News of Note
Cassan – Tax Court of Canada finds that interest should not be recognized on a portfolio or index-linked note until the return is determinable - and that lack of attention of a lender to creditworthiness established lack of bona fide repayment arrangements under s. 143.2(7)
Email this ContentIn December 2009, individual taxpayers participated in a tax shelter that involved making both a leveraged investment and leveraged donation. In the investment component, they used money borrowed from a lender trust (FT) to purchase units in an Ontario LP, which used most of the proceeds to purchase notes of a BVI company (Leeward). The return on the notes was linked to whichever of a stock market index and a notional balanced portfolio performed the better, with Leeward then lending the funds back to FT via a second trust.
Respecting the leveraged donation, they borrowed money from FT at 7.85% p.a. – of which 3.75% p.a. was required to be paid annually in cash (“cash-pay interest”) and the balance was capitalized each year (“capitalized interest”). This borrowed cash was then contributed by them to a registered charity on condition that it invest most of such proceeds in a note of Leeward, that matured in 2028, and bore interest of 4.75%, of which 3.75% was cash-pay interest, and the balance capitalized interest of 1% (which would cause the amount owing under the note to accrete by over 1/3 by 2028). These funds also were mostly circled back to FT. The ability of Leeward to be able to repay this note owing to the charity depended on the small portion of the funds received by it from the individuals (via the LP) under the investment component, that it invested in a fully-indexed note rather than on-lending back to FT via the second trust, appreciating at a rate of 10% p.a. over the close to 20 years until 2028.
Owen J found that the taxpayers’ donation did not qualify as a “gift,” as “Maréchaux and Kossow hold that a transfer of property is not gratuitous if a benefit flows to the transferee as part of an interconnected series of transactions that includes the transfer of property.” The benefit he identified was that the interest rate of 7.85% that was charged to them was less than a reasonable rate of interest, which would have been a minimum of 10% p.a.
This issue was not fixed by the split receipting rules. It is true that having regard only to ss. 248(30)(a), (31) and (a), they could have been entitled to have a gift recognized for the difference between the cash contributed to the charity and the low-interest-rate benefit received from FT. The bigger problem was posed by the combined effect of s 248(32)(b) (deeming the amount of limited-recourse debt to be a benefit), s. 143.2(7)(a) (deeming debt to be limited-recourse if there were no bona fide arrangements for repayment within 10 years) and s. 143.2(12) (deeming there to be no such arrangement if the debtor’s arrangement to repay within 10 years “can reasonably be considered to be part of a series of loans or other indebtedness and repayments that ends more than 10 years after it begins.”) Although the loan from FT to them had a term of 9.3 years, Owen J found that this was insufficient to establish that there were bona fide arrangements for repayment which, in his view, required “that the arrangements reflect what one would reasonably expect arm’s length commercial relations to look like in the circumstances.” This was not the case here as the conduct of the lender (FT) showed relative indifference to the creditworthiness of the taxpayers. Furthermore, respecting s. 143.2(12), it was reasonable to expect the loans to the taxpayers to be renewed on their maturity with the promoter’s assistance.
In finding that Reg. 7000(2)(d) interest accrual did not apply to the index-linked note, Owen J stated:
The assumption underlying paragraph 7000(2)(d) is that [the maximum amount of interest] is capable of determination… .
…In the absence of an actual crystallizing event there is simply no way of knowing the actual amount that the … LP is entitled to be paid under the terms of the Linked Notes… .
In finding that the taxpayers were entitled to an interest deduction on their loans from FT, he noted that the potential for the receipt of interest on the maturity of their share of the Linked Notes held by the LP was sufficient to justify the deduction of interest by them for the 19 preceding years.
Neal Armstrong. Summaries of Cassan v. The Queen, 2017 TCC 174 under s. 118.1(1) – total charitable gifts, s. 143.2(7)(a), s. 143.2(12), Reg. 7000(2)(d), s. 20(1)(c)(i) and Statutory Interpretation – Realization Principle.
