Topic: Tax Tips

Section 116 – A Case Study

Author: Jeannie Lim, CA, CPA, TEP, MMPA
Editors: Peter Weissman FCPA, FCA, TEP and Matthew Cho CPA, CA, TEP

A non-resident of Canada is subject to Canadian taxation on gains arising from the disposition of taxable Canadian property (“TCP”).  TCP includes many items but the most common one we see in practice is Canadian real estate.  Many non-residents selling Canadian real property often discover the purchaser is withholding 25% of the gross proceeds pending receipt of a “compliance certificate”[1] from the non-resident.  In some cases, the withholding is 50%.  Our discussion today focuses on a non-resident’s reporting and withholding tax requirements under section 116 of the Income Tax Act (the “Act”) upon the sale of TCP and more importantly, how to reduce the withholding tax amounts. 

In this case study, a non-resident taxpayer (the “vendor”) is looking to sell rental property in Canada. The rental property consists of land and building.  For tax purposes, the land portion is considered to be a non-depreciable property while the building is considered to be a depreciable property.  It is important to distinguish between the two as the process is slightly different.

Sale of Land

At any time prior to a sale, the vendor may choose to report the disposition of the land to the Canada Revenue Agency (“CRA”)[2].  If such pre-disclosure is not made, the Act requires the vendor to report the land disposition to the CRA within 10 days of the sale[3] on Form T2062. If Form T2062 is filed after the 10 day deadline, late filing penalties of up to $2,500 can apply.

If Form T2062 is not filed with the CRA, or if it was filed but the CRA has not yet accepted it at the closing date, the purchaser must withhold 25% of the gross purchase price of the land and remit it to the CRA within 30 days after the end of the month in which the sale occurred.  However, this payment can be avoided if a comfort letter is obtained. If a comfort letter is issued by the CRA the purchaser can hold the required taxes (25% of the purchase price for non-depreciable TCP and 50% for depreciable TCP) beyond the remittance deadline until the CRA has completed its review of the certificate. Any excess taxes above the amount listed in Form 2068 can then be released to the vendor.

It can take more than 6 months for the CRA to process a compliance certificate application. Without a comfort letter[4], the purchaser must remit the full taxes to the CRA by the stipulated deadline and the vendor will have to wait until its tax return is filed and processed by the CRA to get its refund back.

If Form T2062 is accepted by the CRA, they will issue Form T2068 (commonly known as a compliance certificate) stating that the application was accepted and will request 25% of the capital gain amount (rather than 25% of gross purchase price) of the land sale.  Once the Form T2068 is issued, the purchaser can release any excess withholding taxes to the vendor and remit the required amount to the CRA.

Sale of Building

If the vendor does nothing regarding the building portion, the purchaser is required to withhold 50% of the gross purchase price of the building and remit it to the CRA within 30 days after the end of the month in which the sale occurred. We note there is no legal obligation for the vendor to report the sale.  

However, the vendor should report the disposition to the CRA using Form T2062A in order to reduce the 50% withholding requirement.  If the application is accepted, the CRA will issue Form T2068 outlining the required amount of taxes on the building sale.  The vendor can then forward the compliance certificate to the buyer. The buyer can then release the excess withholdings and remit the required taxes to the CRA.

The amount of taxes that is required by CRA as outlined in IC72-17R6 is 25% of the capital gain amount on the sale of the building plus the amount of taxes applicable on any recapture. If the actual recapture amount cannot be determined, the CRA will assume maximum recapture (i.e. as if the vendor claimed maximum capital cost allowance during the period of ownership).

Summary

If a non-resident disposes of a real property in Canada they should apply for a compliance certificate from the CRA and where necessary, a comfort letter.  Failure to do so could result in the purchaser remitting the full withholding required with the vendor having to wait until its tax return is processed to receive the excess withholdings back. 

If you have situations involving a non-resident disposing TCP, a Cadesky Tax representative would be happy to assist you.

