corporation from converting its employees' salaries into share dividends because the dividend tax credit is inapplicable to RRSPs and RRIFs and the dividends that a corporation has to pay are not deductible in computing its income. Nevertheless, the integrity of the taxation system's assistance to retirement savings would suffer if a corporation could convert salaries into dividends. Subsection 4900(13) represents additional protection against this type of planning and ensures a degree of control throughout the period that shares are held by the RRSP or RRIF.

4.5 Sole Purpose Corporation

To protect themselves again U.S. inheritance duties, many Canadians have established corporations whose sole purpose is to own real estate in the United States in their name. Revenue Canada's policy had been not to consider the use of this ownership vehicle to generate a benefit to a shareholder provided that the following conditions were met:

- the sole purpose of the corporation is to hold the property for the personal use and enjoyment of the shareholder;

- shares in the corporation are held by one person or together with other related persons;

- the sole operations of the corporation are related to the objective of owning the property for the personal use and enjoyment of the shareholder;

- the operating expenses generated by the ownership of the property by the corporation are assumed by the shareholder in such a way that the corporation realizes neither a gain nor a loss on the property in question.

As the new draft agreement between Canada and the United States allows more equitable treatment in terms of U.S. inheritance duties for Canadian taxpayers who own property in the United States, Revenue Canada on June 22, 1995, announced its intention to review its administrative position with respect to sole purpose corporations.

At what stage does this review stand? Will it consist of deeming that it is a benefit to the shareholder? If so, how will this benefit be computed?

Will the new policy apply generally from the date of its announcement or only to those sole purpose corporations established after this date?

Comments by Department of Revenue

The Department of Revenue's position concerning sole purpose corporations is still under review. We plan to publish our conclusions in a forthcoming issue of "Technical News".

The conditions described above were mentioned in the Department's reply to question 20 at the round table of the 1980 annual convention of the Canadian Tax Foundation. The question related to a Canadian corporation. The Department's position therefore applies only to Canadian corporations used to own real estate in the United States. Two additional conditions were added to the original position as noted at the round tables held at the 1985 (question 14) and 1989 (question 9) Canadian Tax Foundation annual conventions. These conditions are: (1) that the corporation acquired the real estate with funds solely from the shareholder and not pursuant to his participation or the participation of a related person in the share capital of another corporation; (2) the real estate must have been acquired on a fully taxable basis (namely, without using any tax-free transfer provisions of the Act).