CRA finds that a payout of (non-excess) sick leave credits on termination was a retiring allowance
On termination of employment, the employee would be paid the value of his or her accumulated sick leave credits. CRA considered that this payment would be a retiring allowance (and thereby presumably excluded from CPP contribution requirements) except for the amount paid in excess of the equivalent of 20 days, which generally would be considered to be employment income given that this excess, in the absence of the termination, would have been paid out to the employee at the end of the year.
Neal Armstrong. Summaries of 21 July 2017 Internal T.I. 2017-0714931I7 F under s. 248(1) – retiring allowance and s. 248(1) – death benefit.
CRA confirms that s. 38(a.1) prevails over s. 69(4)
CRA confirmed that the s. 38(a.1) rule prevails over s. 69(4), as well as s. 69(1)(b)(ii), so that where a corporation transfers shares of a public corporation for no consideration to its sole shareholder, which is a private foundation, s. 38(a.1) will deem there to be no gain to the corporation if the transfer qualifies as a gift.
Neal Armstrong. Summary of 31 May 2017 External T.I. 2016-0642621E5 under s. 38(a.1).
Chiang – Tax Court of Canada finds that a “reasonable error of fact” (e.g., confusion as to how to claim a deduction) established a due diligence defence to penalties
The taxpayer (Chiang) overcontributed to his RRSP (thereby incurring Part X.1 tax) because he “genuinely and reasonably believed” that he had deducted his contributions for two years in his returns for those years (but, in fact, did not enter the amounts in the deduction line) and that for a third year he had unused RRSP deduction room (which he did not). In finding that Chiang was not subject to penalties under s. 162(1) for not filing Part X.1 tax returns, Sommerfeldt J found that because
Mr. Chiang reasonably believed in, and was operating under, a mistaken set of facts that, if true, would have resulted in there not having been a cumulative excess amount…his failure to file tax returns (Form T1-OVP) for 2004 to 2013 resulted from a reasonable error of fact, so as to be excused by the due diligence defence.
Neal Armstrong. Summary of Chiang v. The Queen, 2017 TCC 165 under s. 162(1).
OneREIT asset sale and merger into SmartREIT entails an allocation of recapture of depreciation to its existing unitholders
OneREIT is proposing to sell a substantial portion of its rental assets (held through subsidiary LPs) in a taxable sale to a third party (Strathallen) and then, as part of the same Plan of Arrangement, to be merged into SmartREIT (which is an Alberta unit trust and REIT) under s. 132.2. Those OneREIT unitholders who elect to receive cash for their units, will have their units redeemed immediately after the closing of the Strathallen sale, with all the recapture of depreciation of around $0.15 per unit (as well as capital gains) from that sale being allocated to them. Those electing to receive their consideration as SmartREIT units, will have this result effected through the usual s. 132.2 mechanics. The projected value of the SmartREIT units to be received is estimated to be somewhat lower than for the cash alternative ($4.20 v. $4.275 per unit).
All the properties of OneREIT are held through subsidiary LPs. Applications are being made to CRA for approval of a stub fiscal period in order that the LPs can allocate their capital gains and recapture from the Strathallen sale, and other income to date, to OneREIT for allocation, in turn, to its current unitholders. Unitholders can avoid this allocation by selling on the TSX. Since the cash part of the transaction is structured as a redemption, non-residents will be subject to Part XIII.2 and XIII withholding on the full proceeds if they elect to receive cash.
There are no corporate steps in the Ontario Plan of Arrangement other than an amalgamation of, and $10 unit subscription by, the corporate trustee for the general partner of a subsidiary LP.
Neal Armstrong. Summary of OneREIT Circular under Mergers & Acquisitions – REIT/Income Fund/LP Acquisitions – REIT Mergers.
Income Tax Severed Letters 13 September 2017
This morning's release of five severed letters from the Income Tax Rulings Directorate is now available for your viewing.
Six further translated technical interpretations are available
Full-text translations of the technical interpretation released last week and of the five released between August 20, 2014 and July 30, 2014, are listed and briefly described in the table below.