 

[1] Colloquially referred to as a “clearance certificate”
[2] Subsection 116(1) of the Act.
[3] Subsection 116(3) of the Act.
[4] Although not technically correct, we have seen situations where buyers were willing to hold onto the required withholding taxes past the 30 day remittance deadline pending receipt of a comfort letter/T2068. Granted, CRA can apply a penalty on the buyer on the late tax remittance under subsection 227(9), however the CRA has not been actively enforcing this due to their backlog in processing compliance certificates.

Earnout – Earn More on Your Way Out

Author: Nancy Thandi, CPA, CA, MTax 
Editors: Peter Weissman FCPA, FCA, TEP and Matthew Cho CPA, CA, TEP

It is not uncommon for the sale price of a business to be partially based on future events.  In these cases, an earnout is often used as a mechanism to determine a portion of the sale price based on achieving certain results for a period of time after closing of the sale.  For example, the parties may agree to an initial sale price of $5,000,000, with an additional $100,000 per year in any of the subsequent 5 years, if revenues increase by at least 5% in the year.  To keep things “simple” we will assume shares, not assets, are being sold.

Unlike the defined portion of the sale price, taxed as a capital gain, the earnout portion is taxed as regular income in the year it is received because it is based on performance.  In the above example, the vendor would report a $5,000,000 capital gain (assuming the shares have no cost base), 50% of which is taxable, in the year of sale and regular income of $100,000 (or less if the full earnout is not earned) in each of the subsequent 5 years.

In Information Bulletin IT-426R (now archived),  the CRA details an administrative concession, referred to as the cost-recovery method, intended to allow earnouts to be treated as capital gains to the extent they exceed the tax cost.  However, this method only applies to share transactions and several conditions must be met, including the submission of a formal request to use the cost-recovery method and a copy of the sale agreement with the vendor’s tax return for the year of sale.

Where the transaction does not meet the CRA’s conditions for the cost-recovery method (e.g., an asset sale) vendors should consider a reverse earnout.  This technique sets a maximum purchase price that is later adjusted downwards if certain targets are not met.  To the extent the full proceeds (including the reverse earnout portion) exceed the tax cost the vendor will report a capital gain. 

In our example, the vendor and purchaser would set the purchase price to be $5,500,000.  The purchaser would pay $5,000,000 cash on closing and issue a promissory note for the remaining $500,000.  The vendor would agree to reduce the $500,000 receivable[1] from the purchaser by $100,000 in any of the subsequent 5 years, in which revenues do not increase by at least 5% in the year.  Even though not all the proceeds are received in cash at closing, the full sale price is taxable in the year of sale, with no reserve being available for the reverse earnout portion. 

To the extent a portion must be repaid under the reverse earnout, the vendor can claim a capital loss that can be carried back against capital gains in any of the prior 3 taxation years or carried forward indefinitely to be used against future capital gains.  If the capital loss is recognized within the three taxation years after the year in which the capital gain was recognized, the capital loss can be carried back to offset the initial gain.  To the extent the reverse earnout portion of the proceeds is forgiven after the three-year carryback period, the reduction in the sale price will generate a capital loss that can be carried forward indefinitely, but it cannot be carried back to the year of the sale.

Purchasers are often indifferent to the tax treatment of an earnout or reverse earnout because future adjustments, under both methods, simply change the tax cost of the investment (whether shares or assets), although there may be some complications with capital cost allowance if the cost of a depreciable property is adjusted subsequent to the sale.  Their issues tend to be more business related such as timing of cash flow.

If you have situations involving earnouts, a Cadesky Tax representative would be happy to assist you.

[1] In some cases the reverse earnout amount is held in escrow to be paid out only to the extent the milestones are achieved.

Change in Use – The Unexpected Change

Author: Marco Jotic, CPA, CGA 
Editors: Peter Weissman FCPA, FCA, TEP and Matthew Cho CPA, CA, TEP

Occasionally, a taxpayer moves from his/her principal home into a new home and rents the old home out, or converts part of the home for a different purpose.  Alternatively, he/she may move into one of his/her rental properties and turn it into a principal home.  While this may not be an issue if the change is short term and temporary, a permanent change could give rise to a deemed disposition of the property for tax purposes.  If not carefully managed, this deemed disposition can create undesirable results for these taxpayers.

