Frightening GAAR Facts

One of my favourite scenes in one of my favourite movies, The Sting, has Robert Redford, a young and enthusiastic grifter, meeting Paul Newman, an older and wiser grifter. Redford is soliciting Newman’s help to exact revenge on mob boss Robert Shaw, who killed his friend. Sensing Newman’s hesitation, Redford challenges Newman:

Redford: You’re scared, aren’t you?

Newman: You’re damn right I’m scared. You’re talking about a guy who would kill a grifter over an amount of money that wouldn’t support him for a week.

When the General Anti-Avoidance Rule was first introduced some 22 years ago, the tax community was not overly concerned. The provision was too general. It had no teeth. The good old days went along pretty much the same in terms of aggressive tax planning for some time. Even the courts were somewhat reluctant to impose the GAAR, calling it a provision of “last resort”.

It’s now 2010, and all that has changed. The Supreme Court of Canada has now come down twice in favour of the GAAR . Tax shelter plans that were touted and sold in the 1990’s are being challenged and defeated in the 2000’s. The Quebec government has instituted reporting requirements and hefty penalties unless certain “aggressive” transactions are reported to them. The federal Minister of Finance has followed Quebec’s lead in proposing a “reportable transaction” regime.

Perhaps the most disturbing news comes from the Canadian Tax Foundation who this month reported some incredible statistics regarding the CRA and its increasing zeal for applying the GAAR. As you may be aware, any file that has a potential for a GAAR assessment must be referred to a special committee in Ottawa. Since its inception, the GAAR committee has recommended the application of the GAAR in 72 per cent of all cases brought to it.

Now, get this: Since the start of last year, 99 cases have been referred to Ottawa. The committee has chosen to apply the GAAR in 98 of them!

So, when a fresh-faced fearless tax man comes to me with a plan that might be a candidate for the GAAR, I look him in the eye with no qualms and I say, “you’re damn right I’m scared.”

They’re Not As Dumb As You Think

Once in a while, a client will suggest a scheme that makes me wonder if he is really living out there in the real world.

The case of Jacob Erlich is interesting in that it represents a set of facts which is not all that uncommon in my experience. It tells the story of a taxpayer who is willing to take the risk of excluding certain amounts in reporting his income, and the dire consequences that may befall him if his actions are subsequently investigated by the revenue authorities.

The facts were not complicated. Mr. Erlich was the owner of a chain of retail clothing outlets for a number of years, since he took the business over from his father in 1972. In 1992, someone (although not addressed in the text of the case, that someone was likely a disgruntled former employee with a cross to bear) made a report to the Special Investigations division of the Canada Revenue Agency, with regard to some unreported sales of the business.

During the audit that ensued, the CRA discovered that somehow, the cash register tapes which would verify sales from 1988 to 1991 were nowhere to be found. The Minister accordingly assumed that they had been destroyed by Erlich.

In 1992 Mr. Erlich made a series of deposits to his corporation’s bank account, totaling $367,000. The amounts were credited to his shareholder loan account. The Minister assumed that these amounts represented sales collected directly by Mr. Erlich, and not reported by the company.

In addition to the above, this was not the first time Mr. Erlich was under the gun for a similar offence. He had previously deposited unreported sales of a predecessor company into his shareholder loan account.

At this point, let me make an important point about the burden of proof. Quite simply, it rests with the taxpayer. In other words, the Minister made certain assumptions based on the evidence or lack thereof, issued a net worth assessment against Mr. Erlich, and assessed his company a similar amount with respect to unreported sales. This double tax assessment is one of the ways the government can punish a taxpayer for abusive transgressions.

Often, a client will be under the wrong impression that if the CRA can’t prove their case, they will lose. Unfortunately, as stated above, they don’t have to prove their case. The taxpayer does.

Furthermore, a client will sometimes believe that a suitable story will make the problem disappear. When asked where the money came from to make the deposits in question, Mr. Erlich had such a story. He stated that his mother had found the cash in boxes in a closet of her home, possibly left there by his father (now deceased), who may have had some rich (and, no doubt, generous) friends in Hong Kong.

