DAVID WILKENFELD, CPA, CA, canadian tax CONSULTANT

Posts Tagged ‘the tax issue’

The Morneau Massacre of 2017

In Canadian Income Tax on August 8, 2017 at 9:00 am

loopholes

If you’ve just returned from vacation and wondering what’s new in the tax world, you’d better sit down and take a pill. On July 18, finance minister Bill Morneau rolled out the federal government’s proposals designed to “close loopholes and deal with tax planning strategies that involve the use of private corporations”. In short, Finance is proposing to tax an axe to many of the tax strategies that have been available to small business owners and professionals up until now.

The proposals are complex, comprehensive and wide-ranging, covering the following main areas of tax planning:

  • Income sprinkling
  • Multiplication of the capital gains exemption
  • Converting a private corporation’s regular income into capital gains
  • Holding investments inside a private corporation

Income Sprinkling

This strategy involves the splitting of income to take advantage of lower marginal tax rates available to family members. Many rules have been put in place over the years to curtail this practice. Most notably, the tax on split income (TOSI), or “kiddie tax” applies the highest marginal tax rates to certain dividends paid to minor children.

With the new proposals, the TOSI will no longer be limited to minor children. Complex new rules will apply the TOSI to dividends paid to adult individuals unless such dividends are reasonable in light of that individual’s labour contributions and/or capital contributions to the corporation.

The TOSI will also be expanded to apply to capital gains on property, the income from which was subject to the TOSI. Further, it will also apply (for individuals under age 25) to “compound income” that was previously subject to attribution rules or the TOSI.

These proposals are scheduled to apply to for the 2018 and later years.

Multiplication of the capital gains exemption

A capital gains exemption (CGE) of up to $800,000 (indexed) is currently available to any individual on the sale of qualifying shares of a private company. Issuing shares to family members, either directly or through a trust, is a common way to multiply this tax benefit.

The finance minister has proposed a three-pronged approach that will eliminate the multiplication of the CGE:

Age limit: The CGE will no longer be available to individuals where the gain occurs in any year before the individual reaches the age of 18 years.

Reasonableness test: In essence, this rule will deny the CGE on any gain on the sale of shares if the gain from those shares is subject to the TOSI measures described above.

Trusts: With exceptions for spouse or alter ego trusts the GCE will no longer be available on any gain on a share that is held by a family trust.

These proposals will apply to dispositions after 2017. However, there will be transitional rules that will allow an elected deemed disposition at any time in 2018. The fair market value of the shares would have to be determined, and the qualification criteria for the CGE will be treated as being satisfied if they are met at any time in the preceding 12 months.

Converting a private corporation’s regular income into capital gains

Normally, a distribution of a corporation’s retained earnings is considered a dividend and taxed as such. The top rate on dividends is approximately 44%. Strategies have been used with varying degrees of success to arrange for dividends to be transmogrified into capital gains, which are taxed at 25%. This involves the utilization of the high cost base on shares that have been acquired through a non-arm’s length transaction that had previously triggered a capital gain. Current rules are in place to curtail such “surplus stripping” in limited circumstances. Section 84.1 effectively forces a return to dividend treatment where the capital gains exemption was claimed on the previous capital gain.

The government proposes to extend these rules to any situation where a non-arm’s length transaction involved even a fully taxable capital gain. This proposal is meant to address what has become known as the “pipeline” transaction.

The pipeline has been used extensively in recent years as a post-mortem planning tool to avoid double-taxation where the capital is deemed to occur on the death of a corporate shareholder. Unless the current proposals are altered, the pipeline strategy will no longer be available to an estate.

These proposals will take effect for all dispositions that occur after July 18, 2017. There will be no room for transitional planning.

Holding investments inside a private corporation

One of the long-standing advantages of incorporation is the tax deferral that comes with lower rates on business income. Once the retained income has accumulated over time, the company will have a larger amount available for investment. This has been a great contributor to the retirement of many small business owners. However, it is an advantage that salaried persons or those who don’t incorporate cannot access. Accordingly, the government proposes to eliminate it.

