Recent Developments in Corporate Taxation Post-Mortem Tax Planning A Case Study

Transcription

1 Recent Developments in Corporate Taxation Post-Mortem Tax Planning A Case Study 2017 Pamela Cross, Borden Ladner Gervais, LLP David Mason, Deloitte June 7, 2017, OTTAWA

2 Agenda - Post Mortem Planning 1. Why is it important? 2. What are the tools in the tool-box and how do they work? 3. The Case Study 2

3 Post-Mortem Planning Why is it important? To ensure that assets cannot be passed from one generation to the next, there is a deemed disposition of assets on death (subject to certain exceptions and/or deferrals such as the spousal rollover) For the vast majority of individuals, the deemed disposition is a one time event, and little or no post-mortem planning is necessary. The most common exception is where assets decline in value after death For individuals holding private company shares, there is a potential for double (or worse) taxation on the same value (tax on the deemed disposition, tax in the company on a liquidation of its assets, and tax on a deemed dividend extracting value from the corporation) 3

4 Post-Mortem Planning: Tools in the Tool Box Surprisingly, given the significance of the issue, there is no specific post-mortem regime in the Income Tax Act (the Tax Act ) to deal with private company shares Three main strategies are used (all statutory references are to the Tax Act): S. 164(6) Loss Carryback Pipeline Transaction Para. 88(1)(d) Bump Planning (for certain capital property owned by the company other than ineligible assets ) 4

5 S. 164(6) Loss Carryback - Mechanics Deemed disposition of shares on death, increasing adjusted cost base of shares to Estate Shares held by Estate of Deceased are redeemed before first year-end of the Estate, triggering deemed dividend to Estate (ss. 84(3)) Deemed dividend excluded from proceeds of disposition of shares (para. 54(j)), resulting in capital loss to Estate (subject to stop-loss rules) Carryback of capital loss to terminal return to eliminate capital gain reported on deemed deposition Result: Double tax avoided, but tax paid on dividend (at dividend rates), not capital gain (at capital gains rates) 5

6 S. 164(6) Loss Carryback Selected Considerations Corporate tax attributes (capital dividend account (CDA), refundable dividend tax on hand (RDTOH), ability to pay eligible dividends can reduce the effective tax cost of the rate differential (dividends/capital gains) Creating additional tax attributes? Corporate owned life insurance: confirm adjusted cost basis of policy and amount available to be added to CDA. Consider limiting capital dividend to 50% of full dividend to avoid grind of capital loss under ss. 112(3.2). Will Estate be affiliated with Corporation after redemption (ss. 40(3.6) & (3.61)). Spousal roll and redeem strategy available? Redemption of shares or wind up of company (IT-126R2) One taxation year deadline. Estate must be a graduated rate estate 6

7 Pipeline Transaction - Mechanics Deemed disposition of shares on death, increasing adjusted cost base of shares to Estate Estate transfers shares to new holding corporation ( Newco ), taking back debt or high paid-up capital Newco shares up to the FMV of the shares on death. Wind-up company (or amalgamate Newco and company). Resulting company can repay debt or reduce paid-up capital Result: Double tax avoided, tax paid at capital gains rates. 7

8 Pipeline Transaction Selected Considerations Anti surplus stripping rule #1 (s. 84.1), applies where: Taxpayer (Estate) disposes of shares Taxpayer is resident in Canada and not a corporation Shares were capital property to taxpayer Shares are shares of a resident Canadian corporation (subject corporation) Shares are disposed of to another corporation (purchaser corporation) Taxpayer is non arm s length with purchaser corporation Immediately after disposition, subject corporation is connected with purchaser corporation (ss. 186(4)) Implications: Paid up capital of purchaser shares reduced to extent of soft ACB (i.e. look for capital gains exemption and V-Day value issues). Hard ACB can be converted to debt or paid-up capital. Taxpayer deemed to receive a deemed dividend for excess 8

9 Pipeline Transaction Selected Considerations Anti surplus stripping rule #2 (s. 84(2)) applies where: The corporation is resident in Canada The corporation is winding-up, discontinuing or reorganization its business A distribution or appropriation of the corporation s funds or property (in any manner whatever) The distribution or appropriation is to or for the benefit of the corporation s shareholders Implications: Amount of distribution/appropriation deemed to be a dividend 9