Not surprisingly, the CRA did not take this explanation at face value. Nor, to their credit, did they reject it out of hand. They actually went back through the records of Mr. Erlich’s parents to determine whether any income source existed that would justify the amount of cash found. Unfortunately, no such source was found.

Without proof to substantiate Mr. Erlich’s his story, the court rejected it, and upheld the Minister’s assessments. This case illustrates in vivid fashion, something I try to impart on my clients on a regular basis. The CRA and the courts are not as dumb as you think.

CRA Exposes More Offshore Shenanigans

If you’ve been following the UBS scare in the U.S. (see my previous post on this topic) please add the tiny state of Liechtenstein and the relatively large Canadian  institution known as RBC Dominion Securities to the list of names associated with offshore shenanigans.

The CBC reports that the Canada Revenue Agency is investigating 13 taxpayers who set up offshore accounts with LGT Group in Liechtenstein. These accounts were set up with the aid of Colin Ross, a former investment adviser at the Victoria branch of RBC.

Liechtenstein: Small, beautiful, and one of the tax community's best kept secrets

The CRA’s investigation, launched last year, found that certain foundations were set up and used by taxpayers to “masquerade as non-residents.” The agency says the taxpayers were “hiding their investments and other income” and “evading their obligation to pay Canadian tax.”

Of the 13 taxpayers implicated, some have made voluntary disclosures, and will therefore likely escape criminal charges and penalties. Others are under the gun for tax evasion, including  one Victoria woman who told investigators she felt having an offshore account was “glamorous”.

RBC  has released a statement disavowing any wrongdoing as a firm. The CRA is now investigating whether more Canadians are doing the same thing through RBC advisers across the country. But it won’t stop there. Revenue Minister Jean-Pierre Blackburn is quoted as saying “We will go after every other bank to obtain the list of their clients who do business abroad and to see if those clients declare their income.”

Offshore Trusts – Is The Sun Setting?

So often, I see tax strategies fall short, not due to faulty planning, but faulty execution. It is so easy to fall into complacency with regard to documentation. But I’m not going to ask you to take my word for it. I’ll let you read a great excerpt from the Tax Court of Canada in the case of Antle (2009 TCC 465). This case, by the way is one of the two recent “Barbados trust” cases involving the use of offshore trusts to escape tax on large capital gains.

Parenthetically, the other case, Garron Family Trust, (2009 TCC 465) calls into question the long-standing notion that a trust is resident in the jurisdiction where the majority of the trustees reside. This absolute certainty, like the shape of our globe, once considered to be flat, has given way to the reality that the residence of a trust should be determined based on the set of circumstances in question, and that the place where management and control takes place is now the overriding factor.

But I digress. I want to get to this great quotation, because the lawyers involved in this case must be pulling out their hair. When Mr. Antle was about to sell his shares, he decided he could avoid the capital gains tax by following a few simple tax planning steps, as follows:

Step 1: Set up a spouse trust with a trustee resident in Barbados.

Step 2: Transfer shares to a spouse trust (tax free under Canadian law)

Step 3: Trust sells shares to Mrs. Antle (tax-free under Barbados law and Canadian-Barbados tax treaty)

Step 4: Mrs. Antle sells shares with stepped-up cost base

Forget the fact that GAAR also applies to this transaction. The court, in fact made another fun statement in this regard, calling the strategy “a classic law school model of what GAAR was intended to capture”.

But again, I digress. The point is, don’t lose your case for a client before it gets out of the starting block through sloppy paperwork and poor execution. In Antle, the court stated:

“With certainty of intention and certainty of subject matter in question and, more significantly, no actual transfer of shares, there is no properly constituted trust: the Trust never came into existence. This conclusion emphasizes how important it is, in implementing strategies with no purpose other than avoidance of tax, that meticulous and scrupulous regard be had to timing and execution. Backdating of documents, fuzzy intentions, lack of transfer documents, lack of discretion, lack of commercial purpose, delivery of signed documents distributing capital from the trust prior to its purported settlement, all frankly miss the mark — by a long shot. They leave an impression of elaborate window dressing. In short, if you are going to play the avoidance game, it is not enough to have brilliant strategy, you must have brilliant execution.”