These (and the other translations covering the last 38 months of CRA releases) are subject to the usual (3 working weeks per month) paywall.
| Bundle Date | Translated severed letter | Summaries under | Summary descriptor |
|---|---|---|---|
| 2017-09-06 | 28 October 2016 External T.I. 2016-0654331E5 F - Transfer of rights to income | Income Tax Act - Section 9 - Nature of Income | where rental lands purchased subject to obligation to pay the rents to vendor, rents did not have quality of income to purchaser under s. 9 |
| Income Tax Act - Section 18 - Subsection 18(1) - Paragraph 18(1)(a) - Incurring of Expense | where rental lands purchased subject to obligation to pay the rents to vendor, no income inclusion and deduction of the rents by the purchaser under ss. 9 and 18(1)(a) | ||
| Income Tax Act - Section 56 - Subsection 56(4) | where rental lands purchased subject to obligation to pay the rents to NAL vendor, s. 56(4) trumps s. 9 to include rents in purchaser’s income | ||
| Income Tax Act - Section 56 - Subsection 56(2) | s. 56(2) could apply to shareholder of purchaser of lands if vendor did not pay FMV consideration for retaining rights to rents | ||
| 2014-08-20 | 7 July 2014 External T.I. 2014-0518561E5 F - Superficial loss | Income Tax Act - Section 54 - Superficial Loss | shares of Holdco as identical property to shares of Opco/transferred corporation wound-up but not dissolved within 30 days |
| Income Tax Act - Section 88 - Subsection 88(1) | transferred corporation wound-up but not dissolved within 30 days | ||
| 27 June 2014 External T.I. 2013-0500701E5 F - Déductibilité de certaines dépenses | Income Tax Act - Section 18 - Subsection 18(1) - Paragraph 18(1)(a) - Income-Producing Purpose | distinction between principal and secondary reason for incurring expense | |
| 2014-08-13 | 27 June 2014 External T.I. 2013-0498191E5 F - Interaction entre 55(2) et l'impôt de partie IV | Income Tax Act - Section 186 - Subsection 186(1) - Paragraph 186(1)(b) | Part IV tax on cross-redemptions takes into account the Part I tax (and RDTOH addition) generated by s. 55(2) application thereto |
| Income Tax Act - Section 55 - Subsection 55(2) | s. 55(2) tax on cross-redemption deemed dividends between connected CCPCs gave rise to circular Part IV tax | ||
| 2 July 2014 External T.I. 2014-0529731E5 F - Stop-loss Rules | Income Tax Act - Section 40 - Subsection 40(3.4) | taxpayer able to designate sourcing of disposed-of shares/illustration of application of CRA formula | |
| 2014-07-30 | 9 July 2014 External T.I. 2014-0527591E5 F - Résidence principale | Income Tax Act - Section 54 - Principal Residence - Paragraph (a) | housing unit rented to son and unrelated roommate potentially could qualify as principal residence |
The new investment limited partnership definition in the draft GST/HST draft legislation is potentially intractable
The investment limited partnership (“ILP”) definition contained in the September 8, 2017 draft legislation is one of the building blocks for the proposed ETA s. 272.1(8) rule, which would render many previously-exempt general partner distributions taxable.
It also is the key definition for extending, effective January 1, 2019, the special attribution method (SAM) rules, which currently are applicable to most selected listed financial institutions (SLFIs), to ILPs. These rules, for example, require a distributed investment plan, such as a mutual fund trust with unitholders across Canada, to follow detailed rules for determining the place of residence (under some somewhat artificial definitions of that concept) for the purpose of computing (to speak quite simplistically) a blended rate of HST that reflects that geographic distribution of its unitholders so that if its unitholders were mostly in the west, its blended rate would be close to 5%, whereas if they were mostly in the Maritimes, that blended rate would be close to 15%. This normative blended rate is then compared to the actual rate of HST charged to the MFT on its purchases to determine whether it owes top-up tax or is entitled to an HST refund. (See the Example in our Commentary on s. 32(1) of the SLFI Regs.) If the MFT does not follow safe-harbour procedures for determining the imputed residence of its unitholders on a timely basis, those unitholders may be deemed to be resident in high-rate (15%) provinces for SAM computation purposes.
These SAM rules are being extended to ILPs simply by defining a distributed investment plan to include an ILP.