Complete change in use

Where a taxpayer owns real property and converts it entirely from personal to income-producing (e.g., rental) purpose or the other way around, the taxpayer is deemed to have disposed of the property at the time of conversion at its fair market value and reacquired it for the same amount. 

The result is not troublesome if any accrued gain on the property is fully sheltered by the principal residence exemption but in cases where a full exemption is not available or the exemption is not an option (e.g., the change is from rental to personal), the resulting capital gain and/or recapture will give rise to unexpected tax liabilities.

Thankfully, there are two elections available to taxpayers to avoid this change in use deemed disposition.  The first election, under subsection 45(2) of the Income Tax Act (the “Act”), overrides the deemed disposition when the change is from personal to income-producing use unless the taxpayer rescinds the election in a later year or claims capital cost allowance (“CCA”) on the property.  This election allows the gain upon conversion to be deferred until an actual disposition.  An additional benefit is that the property may be eligible for the principal residence exemption for up to 4 years after the year the election was made.  This 4 year limit may be extended if certain conditions are met.

This election should be filed with the taxpayer’s income tax return for the year that includes the change in use.  The Canada Revenue Agency (the “CRA”) may accept a late election if CCA is not claimed at any time.

When the change is from income-producing to personal use, the second election, under subsection 45(3) of the Act, can be used to prevent the application of the change in use rules.  Unlike the first election, this election is filed with the tax return for the year when the property is actually disposed of (or within 90 days after a formal demand is issued by the Minister).  However, this election is not available if CCA has been claimed at any time prior to the conversion.  This election also allows the property to be eligible for the principal residence exemption for up to 4 years prior to the change.  The CRA may also allow late filing if it meets the criteria for taxpayer relief.

Partial changes in use

When only a portion of the property undergoes a change in use, the deemed disposition will only apply to that portion of the property.  The elections under subsections 45(2) or 45(3) cannot be made as they only apply to a complete change in use.  Therefore, a thorough analysis should be conducted for situations when a taxpayer contemplates changing a single use property into multiple uses or vice versa, in order to fully appreciate and plan for any tax consequences arising from the change.

CRA Practice

For principal residences, the CRA considers a partial change in use to occur where there have been significant modifications to the property that are permanent in nature.  In addition, the CRA will not apply the deemed disposition rules with respect to a principal residence (and takes the view that the entire property remains a principal residence) where the following conditions are met:

  • There have been no structural changes to the property
  • CCA has not been claimed on the property; and
  • The main use of the property is as a residence and the income producing use is ancillary.

The change in use rules are often considered after the fact.  Even though some relief is available to defer the resulting tax, there are conditions attached to them that may not be reversible.  As a result, taxpayers should consider the impact of these rules when they are considering changing or expanding the use of a property, particularly with respect to their principal residences.  If you have situations involving the application of these rules, a Cadesky Tax representative would be happy to assist you.

T4A: The Compliance Conundrum of Fees Paid for Services

Author: Navi Grewal, CPA, CA
Editors: Peter Weissman FCPA, FCA, TEP and Matthew Cho CPA, CA, TEP

In accordance with regulation 200(1) of the Income Tax Act, every person paying commissions, fees or other amounts for services shall report these payments on a prescribed information return (i.e., the T4A slip). Over the years, the Canada Revenue Agency (the “CRA”) has not provided  clear guidance on how the fees are to be reported on the T4A slip.

Many people are under the impression that T4A slips are only necessary for unincorporated individuals. However, this is not the case and the CRA is beginning to enforce the reporting requirement for fees for services regardless of whether the services were rendered by a corporation, partnership, trust or individual.

The CRA in their publication RC4157 (the “Guide”) only states, for box 048:

“Enter any fees or other amounts paid for services. Do not include GST/HST paid to the recipient for these services.”

The only exemption mentioned in the Guide is for total payments less than $500, made in a calendar year to a service provider, on which no tax was deducted. In question 1B from the 2016 APFF Roundtable, the CRA stated that it will not require the issuance of T4As for professional or business services provided to an individual in a personal capacity or a person whose services were provided to repair or maintain an individual’s principal residence.