Of all the proposals announced, this is the only one that is not fully developed with draft legislation. The Minister has included some suggested strategies to deal with the issue, each one complex in its own right, and generally altering the system of integration currently in place by eliminating the effect of the corporate tax deferral for future passive investment.

The Minister acknowledges that there currently exists a significant amount of capital invested within private corporations, and it is not his intent to affect these holdings. Any new rules will have effect on a going-forward basis.

These proposals are subject to a consultation period which will end on October 2, 2017. Interested parties should write to the Minister of Finance with any concerns before that date. I suspect that it will be an interesting and eventful autumn for the tax community.

They’re Not As Dumb As You Think

In Canadian Income Tax, Tax Avoidance on March 21, 2010 at 7:55 pm

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.

New Rates for New Buildings

In Canadian Income Tax, Capital Cost Allowance, Uncategorized on February 28, 2010 at 12:53 pm

The federal budget of 2007 included some new rules that would be favourable to taxpayers who incur the cost of a new building used for non-residential purposes. In essence, the new rules allow for enhanced capital cost allowance (CCA) rates for buildings located in Canada and purchased on or after March 19, 2007. The new rates are 10% for buildings used in manufacturing and processing (M & P) and 6% for all other non-residential buildings. The operation of these rules are fairly technical, and so they deserve the Tax Issue treatment. Let us first look at the two major traps embedded in the law.

Trap #1 – Election Required

The most important trap in the regulations seems to be that if you have acquired a qualifying building, it is not enough to simply place it in a separate class. You must make an election by supplying a letter attached to a timely filed income tax return, requesting that Regulation 1101(5)(b.1) be applied to place the building in a separate class.

Trap #2 – No Use Prior to March 19, 2007

The election is only available for acquisitions of an “eligible non-residential building”. Among other things, this definition requires that the building has not been used, or acquired for use by any person before March 19, 2007. Therefore, these new CCA rates do not apply to just any commercial building purchased. If the building was used prior to purchase by another person in any non-residential fashion prior to March 19, 2007, the enhanced CCA rates do not apply.

Building Use

The enhanced rates include the 4% allowed by Class 1. The building is placed in a separate class 1.3, and an additional allowance of either 6% or 2% applies. The 6% rate (making the total 10%) is allowed for buildings where at least 90% of the floor space is used at the end of the taxation year for the manufacturing and processing in Canada of goods for sale or lease. Note that the 90% applies at the end of the year. Thus, a building that did not qualify for the first part of the year may still qualify if its use changes by year-end.

The 2% additional allowance (making a total of 6%) is available where the building does not qualify for M & P as above, but 90% of the floor space is used in any other non-residential capacity.

Since the determination of the building’s CCA rate is based on its use at the end of each year, it seems that the additional rate could, theoretically, be different from year to year. Thus, a building whose M & P usage drops below 90% at the end of any given year could have its CCA rate reduced from 10% to 6% for the year and vice versa.

Building Under Construction

The new rates apply to buildings that were under construction on budget date. Construction costs incurred prior to March 19, 2007 are deemed under a special rule to have been incurred on March 19, 2007, unless the taxpayer elects out of this deeming rule. This will allow for the full cost of a new building completed after budget date to be eligible for the enhanced rates.

However, care should be taken to ensure that no part of the building was put in use prior to March 19, 2007. If this is the case, it will not qualify. However, post March 18, 2007 costs will still be eligible to be placed in a separate class under the rules described below.

Additions and Alterations

A special rule provides that the cost of an addition to or alteration of an otherwise non-qualifying building is deemed to be a separate building for the purpose of the new allowances. The election must be made to place these capital costs in a separate class 1, and the new rates will apply.

Conclusion

The enhanced CCA rates for new non-residential buildings are attractive, but care must be taken to ensure that a building, addition or alteration qualifies for the new rates and that the proper compliance steps are not forgotten.