So true. Both the Garron and Antle cases are being appealed.

GAAR Wars: The (Quebec) Empire Strikes Back

Not Quebec's Finance Minister

The Minister of Finance of Quebec has announced major new rules in the fight against “Aggressive Tax Planning” (“ATP”).

Remember the “Quebec Shuffle”? How about the Alberta-Resident Trust? These and other tax-planning strategies were once all the rage, saving tax dollars by exploiting differences among provincial tax rules. Before they became well-known, they were marketed by tax planners as “confidential” or “proprietary” tax plans, and clients would have to sign non-disclosure agreements before gaining access to these strategies. Often, the fees charged by tax advisors were contingent – based on the value of the taxes saved.

Although the provinces took steps to eliminate many of these plans by introducing specific legislation over the years, and despite the existence of the General Anti-Avoidance Rule (“GAAR”), last January the government of Quebec issued a discussion paper to float proposed rules to further combat ATP transactions.

On October 15, 2009, the Minister of Finance released Information Bulletin 2009-5, which outlines the final version of new rules that will immediately apply to Quebec taxpayers and their advisors.

Mandatory Disclosure

The centerpiece of the proposed legislation is the new reporting regime. These rules are largely based on the U.S. model of “Reportable Transactions”, which has been in place for some years.

In certain instances, taxpayers will now be required to report the details of a transaction (or series of transactions) to Revenue Quebec by the due date for filing their returns. Taxpayers will have to report a complete and detailed description of the facts and the tax consequences relating to the transaction.

There are two categories of transactions that must be reported:

  • Confidential transaction – where the tax advisor has demanded secrecy from the taxpayer regarding the plan; and
  • Transaction with conditional remuneration – where the tax advisor is being compensated based on some form of contingency arrangement. (this would exclude contracts for R&D and other tax credits)

The mandatory disclosure will apply to either of the above types of transactions; however, they will not apply unless the transaction in question results in a tax benefit of at least $25,000 or a deduction of at least $100,000.

Failure to file the information will result in onerous consequences – a penalty of $10,000 plus $1,000 per day up to a maximum of $100,000, as well as suspension of the limitation period for reassessment until the disclosure is filed.

New Punitive Rules Where GAAR Applies

The Minister proposes to extend the limitation period and assess penalties where a transaction is found to be subject to the GAAR.

Firstly, the normal reassessment period (currently 3 or 4 years) will be extended by a full three years. Furthermore, a penalty of 25% of the additional tax will be levied on the taxpayer; and finally, in all cases where GAAR applies, a promoter who markets the plan will be subject to a penalty of 12.5% of the consideration he receives.

Preventative Disclosure

In order to prevent the possibility of an extended limitation period and the penalties in GAAR cases, taxpayers can choose to disclose any transaction to Revenue Quebec on a voluntary basis. If the transaction is reported by the due date of the taxpayer’s tax return, then the application of the GAAR will not come with the extension of the limitation period for reassessments and the above penalties will not be imposed.

New Administrative Department

I suspect that the government will quickly become inundated with disclosures, especially since now, any over-zealous tax auditor could decide to extend the reassessment period by simply pulling out the “GAAR” card (an over-zealous tax auditor in Quebec? Dave, you can’t be serious!).

To this end, the government has established a division of Revenu Québec, called the Direction principale de la lute contre les planifications fiscales abusifs (hooray! another Quebec bureaucratic department!), where all of the disclosures must be sent, on a prescribed form, separately from tax returns .

Quebec has taken a bold step in the fight against tax avoidance. One wonders how long it will be before the federal rules follow suit.

What’s Your Tax Issue?: Surplus Stripping

The Tax Issue:

Can I claim the capital gains exemption if I sell my shares to my brother’s company?

The Answer:

This could be the most common question I get on this topic. The capital gains exemption is intended to shelter the gains from the sale of private company shares. The exemption is available to individuals only, up to a lifetime cumulative limit of $750,000. The shares must meet certain tests which are too complicated to get into here. Suffice to say, you would not want to claim the exemption without consulting a tax professional first.