The ILP definition references a limited partnership (LP), the primary purpose of which is to invest funds in property consisting primarily of financial instruments, provided that either or both of the tests in paragraphs (a) or (b) of the definition is satisfied.
Paragraph (a) references the situation where the LP is (or forms part of an arrangement or structure that is) represented or promoted as a hedge fund, investment limited partnership, mutual fund, private equity fund, venture capital fund or other similar collective investment vehicle.
Paragraph (b) references the situation where the total value of interests in the LP held by listed financial institutions (defined in s. 149(1)) is 50% or more of the total value of all interest in the LP.
A number of observations on this definition:
- It is quite unclear how to apply the primary purpose test. For example, if the investors in an LP think of it as a commercial real estate vehicle, but its modus operandi is to invest in projects through separate subsidiary LPs or other subs, is this test satisfied? (See Example 1 of our Commentary.)
- It is quite unclear what is meant by the reference in paragraph (a) to an LP that forms part of an “arrangement or structure.” What if it is 40% owned by an entity (such as a s. 149(1)(o.2) corporation) that would clearly taint it if it held a 100% interest? (See Example 2.)
- Respecting the paragraph (b) test, in some situations, an LP and its general partner may have difficulties ascertaining what is the tax status of a partner, for example, whether it is a listed financial institution by virtue of being “a person whose principal business is the lending of money or the purchasing of debt securities” (s. 149(1)(a)(viii). Furthermore, an investor could become a listed financial institution if it amalgamated with one (see s. 149(2).) (See Example 3.)
Neal Armstrong. Commentary on the investment limited partnership definition under ETA s. 123(1) - investment limited partnership.
Moller Maersk – Supreme Court of India finds that computer tracking-system charges of a Danish company to local agents were profits of its international shipping business
A Danish international shipping company (“Maersk”) charged local agents in India, who booked and tracked cargo, for their pro rata share of the costs of a Maersk computer and telecommunication system that was key to these functions. Article 13 of the India-Denmark Treaty permitted India to impose tax of 20% on the gross amount of fees for technical services (essentially defined, somewhat similarly to Art. 12(4) of the India-Canada Treaty, as “consideration for the services of technical or other personnel”), and Article 9 provided for a reduced rate of Indian tax on “profits derived from the operation of ships in international traffic.”
In finding that Maersk’s fees came within Article 9 rather than 13, Sikri J stated:
'[P]rofit' from operation of ships under Article…9 … would necessarily include expenses for earning that income and … [the] more so, when it is found that the business cannot be run without these expenses. This Court … has categorically held that use of [a] facility does not amount to technical services, as technical services denote services catering to the special needs of the person using them and not a facility provided to all.
Neal Armstrong. Summary of Director of Income Tax v. A.P. Moller Maersk, Supreme Court Of India, Civil Appellate Jurisdiction, Civil Appeal No. 2960 of 2017 under Treaties – Art. 8.
The new rule subjecting GP draws from investment limited partnerships to GST/HST could extend beyond private equity and portfolio investment LPs
Draft ETA s. 272.1(8)(b), which was included in Friday’s release of draft legislation, would effectively provide that if the general partner (GP) of an investment limited partnership provides a management or administrative service to the partnership, the supply of such service is deemed to be a taxable supply that is subject to GST/HST on its fair market value. The draft definition of “investment limited partnership” is quite broad, and could include LPs that would be viewed commercially as being engaged in a real estate or operating business, rather than being in the targeted category of private equity or portfolio investment LPs. For example, if a majority of the interests in a real estate LP, which carried on its business through subsidiary LPs, was held by “listed financial institutions” such as pension plans or REITs, the carry of the general partner would be subject to GST/HST. See Example 1 in our Commentary.
The effective-date rule is quite draconian, and appears to have the effect of retroactively making draws paid to the GP of a calendar-year investment limited partnership from January 2017 onwards subject to GST/HST assuming that the GP compensation for the year will not be finally determined until the accounts for the year are finalized in 2018. See Example 2.
Neal Armstrong. Commentary on s. 272.1(8) under s. 272.1(8) and s. 272.1(3).