Where the services are provided to a corporation, the CRA made the following statement at the 2017 APFF Roundtable (Question 2):

“The administrative relief provided since 2010 is an interim measure related to a change on the T4A of the box where these amounts should be indicated and not one relieving from the obligation of payers from filing T4A slips for services rendered”.

Despite the foregoing, the most current version of the Guide (2018) states that fees for services“should be reported in Box 048” and “the CRA is not assessing penalties for failures relating to the completion of Box 048”.

As a result, non-compliance of T4A reporting for service payments is more widespread than any other income.  Although the CRA has stated they will waive the penalties, they are not obligated to do so and their position can change at any time.  The CRA is currently presenting seminars about these reporting requirements to various industry groups, so a change could be coming.

The CRA recently tried to subtly change administrative and assessing positions with no advance notice. For example, in the fall of 2017 the CRA began denying shareholders-employees employment expenses.  This was a change made without notice.  The CRA subsequently back tracked and has stated they will come out with a position for the 2019 tax year.  Around the same time, the CRA changed their position on employee discounts to make them taxable.  After significant backlash, the CRA reversed the change.

Given the CRA’s track record, taxpayers should not be surprised if the administrative relief from penalties for not filing T4A slips in the circumstances noted above is cancelled.  If you have an issue regarding the issuance of T4A slips for fees for services, a Cadesky Tax representative would be happy to assist you.

The Multilateral Instrument – The New Preface to the Tax Treaty Brochure

Author: Henry Shew, CPA, CA, TEP, CPA (Washington), MAcc
Editors: Peter Weissman FCPA, FCA, TEP and Matthew Cho CPA, CA, TEP

The use of creative international structures by multinational corporations to transfer a significant portion of their global profits to low tax jurisdictions led the Organisation of Economic Co-operation and Development (“OECD”) to undertake the Base Erosion and Profit Shifting (“BEPS”) study. The study concluded with 15 proposed initiatives, one of which is to address potentially abusive use of tax treaties between countries to shift profits. Renegotiating individual treaties is not feasible and hence the multilateral instrument, formally called the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (“MLI”) was developed.  

On June 7, 2017, Canada signed the MLI along with 67 other jurisdictions. As at today, there are a total of 89 signatories to the MLI. However, the U.S. did not sign the MLI as they believe their tax treaties have sufficient measures to mitigate exposure to BEPS.

The MLI is a multilateral treaty that modifies the effect and interpretations of all covered tax agreements (“CTAs”) between participating countries. Canada has designated 75 of its 93 bilateral tax treaties as CTAs. The MLI contains minimum standards that all participating countries must agree to adopt which deal with treaty abuse and improving dispute resolutions.  Additional optional provisions or reservations can be adopted by participating countries.

One of the minimum standards adopted by Canada is the principal purpose test (“PPT”) in relation to treaty abuse.  Under the PPT, treaty benefits will be denied if one of the principal purposes of a tax arrangement is to obtain treaty benefits that is not in accordance with the object and purpose of the relevant treaty provision.

The following are some other optional measures Canada adopted:

  • Canada and its CTA partners will determine the residence of a dual resident entity by mutual agreement. If the competent authorities are unable to determine the residence of the entity, such an entity will not be entitled to the treaty benefits.  This impacts mostly corporations or trusts as tax treaties generally have tie-breaker rules for individuals.
  • A foreign shareholder of a Canadian corporation must hold the shares for at least 365 days preceding any dividend payment before the foreign shareholder can access low treaty-based withholding tax rates. An exception to this restriction is if qualifying shareholdings change due to a corporate reorganization.
  • Capital gains are usually exempt from taxation in the source country under most bilateral treaties unless the ownership interest is derived principally (i.e., 50%) from immovable property in the source country (or shares that derive more than 50% of their value from such property). The MLI will deny this exemption under a CTA if the relevant value threshold (i.e., 50%) is exceeded at any time 365-days prior to the disposition.