10 Pipeline Transaction Surplus Stripping Issues Does (should?) the specific rule in s supersede s. 84(2)? CRA position: both can apply to same transaction ( C STEP National Conference) Is Estate a creditor or a shareholder? What does on the winding up, discontinuance or reorganization mean? Fact specific. See E5 which suggested continuance of business for at least 1 year and distribution over a further period of time C6 where CRA indicates these conditions are not required but may be evidence that there is no discontinuance of business R3 (ruling withdrawn) Cash company CRA may apply 84(2) Surplus Stripping Jurisprudence: Most involve accommodation party transactions, not post-mortem planning No general scheme in the Act against surplus stripping Should there be specific post mortem rules? 10

11 The 88(1)(d) Bump Permits increase in adjusted cost base of certain property of corporation where there has been an arm s length acquisition of control Para. 88(1)(d.3) deems control to have been acquired by an estate from an arm s length person in a post mortem context May have limited application: Rules technical and complex Only certain capital property can be bumped Same mechanics as a Pipeline, so often used in combination. 11

12 The Case Study Harry owns preferred shares in an operating company (OpCo) ACB and PUC are nil FMV = $2M Harry is a widow and has three adult children: Ron, Lily and Phoebe. They currently own all issued common shares of OpCo in equal parts. He passed away on December 31, 2016 The children do not wish to carry on their father s business The corporation had the following tax attributes: GRIP of $500K CDA of $400K RDTOH of $25K *Assumption: Harry and his children are taxed at the highest marginal income tax rate Harry OpCo 1,000 Preferred Shares ACB = nil PUC = nil FMV = $2M 12

13 Scenario #1: No Tax Planning (if Opco has cash only) Harry s Terminal Tax Return Deemed disposition on death $2,000,000 Less adjusted cost base - Capital gain 2,000,000 Taxable capital gain 1,000,000 Personal tax rate 53.53% Harry s income tax payable $535,300 Harry s Estate OpCo 1,000 Preferred Shares ACB = $2M PUC = nil FMV = $2M 13

14 Scenario #1: No Tax Planning (cont.) On the wind-up of OpCo, the Estate will receive deemed dividend on which personal tax liabilities are created. Deemed dividend on distribution of assets Eligible dividend $500,000 Capital dividend 400,000 Non-eligible dividend 1,100,000 Total deemed dividend 2,000,000 Personal tax on eligible dividends (39.34%) 196,700 Personal tax on non-eligible dividends (45.30%) 498,300 Total personal tax payable 695,000 Less: corporate dividend refund (25,000) Net income tax liability $670,000 14

15 Scenario #1: No Tax Planning (cont.) Harry $535,300 Children $670,000 Total $1,205,300 Note: A capital loss of $2M would be created on the wind-up. Stop loss rules may apply to postpone the availability of the capital loss. 15

16 Scenario #2: Pipeline Transaction Harry s Terminal Tax Return Deemed disposition on death $2,000,000 Less adjusted cost base - Capital gain 2,000,000 Taxable capital gain 1,000,000 Personal tax rate 53.53% Total income tax payable $535,300 Note: OpCo s RDTOH and CDA balances may not be fully utilized in the pipeline transaction Promissory note of $2M Harry s Estate HoldCo OpCo 100 Common Shares 1,000 Preferred Shares ACB = $2M PUC = nil FMV = $2M 16

17 Scenario #3: S. 164(6) Loss Carryback Estate Tax Return Deemed dividend on redemption of shares Eligible dividend $500,000 Capital dividend 400,000 Non-eligible dividend 1,100,000 Proceeds of disposition $2,000,000 Less deemed dividend (2,000,000) Less adjusted cost base (2,000,000) Capital loss $2,000,000 Total deemed dividend 2,000,000 Personal tax on eligible dividends (39.34%) 196,700 Personal tax on non-eligible dividends (45.30%) 498,300 Total personal tax payable 695,000 Less: corporate dividend refund (25,000) Total Tax $670,000 Net income tax liability $670,000 17

18 Scenario #3: S. 164(6) Loss Carryback (cont.) Harry s Terminal Tax Return Deemed disposition on death $2,000,000 Less adjusted cost base - Capital gain 2,000,000 Less loss carryback (2,000,000) Taxable capital gain - Personal tax rate 53.53% Harry s income tax payable - Harry s Estate OpCo 18