Generally, any sale of shares that qualifies should be eligible for the exemption, even a sale to a non-arm’s length party, such as your brother’s company. However, if you plan on receiving any consideration other than shares, such as cash, forget it.

Let’s cut to the real question. What you are really asking is, “can I get cash out of a non-arm’s length company without paying tax?” What the CRA calls this is “surplus stripping”, and there are rules in place to stop you.

Specifically, the most common anti-surplus-stripping rule in the Income Tax Act is found in section 84.1, which will convert your capital gain into a taxable dividend if you receive cash as part of your proceeds from the sale of shares to a non-arm’s length company.

If you wish to take back shares of your brother’s company as your proceeds, that’s ok, but any subsequent redemption of those shares will be taxed as a dividend.


The Tax Issue:

I was wondering If I earn money offshore and do not repatriate any of it back to Canada do I have to pay tax on it. (i.e. Work, Investments, etc…)?

The Answer:

The short answer is YES!

With all the talk recently about UBS, offshore bank accounts and tax evasion, this question comes at a crucial time for any Canadian taxpayer with funds offshore.

Generally, if you are a Canadian resident, you are obligated to declare and pay tax on your world income. So, if you go off to Dubai and earn revenue as a systems consultant there for a few weeks, deposit the funds in a Swiss bank account and never bring the money into Canada, you are still obligated to report the income earned on your Canadian income tax return for the year.

Similarly, any investment income earned while that money sits in an offshore account is taxable in Canada as it is earned.

If the income is from employment, and you meet certain criteria, you may be eligible for an overseas employment tax credit to be deducted on your return. You should consult your tax advisor if you were employed on a long-term project offshore at any time in the year.

The Canadian system operates on the basis of residency alone. So, if you leave Canada permanently, you will no longer be subject to Canadian income tax from the time of departure. As a non-resident you will generally not be subject to tax in Canada, even if you are a Canadian citizen.

So, if you’ve read my previous post on the UBS affair and how it affects us here in Canada, you should be aware that any funds deposited in any offshore account that contains proceeds from taxable earnings you derived while a resident of Canada is subject to the scrutiny of the CRA at any time.

Update: See the case of Bensouilah v. MNR (2009 DTC 1327) for an illustration of Canadian resident taxpayer failing to report employment income earned in Saudi Arabia.

Brian Mulroney and the CRA – Part 2

This is a continuation of my Mulroney rant from last post.

While Mr. Mulroney admits to collecting $225,000 as a retainer for services to be rendered to Karlheinz Schreiber, he claims he did not report the amounts as income for tax purposes because he didn’t feel they were earned yet.

Muroney with Reagan - happier days

Mulroney with Reagan in happier days

Fast forward to 1999, when the amount was finally reported as income. First of all, the event that triggered the reporting was not the fact that anything was earned, it was the fact that Mr. Mulroney was feeling threatened that Schreiber was going to report him to the tax authorities. So, if Mulroney was complying with the tax law as he claimed, why would he worry about such a threat?

Next, if all was above board with this amount of income, why would Mulroney not simply add  it to his tax return for 1999? Here’s a fact: the voluntary disclosures route taken by Mr. Mulroney is only available to taxpayers where negligence penalties are involved.

And why, for heaven’s sake, would he not insist on reporting the full amount when his lawyers came to him with the deal they negotiated with the CRA that allowed him to escape tax on half the cash? That’s what I would do if I were a former Prime Minister conscious of my appearance in the public view.

When asked these very questions, Mr. Mulroney simply blamed it all on his lawyers. Trust me when I say that pleading ignorance and relying on professionals never works with the CRA or the courts. Taxpayers, especially sophisticated taxpayers are always assumed to have knowledge of the contents of the tax returns as evidenced by their signatures and are held responsible for them. For someone like Mr. Mulroney to reply to a direct question concerning his taxes with the statement that he “gave it to (his) tax advisers” is the epitome of brazenness.

Mulroney was followed immediately by Wayne Adams of the CRA who tried to explain to the committee much of what I’ve just said. At the end, Commissioner Oliphant said “I listened to Mr. Mulroney for six hours and I find myself more tired listening to an hour and a half of tax law here”.