Canada’s proposed legislation to implement the MLI received Royal Assent on June 21, 2019 and the final step bring the MLI into force is to deposit the instrument of ratification with the OECD.  The MLI will become effective on the first day of the third month after the month in which the deposit was made.  For example, if the deposit date is July 15, 2019, the in force date is October 1, 2019.  However, the MLI will only modify a CTA if both CTA partners ratify the MLI.   The Department of Finance previously indicated its intent to make the deposit sometime in 2019.  As at June 28, 2019, the deposit has not been made yet.

In addition, certain measures will only take effect at specific timelines listed below, based on the latest of the dates (the “countdown date”) on which the MLI comes into force for each party to a CTA:

  • Withholding taxes – MLI will take effect beginning on the day of the next calendar year after the countdown date. For example, if the MLI for both Canada and another CTA partner both came into force in 2019, the effective date would be January 1, 2020.
  • Other taxes – MLI will take effect for taxation years beginning on or after six months after the countdown date.  For example, if the other party to a CTA already ratified the MLI and Canada’s MLI comes into force on October 1, 2019, this provision will take effect for taxation years that begin on or after April 1, 2020.

It is important to understand the effect of MLI on businesses with an international presence. Organizations that rely on bilateral treaties should evaluate their tax exposures when determining withholding tax rates, dispute resolution procedures and other treaty benefits. PPT will now also be a risk factor for international structures, particularly with holding companies. If you have situations involving the use of tax treaties, a Cadesky Tax representative would be happy to assist you.

When Safe Income Isn’t so Safe

Author: Peter Weissman, FCPA, FCA, TEP
Editors: Peter Weissman FCPA, FCA, TEP and Matthew Cho CPA, CA, TEP

The Income tax act contains a number of anti-avoidance provisions.  Subsection 55(2) applies to convert some intercorporate actual or deemed dividends into capital gains or proceeds of disposition, respectively.

This provision was created when capital gains tax rates were higher than dividends.  The intent of the section is to allow companies to move their tax paid retained earnings (“Safe Income”) out of, say, an operating company to a holding company, tax free. There is no further tax paid until the amounts are paid out as dividends to a shareholder who is a “natural person” where the amounts are taxed as eligible or “ineligible” dividends. 

To the extent intercorporate dividends exceed Safe Income they are considered to be reducing the untaxed appreciated value and are converted into capital gains which would be taxable.     

Given that capital gains tax rates are actually lower than dividend tax rates, it is sometimes beneficial to pay dividends in excess of Safe Income.  This strategy,   effectively, allows shareholders access to capital gains tax rates on funds they might otherwise have to pay higher dividend tax rates on.  This type of capital gains stripping is not liked by the Department of Finance but a solution has been elusive to date.

Whether you want the tax deferral Safe Income can provide or want to create a capital gain above Safe Income, it is critical to calculate Safe Income properly.  The calculation is inherently imprecise to start with, given that there is no definition in the Act, and the calculation is based on administrative positions that go back to the early 1980’s, when the rules were first introduced.

It is generally accepted that the Safe Income calculation is performed on a “consolidated” basis for  investee companies, no matter what percentage is owned, where it can be clearly demonstrated that the Safe Income of the investee companies contribute to the inherent gain in the holding company’s shares.  However, relying on consolidated Safe Income in planning is dangerous. 

A holding company with $1 million of consolidated Safe Income may derive that total from Subsidiary A, with $250,000 of Safe Income and Subsidiary B, with $750,000 of Safe Income.  If the $1 million is moved up to the holding company with dividends of $300,000 from Subsidiary A and $700,000 from Subsidiary B a $50,000 capital gain will be triggered. Although the total dividends equal the consolidated Safe Income, the holding company will pay tax on a $50,000 capital gain due to the dividend in excess of Safe Income ($300,000 – $50,000) from Subsidiary A.

Understanding how to use Safe Income properly can avoid unexpected tax or create an intentional conversion of a dividend into a capital gain.  If you have situations where Safe Income is an issue, a Cadesky Tax representative would be happy to assist you.