19 Scenario #4: Hybrid Approach The hybrid approach consists of redeeming sufficient shares to use the CDA and RDTOH balances, and performing a pipeline with the remaining shares held by the Estate Estate Tax Return Deemed dividend on redemption of shares Eligible dividend (2.61 x RDTOH balance) $65,250 Capital dividend 400,000 Total deemed dividend 465,250 Personal tax on eligible dividends (39.34%) 25,670 Total personal tax payable 25,670 Less: corporate dividend refund (25,000) Net income tax liability $670 Proceeds of disposition $465,250 Less deemed dividend (465,250) Less adjusted cost base (465,250) Capital loss $465,250 Total Tax $456,243 19

20 Scenario #4: Hybrid Approach (cont.) Harry s Terminal Tax Return Deemed disposition on death $2,000,000 Less adjusted cost base - Capital gain 2,000,000 Less loss carryback* (297,875) Adjusted capital gain 1,702,125 Taxable capital gain 851,063 Personal tax rate 53.53% Harry s income tax payable $455,574 *Stop-loss rule applies to grind down capital losses available for loss carryback Promissory note of $1.5M Harry s Estate HoldCo OpCo 100 Common Shares 1,000 Preferred Shares ACB = $1.5M PUC = nil FMV = $1.5M 20

21 Summary of Scenarios Tax owing on Terminal T1 Tax owing by the corporation Tax owing by the Estate No Tax Planning Pipeline Transaction Loss Carryback Hybrid Approach $535,300 $535,300 - $410, , , Total Tax $1,205,300 $535,300 $670,000 $411,445 Available CDA - 400, Available GRIP - 500, ,750 Available RDTOH - 25,

22 Scenario #5: Asset Liquidation The asset liquidation approach consists on selling all of OpCo s assets to a newly incorporated corporation ( NewCo ) This transaction resembles a 88(1)(d) bump with less restriction on the type of assets on which it can be performed If the assets are sold within a year, the capital loss realized on the redemption of shares may be carried back to Harry s terminal return but may be subject to the stop-loss rules Harry s Estate OpCo 1,000 Preferred Shares ACB = $2M PUC = nil FMV = $2M 100 Common Shares NewCo 22

23 Scenario #5: Asset Liquidation (cont.) Old ECP Rules New ECP Rules With tax attributes Without tax attributes With tax attributes Without tax attributes Accrued gains on assets $2,000,000 $2,000,000 $2,000,000 $2,000,000 Taxable capital gain 1,000,000 1,000,000 Total business income 1,000,000 1,000,000 Corporate income tax payable $265,000 $265,000 $501,700 $501,700 Available cash for distribution 1,735,000 1,735,000 1,498,300 1,498,300 CDA balance 1,400,000 1,000,000 1,400,000 1,000,000 RDTOH balance 25, , ,700 GRIP balance 1,220, , ,000-23

24 Scenario #5: Asset Liquidation (cont.) Old ECP Rules New ECP Rules With tax attributes Without tax attributes With tax attributes Without tax attributes Deemed dividend on distribution of assets Eligible dividend $335,000 $720,000 $98,300 - Capital dividend 1,400,000 1,000,000 1,400,000 1,000,000 Non-eligible dividend - 15, ,300 Total deemed dividend $1,735,000 $1,735,000 $1,498,300 $1,498,300 Personal tax on eligible dividends 131, ,250 38,670 Personal tax on non-eligible dividends - 6, ,730 Less corporate dividend refund (25,000) - (37,680) (191,015) Net income tax liability $106,790 $290,045 $990 $34,715 Un-utilized RDTOH , ,685 24

25 Scenario #5: Asset Liquidation (cont.) Old ECP Rules New ECP Rules Tax owing on Terminal T1 Tax owing by the corporation Tax owing by the Estate With tax attributes Without tax attributes With tax attributes Without tax attributes $535,300 $535,300 $535,300 $535, , , , , , , ,715 Total Tax $907,090 $1,090,345 $1,037,990 $1,071,715 Available CDA Available GRIP 885, ,700 - Available RDTOH , ,685 25

26 Other Elements to Consider A hybrid approach, combining the pipeline transaction and loss carryback strategy, typically yields the lowest overall tax to the estate The CRA has accepted the use of the pipeline transactions for investment type corporations so long as the property distributed to the estate s beneficiaries is equal to the cost basis of the shares as a result of the deemed disposition on death (i.e. the fair market value on time of death) Time is of the essence when performing post-mortem tax planning 26