Charisma. Mulroney’s got it. Tax nerds like me, not so much.

Brian Mulroney and the CRA – Part 1

Now that I’ve got a Blog, I’ve got a platform to whine, to vent, and to set the record straight on whatever I choose.  So, even though it’s a bit late, I’d like to clear up a few of the tax issues brought up during Brian Mulroney’s testimony at the Oliphant commission last May.

Don’t get me wrong. I’ve got nothing personal against Mr. Mulroney. Apart from Pierre Elliott Trudeau, I consider him to be the most charismatic prime minister I’ve seen.

But his tax knowledge is weak, and the news reports about when and how he paid taxes on the payments he received are somewhat misleading. So it’s my job to try to clear things up.

Brian Mulroney - Charisma : Yes - Tax Expertise: NoBrian Mulroney – Charisma : Yes;  Tax Expertise: No

It’s old news now, but just to refresh our memories, Mulroney admitted to receiving cash payments totaling $225,000 from German businessman Karlheinz Schreiber. The payments were received in 1995, just after Mulroney left office.

When asked about reporting this amount on his income tax return, Mulroney suggested that he did not report the amounts because he considered them to be “retainers”, and had every intention of reporting the income at such time as he felt they were earned. This, he stated was according to the rules of the Income Tax Act, and I have yet to see any news reports that challenge this view.

Assuming the amounts received were retainers for services to be rendered in the future, the law does not allow for a taxpayer to simply report the amounts when they are earned. There’s a mechanism in place that allows the CRA to keep tabs on us.

Section 12 of the Act requires any amount on account of future services to be reported as income in the year received. Then if the services have not been rendered by year-end, section 20 allows for a reserve to be deducted.

So, if we accept that Mulroney intended to comply with the law from the start, we should have seen an income inclusion of $225,000 in his 1995  tax return, and a deduction for the same amount as a reserve. Each year thereafter, the reserve is brought into income and another reserve claimed if the services have not yet been rendered.

No, I don’t work for the CRA. It’s just that of all people, a former PM should be very careful to actually report income that he says he intends to report.  It would have set such a good example for the rest of us, wouldn’t you say?

This rant is not over. There’s even more to come next time.

Canada’s Quieter Campaign

With the UBS ordeal making loud news across the border, Canada , in addition to continuing to piggy-back on the success of the IRS, quietly pursues its own ongoing campaign against off-shore tax evasion. While some may see the CRA’s efforts as slow to the point of non-existent, it is real, and it is progressing.

The Minister of Finance announced last week that it has signed its first Tax Information Exchange Agreement (TIEA) with a non-treaty tax jurisdiction. The sharing of tax information is normally included in Canada’s treaties, but this is different – it applies to non-treaty, traditionally low tax jurisdictions such as Bahamas, Caymen Islands, Jersey and the like. Last week’s agreement with the Netherlands-Antilles is the first in a long list of agreements that will be signed over the next five years.

The bad news, of course, is that these countries will now be happy to turn over information to the CRA that is necessary to help enforce Canadian tax law. Anyone doing business in these jurisdictions would be well advised to start thinking about the future and ensure that they have, in fact been complying with the rules.

The good news is that these countries will become more attractive jurisdictions for foreign business operations from a Canadian tax point of view. Any country that has signed a TIEA with Canada will be eligible for favourable treatment with respect to dividends coming back to Canada. The current rule is that any dividend paid from a non-treaty country is not eligible for exemption under our foreign-affiliate system. Now, any country that has a TIEA with Canada will also qualify for this treatment. So, earnings from active business in these countries can be repatriated to a Canadian parent company on a tax-deferred basis.

Now, back to the bad news. For those countries that do not sign a TIEA with Canada within five years from the day that Canada invites negotiations, active business earnings will not only fail to qualify for tax exempt repatriation, it will also become subject to Canada’s Foreign Accrual Property rules, better known as “FAPI”.

The bottom line? Expect Canada to put the pressure on many tax haven jurisdictions to sign these agreements, allowing the CRA to quietly cast its net over an ever-increasing area of the tax world.