Changing Your Corporation’s Fiscal Period

A Canadian corporation’s first fiscal year can end up to 53 weeks after the date of incorporation. Once the fiscal period has been chosen, it cannot be changed, unless by operation of law, without the permission of the Canada Revenue Agency (“CRA”).

The CRA is concerned about taxpayers changing fiscal periods with the motive of minimizing taxes. As such, the CRA requires that there must be a sound business reason to change a corporation’s fiscal period. Some examples of such business reasons include the following:

  • Changing a fiscal period to be in line with a parent or associated company; or
  • Changing a fiscal period to end at a time when inventory is seasonally low

Over the last number of years, the CRA has been denying requests for a change in fiscal period where it does not see sufficient merit. The bar has been set higher than in the past, when most reasonable requests were allowed. The presumption should no longer be that a reasonable request will automatically be allowed. You can anticipate having to prove your case to the CRA.

In order to request a change in your corporation’s fiscal period, write a letter to your tax services office and be sure to include details as to why you are requesting a change, as well as relevant supporting documents. The letter should be signed by the taxpayer or an authorized individual. Requests should be submitted well in advance of the desired new fiscal year end, as the request has to be approved before the new fiscal period can be used.  Changing a fiscal period retroactively is generally not permitted.

There are certain circumstances in which approval is not required to change a fiscal period – these include the following:

  • The corporation undergoes an acquisition of control by an unrelated person or group of persons
  • The corporation amalgamates with another Canadian corporation[1]
  • The corporation has been wound-up, resulting in a short fiscal period
  • The corporation becomes or ceases to be:
    • exempt from income tax;
    • a resident of Canada; or
    • a Canadian-controlled private corporation

The CRA’s very limited information regarding changing a year end can be viewed here.  The CRA’s cancelled Interpretation Bulletin IT-179R – Change of Fiscal Period had helpful information but can no longer relied upon.


[1] However, the CRA has stated in Information Circular 88-2 General Anti-Avoidance Rule – Section 245 of the Income Tax Act (paragraph 21), that it considers an amalgamation conducted under subsection 87(1) solely for the purposes of creating a year end under paragraph 87(2)(a) to be subject to the GAAR.

Changes to the T1134 deadline

Form T1134, Information Return Relating to Controlled and Non-Controlled Foreign Affiliates is a foreign reporting form which must be filed by all Canadian resident taxpayers (corporations, individuals and trusts), and partnerships for any year in which the taxpayer has an interest in a controlled or non-controlled foreign affiliate, at any time in the year.

The term ‘foreign affiliate’ means a non-resident corporation in which the taxpayer has at least a 1% direct ownership interest, and at least a 10% combined ownership interest when considering the interest of the taxpayer and each person related to the taxpayer. A “controlled” foreign affiliate is a foreign affiliate that is controlled by the taxpayer or would be controlled by the taxpayer if the taxpayer owned all of the shares of the foreign affiliate that are held by four or less Canadian resident shareholders and persons who deal at non-arm’s length with the taxpayer or the other Canadian resident shareholders. In stacked company structures, only the lowest tier Canadian subsidiary is required to file Form T1134.

If certain thresholds are not met, there is no filing requirement for Form T1134. In particular, exemptions apply if:

  • The total cost to the reporting taxpayer of the interest in all foreign affiliates at any time in the year is less than $100,000,

AND

  • The foreign affiliate is deemed to be “dormant” – this is the case if the foreign affiliate had gross receipts of less than $25,000 in the year, and at no time in the year had assets with a total fair market value of more than $1 million.

The current filing deadline for Form T1134 is 15 months after the taxation year end of the reporting taxpayer.  For example, the due date for the 2017 T1134 Form for an individual with a December 31 taxation year end will be due on March 31, 2019.   However, as proposed in the 2018 Federal Budget, this deadline will be accelerated to allow the CRA to have the information sooner for their audit purposes.  The new proposed deadline is 12 months after the taxation year end of the reporting taxpayer for taxation years beginning in 2020 and 10 months thereafter.  