27 Transaction Costs Issues in Analysis and Application 2017 Name: Gary Donell Company: Welch LLP June 7, 2017, OTTAWA

28 Agenda Introduction Objective The importance of transaction costs Common problems in determining the tax treatment of transaction costs Expenditure analysis The legislative scheme Transaction cost analysis overview Is transaction cost analysis being properly applied? A few words on the Rio Tinto Alcan decision of the Tax Court 2

29 The Presentation Objective To provide an overview of the methodology necessary to thoroughly and properly analyze the income tax treatment of transactions costs and to then take a close look at whether this methodology is being applied consistently by both the CRA and the practitioner community. 3

30 The importance of Transaction costs Transaction costs include a wide variety of expenditures including Accounting and legal; Investment banker fees; Fairness opinions; Communication & Printing costs; Director Circular costs; Misc Fees including Hello and Break fees 4

31 The importance of Transaction costs Transaction costs often represent material amounts International Colin Energy $ 1.2M Potash Corporation of Saskatchewan $ 1.7M BJ Services $ 48.7M Rio Tinto Alcan $ 97.0M 5

32 The importance of Transaction costs High on CRA s radar for two main reasons Reassessment potential Indicator of tax planning 6

33 Determining the income tax treatment of Transaction costs The right way The proper approach to transaction cost analysis requires a systemic analysis that considers the actual facts (including a detailed understanding of the business to which the transaction costs relate and the specifics of each transaction), the legislative scheme of the Income Tax Act and the various judicial doctrine that have been formulated by the courts. 7

34 Determining the income tax treatment of Transaction costs The wrong way Having identified a particular troublesome transaction cost it is not uncommon for many to solely rely upon quick searches for the answer rather than perform the requisite analysis. Such searches include existing case law, tax articles, tax textbooks and other publications, tax services, CRA publications including Ruling documents etc. These types of searches typically play a subordinate complimentary role in the total analysis only. 8

35 Transaction cost analysis overview 1. An in-depth understanding of the business; 2. Delineate the business into its capital and income components; 3. Understand the purpose, intention, and expectations of the expenditures; 4. Analyze each expenditure separately; 5. Compare the outcome of the analysis to judicial doctrine and relevant transaction case law; 6. Determine whether the analysis is consistent with the case law & judicial doctrine and if not the reasons for the difference. 9

36 Transaction cost analysis overview The ITA An understanding of the interaction amongst the various provisions of the Income Tax Act is crucial to the ability to be able to undertake a proper analysis of all expenditures. The principle provisions are 9(1) 18(1)(a) & (b) 20(1) Note: The paper prepared for this presentation includes a detailed flowchart setting out the basic analysis. 10

37 Transaction cost analysis overview Judicial Doctrine Transaction-based approach; Symmetry? Accurate Picture/Running expenses; Law not Accounting; Source of Income; Capital vs Income; Expense Characterization; The Entity concept; Nothings. 11

38 Transaction cost analysis overview Capital vs Income One of the more important judicial doctrine is capital vs income where decades of case law dealing with unique facts and specific transactions has led to the development of a number of concepts such as Enduring benefit; Once and for all; Recurring or non-recurring expenditures 12

39 Transaction cost analysis overview Capital vs Income The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a common sense appreciation of all the guiding features which must provide the ultimate answer. Although the categories of capital and income expenditure are distinct and easily ascertainable in obvious cases that lie far from the boundary, the line of distinction is often hard to draw in border line cases; and conflicting considerations may produce a situation where the answer turns on questions of emphasis and degree. BP Australia Ltd [1966] A.C

40 Capital structure vs Income structure One cannot fully appreciate the intention behind a transaction without first understanding the nature of the business and being able to conceptually divide the business into two pieces a capital structure vs its income structure. In brief the core of a business capital structure includes its work force, its long-term financing, its share structure, its fixed assets whereas the revenue generating or income structure is the income earning process seen as separate. The courts have distinguished these two structures with expressions such as selling versus production, fixed versus circulating capital and structure versus the money earning process to name a few of the more common expressions 14

41 Transaction cost analysis overview Capital vs Income Depends on what the expenditure is calculated to effect from a practical and business point of view rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process. Hallstroms Pty. Ltd. (1946) 72 C.L.R