Quebec Business Corporations Act

In Canadian Income Tax, Corporate Law on December 17, 2009 at 2:51 pm

I just got back from a seminar on the new Quebec Business Corporations Act (“QBCA”). These proposals will replace the current Quebec Companies Act in its entirety. When the new law is enacted (probably within 1 year) all companies currently incorporated under Part 1A of the current law will automatically become QBCA corporations.

UPDATE: The new Act received royal assent on February 19, 2010, and will be in full effect by the fall. See the press release from Revenue Quebec.

The new act incorporates all the best features of the CBCA and other provincial statutes, billing itself as the most modern of Canada’s corporations acts.

The term “company” will no longer apply to Quebec charters; they will now be known as “corporations”.

Some of the features of this new act that are most interesting to me as a tax practitioner are:

Incorporation: The incorporation process will be much easier. Online incorporation will be available, and no name search report will be required.

Ability to issue par value shares: OK, this one already exists in the current law, but it will continue in the QBCA, which remains an advantage over the CBCA. This facilitates the use of “high/low” stock dividends in corporate reorganizations.

Ability to issue different classes of identical shares: The CBCA currently allows this, although few people are aware of it. This feature will facilitate the payment of discretionary dividends.

Corporate incest allowed: The QBCA will allow shares of a parent company to be held by its subsidiary for a period of 30 days. This will be a big help to those of us doing corporate spinoffs and other internal reorganizations.

Fractional shares permitted: Very often, when performing a reorganization, shares are split up into fractions. The old law did not allow such shares to exist. Now it will, but not upon an issue from treasury.

Amalgamations: Short-form amalgamations will be much easier, and will include sister companies where the shares are owned by an individual.

Dissolutions: There will be a much more streamlined method for dissolution, including the elimination of the need to put an ad in the newspaper.

Directors: There will be no requirement for directors to resident in Canada.

That’s just a small sampling of the more interesting features of the coming law. Of course, the list is by no means exhaustive. If you are truly interested in this topic, you can  read the entire text of Bill 63, either in English or in French.

Offshore Trusts – Is The Sun Setting?

In Canadian Income Tax, Tax Avoidance on November 3, 2009 at 1:27 pm

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

In Canadian Income Tax, Tax Avoidance on October 17, 2009 at 3:53 pm

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?: Income or Capital Gains?

In Canadian Income Tax on October 12, 2009 at 4:55 pm

The Tax Issue:

I recently sold my business and started trading commodities as a full-time occupation. Can I report my gains from these transactions as capital gains?

The Answer:

This is one of the more contentious tax issues that arise on a daily basis. The gains from the sale of any property is either fully taxable on income account or a capital gain (50% taxable). The determination is not always easy. A capital gain arises on the sale of capital property, which is generally thought of as a long-term asset that is held for investment purposes, such as shares of public corporations.

Trading in commodities as a full-time career suggests to me that you are not purchasing commodities for investment purposes, Rather, your intention is to buy and sell frequently, earning your profit on short-term price differentials. This would indicate that your profits will be seen by the CRA as being on income account.

A more difficult question would arise if your activities included the purchase and sale of public company shares. Here, there is often an argument to be made that shares may be held for investment purposes, and the line may not be so clear. The courts and the CRA have established certain guidelines to help in making the determination. Some of the factors that may indicate that you are carrying on a business (and must report gains as income) are:

  • Frequency of transactions – a history of extensive buying and selling
  • Period of ownership – securities are owned for a relatively short period of time
  • Knowledge of the markets
  • Time spent – a substantial amount of time is spent studying the markets
  • Financing – transactions are financed on margin or some other form of debt

For Canadian taxpayers who are not dealers, or in the business of trading, a special election is available that would ensure that gains on the sale of Canadian securities are always treated as being on account of capital. The downside is that losses will also be treated as capital losses The election is once-and-for-all, and cannot be revoked in the future.

The CRA has published IT-479R, which goes into this topic in greater detail, for those that are interested in this topic.