The purpose of the form is to require taxpayers to report various financial information regarding a foreign affiliate for CRA’s risk assessment purposes.  For instance, Foreign Accrual Property Income or “FAPI” represents passive income earned by a controlled foreign affiliate, which is imputed and taxable in the hands of a Canadian resident shareholder as earned.  Form T1134 provides a tracking mechanism for the CRA to match the information reported on the form to the income tax filings of such Canadian resident taxpayers.

It is important that Form T1134 be filed on time.  The penalty for not filing this information return is $25 for each day late, to a maximum of $2,500 for each supplement that is required for a foreign affiliate.

Tax Planning Bomb Shell

“Changes to strategies that have been the basis
for shareholder remuneration planning for decades
will be eliminated”

On July 18, 2017 the Department of Finance issued draft legislation which, if passed into law, will limit many of the advantages of using private corporations.  The changes are fundamental and will have widespread impact.

The changes fall into four basic categories as follows:

  • Income splitting
  • Capital gains exemption
  • Capital gains within a corporate group
  • Deferral of tax using private corporations

Income Splitting

Beginning in 2018, the kiddie tax rules will be extended substantially.  Instead of being limited to persons under the age of 18, they will now apply to all Canadian resident individuals where a person receives income from a related private corporation, unless the amount is reasonable in the circumstances having regard to certain criteria.  These criteria include the labour contribution of the individual and the capital committed.  A more stringent test applies for persons between the ages of 18 and 24.  Essentially the idea is to determine the amount of compensation (in whatever form) that would be reasonable in the circumstances, and any amount in excess of this would become part of the individual’s “split income” taxable at the top personal tax rate.

Obviously rules such as these are complex, and require detailed study.  They will also create a great deal of uncertainty and subjectivity as to how they are applied.

Capital Gains Exemption

Three changes are proposed to the capital gains exemption.  Individuals under the age of 18 would no longer be able to claim the capital gains exemption.  More precisely, gains accrued during a taxation year before the individual attains the age of 18 will not be eligible.  Secondly, any amount of a taxable capital gain which is included in split income will not be eligible for the capital gains exemption.  Lastly, gains accrued during the time that property was held by a trust will no longer be eligible.

These new rules will come into effect in 2018.  An election will be available to realize gains on hand in order to provide transitional relief. Curiously a date in 2018 may be selected for this purpose.

We anticipate that this election will be widely used, and that valuations will be required in an enormous number of cases in 2018 to support the value used.

Capital Gains within a Corporate Group

It has become popular to realize capital gains within a corporate group, and pay out the proceeds, particularly via the capital dividend.  This is because the tax rate on a capital gain (realized within the corporate group and distributed to shareholders) is lower than the tax rate on taxable dividends.  As a result of this becoming widespread, steps are being taken to close down this planning approach.

The draft legislation will extend the scope of section 84.1 which results in a dividend rather than a capital gain where the section is triggered.  Because the capital gain will be recharacterized as a dividend, no amount will be added to the capital dividend account.  There may also be a denial of an increase in the adjusted cost base, potentially resulting in double taxation which, according to the materials, is consistent with the intent of the provisions.  Unfortunately, no distinction is made between the application of this provision to post-mortem and pre-mortem planning.

An additional anti-avoidance rule will be inserted to deal with surplus stripping via capital gains, in the event that new section 84.1 is not sufficient, on its own, to deny the benefit.

This change is to be effective from announcement date (i.e. July 18, 2017).

Accumulating Funds in Private Corporations

While the first three items above are dealt with in 27 pages of draft legislation, the issue of accumulating funds in private corporations is dealt with conceptually, explaining the issues, and outlining two possible approaches.  In simple terms, the Department of Finance has identified that a significant tax deferral arises where active business income is retained within a corporate group.  Because corporate tax rates are so much lower than personal tax rates, there has been a continuing trend to retain excess funds within the corporate group and make passive investments, thereby deferring the tax that would be paid if the excess funds were distributed as a dividend.  Nobody should be surprised at this.  Indeed, one should be surprised if anyone is surprised!