42 Transaction cost analysis overview Capital vs Income no one test or principle or rule of thumb is paramount. The question is ultimately a question of law for the court, but it is a question which must be answered in the light of all the circumstances which it is reasonable to take into account and the weight which must be given to a particular circumstance in a particular case must depend rather on common sense than on strict application of any single legal principle. Johns Manville (SCC) 85 DTC

43 The current abbreviated version of Capital vs Income Here no capital asset was acquired, nothing of an enduring benefit came into existence nor was any capital asset preserved. International Colin Energy (TCC) 2002 DTC 2185, para. 48 expenses can be classified by reference to their form (recurring or single outlay), effect (enduring benefit) or purpose. Because expenses can be incurred for a myriad of reasons, the courts have cautioned that the aforementioned tests must be applied on a caseby-case basis. In other words, there is no set formula as to their application. Rio Tinto Alcan (TCC) 2016 DTC 1144, para

44 Is transaction cost analysis being properly applied? Practitioners 1. Over-reliance upon the court decisions in Colin Energy, BJ Services, Boulangerie Ste-Augustine & Truckbase Corporation; 2. Applying accounting concepts to transaction cost issues; 3. Failure to properly consider the shareholder connection. 18

45 Is transaction cost analysis being properly applied? The CRA 1. Some interpretations & positions inconsistent with current commercial reality (hostile takeover bids & communication costs); 2. Inconsistent application of the transaction based approach; 3. Failure to provide useful timely internal and external guidance, communication & training/education on transaction costs. 19

46 A few words in the Rio Tinto Alcan decision Oversight & execution expenses a new concept? The capital structure issue unresolved!!! The interpretative expansion of ITA 20(1) 20

47 Transaction Costs Closing remarks In this presentation I have attempted to provide a general overview of the methodology required in conducting a thorough and professional transaction cost based analysis; have alluded to concerns about short-cut approaches that miss the mark; have taken a close look at some of the areas of concern applying transaction cost analysis in the practitioner community; 21

48 Transaction Costs Closing remarks have been critical of the CRA with respect to certain interpretations that are sometimes inconsistent with today s commercial reality; been critical of the CRA for failing to provide timely useful information with respect to transaction cost issues that would assist all concerned in determining with confidence the accurate reporting of transaction costs. 22

49 TRANSACTION COSTS (Issues in Analysis & Application) June 7, 2017 CTF Presentation Introduction A decade ago while working for CRA Head Quarters in Ottawa as a National Trainer teaching CRA income tax auditors across the country a variety of intermediate and advanced level income tax courses I was asked to participate and co-host a weeklong event in Ottawa with two of my senior colleagues. The event was an initiative undertaken by a relatively new management team whose responsibility was overseeing the training and education of CRA auditors. The objective of the event, triggered in large part by comments made by the Auditor General in regards to training in the CRA, was to determine whether the then existing technical income tax courses were meeting the needs of experienced auditors 1. Invitations were extended to a significant number of experienced auditors, managers and other technical staff with backgrounds in audit of large corporations, international tax and tax avoidance. I was tasked with uncovering the training/educational concerns of the large corporate auditor group. Heated discussions ensued with respect to strengths and weaknesses of existing courses but more importantly a lengthy list was compiled of high priority issues for which no training was then being provided. At the number one spot were transaction costs. In fact it spilled over into the other two areas of tax avoidance and International as a topic that auditors in general felt ill-prepared to address with any level of confidence. There existed a scattered hodgepodge of CRA Ruling positions addressing very selective aspects of transaction costs that essentially provided guidance as to how auditors were to handle very specific issues, a handful of IT bulletins 2 and some internal communiques with limited guidance that generally supported and reinforced the Ruling positions. Following the event I was asked and readily agreed to write a training course on transaction costs to be given to all income tax auditors. Unfortunately the management team changed and new priorities and challenges for CRA indefinitely shelved the project. Aware of the importance of transaction cost analysis and somewhat frustrated with this turn of events I began to include brief discussions in other courses such as corporate reorganization, wind-ups and amalgamations to assist auditors with the analysis of transaction costs. Over the next number of years auditors would regularly contact me for guidance on potential transaction cost issues. I saw firsthand how tax practitioners responded to transaction cost reassessments and the manner in which most defended their client positions. In the vast majority of cases full deductibility had been claimed of all 1 The Auditor General of Canada had issued a report on training in the CRA that did expand on this concern. 2 IT99R5 for example dealt with the tax treatment of legal and accounting fees and IT143R3 the meaning of eligible capital expenditures. 1 P a g e