This tax deferral is considered to give owners of private corporations an advantage over their counterparts who do not have such opportunities (for example a person who receives a salary).  The starting point for accumulating investment assets is clearly different when a corporate tax rate of 15% or 25% is applied to the income rather than a personal tax rate of 53%.  How to design a system to deal with this is conceptually very difficult.  Whether or not taking action is appropriate is another very relevant question.

In this, the Department of Finance has asked for input from interested parties, perhaps in part because there is no simple solution to this issue.

Implications

The implications of these potential changes are significant.  Not only will they limit income splitting opportunities, multiplication of the capital gains exemption, and other tax strategies, they will also add very significant complexity to the taxation of private corporations and their shareholders.  Given the additional complexities created in recent years with changes to section 55 (Safe Income and Intercorporate Dividends) and the changes to the Small Business Deduction (expansion of circumstances where the $500,000 small business limit must be shared), this will clearly compound upon what is already a very difficult area.

Introducing a reasonableness test, failing which dividends from private corporations will be taxed at the top tax rate, is a sweeping change, which will confer a huge amount of discretion onto CRA.  Limiting the capital gains exemption to natural individuals, and preventing its use where shares are held through trusts, will alter the landscape considerably.

While the Department of Finance has indicated that it wishes to conduct a consultation on these issues, with a deadline for submissions in early October, our experience in recent years indicates that once proposals are at the draft legislation stage, little in the way of substantial change can be brought about.

We will be reviewing these rules in greater detail, and issuing further notes on various aspects of the proposals, as well as any changes to them which may arise.


TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.

Major changes to the Voluntary Disclosures Program

“relief from penalties will be significantly curtailed”

The Voluntary Disclosures Program (VDP) is a CRA administrative program that allows taxpayers to voluntarily come forward and correct up to 10 years of errors or omissions in their Canadian tax affairs with relief from prosecution and penalties.  There can also be relief from interest for amounts owing for statute barred years.

In Tax Tip 16-01 we recommended that taxpayers with unreported income make a voluntary disclosure (Disclosure) as soon as possible. Now there may be more reason to act quickly.  Under proposed changes to the VDP (Draft Information Circular IC00-1R6), the relief from penalties will be significantly curtailed in certain common scenarios after December 31, 2017.

Under the new VDP program, there will be two tracks for income tax disclosures, being the General Program and the Limited Program.  If a Disclosure is accepted under the General Program, the Taxpayer will be eligible for penalty relief and partial interest relief, in a way similar to what is provided under the current program.  Although not stated in draft IC00-1R6, it appears that non-compliance that could result in criminal prosecution will not be eligible for the General Program.

VDP applications that disclose “major non-compliance” will be processed under a new “Limited Program” and, if accepted, relief will only be provided from prosecution and gross-negligence penalties.  All other penalties such as late-filing penalties will be applicable and no interest relief will be provided.

The Limited Program will be applicable in any of the following situations:

  • active efforts to avoid detection through the use of offshore vehicles or other means
  • large dollar amounts (not defined)
  • multiple years of non-compliance
  • a sophisticated taxpayer
  • the disclosure is made after an official CRA statement regarding its intended focus of compliance or following CRA correspondence or campaigns
  • any other circumstance in which a high degree of taxpayer culpability contributed to the failure to comply

For example, the CRA has sent letters to taxpayers regarding receipt of funds reported by banks and the letters provide a note for the taxpayers to consider reporting income and Form T1135 under the VDP.  If the disclosure is made by such a taxpayer after 2017, it will come under the Limited Program with no relief for late filing penalties or interest.  In addition, it would appear that any late filing of foreign reporting forms will also be subject to late-filing penalties of $2,500 per year per form under the Limited Program from 2018 onwards.

The new VDP program eliminates the protection provided under the current no-names disclosure process and replaces it with  a no-names pre-disclosure discussion process that does not protect the Taxpayer if they are approached by the CRA before filing a “named” voluntary disclosure, with a completed and signed Form RC199 to mark the Effective Date of Disclosure.

Taxpayers and their advisors should consider whether a voluntary disclosure is desired, even if it is for something as simple as not filing Forms T1135 for required years.   If a voluntary disclosure is required, it should be made before the end of 2017 before the new limitations become applicable.


TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.