50 costs supported by quoting one or more of the three court decisions International Colin Energy (TCC) 2002 DTC 2185, BJ Services Company of Canada (TCC) 2004 DTC 2032 & Boulangerie Ste-Augustine (FCA) 1997 DTC On occasion the informal Tax Court decision of Truckbase Corporation 2006 DTC 2930 would be thrown in for good measure. I will have more to say on that approach in this brief paper. Seven years after the Ottawa event I was approached by another new management team who, having come to the realization that the subject of transaction cost remained an important issue, tasked me with the responsibility to finally write the course. My objective was not to simply list how specific expenditures were historically treated by the CRA by providing a list of CRA publications and Ruling positions but rather to describe the analytical process required to determine, with a high level of supportable certainty, how particular expenditures were to be treated cognizant of course of the various fixed CRA positions. In other words the goal was to teach auditors how to apply the analysis themselves. The course was completed in mid-2013 and underwent three pilot sessions over the next year and a half before again being temporarily shelved. The results of those attending any of the pilot sessions was exceptionally positive. In the fall of 2015 the course was green-lighted for release to CRA income tax auditors. I retired in March 2016 and joined the firm of Welch LLP in Ottawa shortly thereafter as a tax consultant. The Presentation objective My goal in this presentation is to look at the underlying causes that in my opinion lie at the heart of the difficulties associated with the determination of the income tax treatment of transaction costs. Simply put, transaction cost analysis is really expenditure analysis. Most involved to some degree with Canadian income tax would be of the view that determining the tax treatment of expenditures of any type, should, for the most part be relatively straight-forward yet this is not the case. One only has to look at the expenditure case law over the last decade to get a hint of some of the difficulties. 3 The divergence of views between practitioners and the CRA as they relate to transaction costs has been ongoing for decades and continues to this day as evidenced with the appeal by the CRA to the Federal Court of the recent Tax Court of Canada decision in Rio Tinto Alcan. 4 In this presentation I will attempt to pinpoint some of the issues and concerns that contribute to this ongoing analytical difficulty and explain some of the reasons behind the 3 See the Tax Court of Canada decisions in Ironside 2015 DTC 1123, Gouveia 2014 DTC 1035 & Hanmar Motors 2007 DTC DTC P a g e

51 transaction cost confrontations between the CRA and practitioners that I believe are destined to become much more frequent in view of new CRA training for its auditors. The importance of Transactions Costs Transaction costs are an important topic to both the CRA and to tax practitioners alike. Transaction costs are generally defined as costs associated with a potential transaction or transactions that relate to the gathering of information, identification of subject matter, bargaining, negotiating and implementation. Such costs can easily amount to millions of dollars of costs including a variety of expenditures from legal, accounting, investment banker fees, fairness opinions, communication and printing costs, Director circular costs, miscellaneous amounts such as break and hello fees etc to name but a few of the more common costs. An example of the dollar amount of disputed transaction costs in some of the more high profile transaction cost based case law is as follows; Colin Energy $ 1.2M Potash Corp. $ 1.7M BJ Services $ 48.7M Rio Tinto Alcan $ 97.0M From a CRA perspective experienced auditors will often focus upon areas where there is potential for tax treatment that differs from that of the CRA. Transaction costs are therefore of immediate interest since it is well known within the CRA that many practitioners advocate full deductibility when this may often not be supportable. The likelihood of some reassessment is high in respect of transaction costs relative to other audit issues given this full deductibility approach. In addition transaction costs, particularly in years where such costs are higher than usual, are an indicator that some tax planning has occurred that might be worthy of a closer look. In each of the 2013 and 2016 federal budgets statements were made to establish priorities in identifying what the CRA refers to as unacceptable tax planning or aggressive tax avoidance. Transaction costs remain one of the key indicators of such potential. It is inevitable that the CRA will clash with tax practitioners in regard to transaction cost issues. In general terms where tax practitioners envisage fully deductible expenses the CRA will see non-deductible capital outlays, partially deductible costs or costs that are not deductible at all. In very general terms potential conflicts between the CRA and tax practitioners are high with respect to transaction costs particularly where auditors are aware of the issues and possess some rudimentary analytical ability to assess whether the actual treatment of any such costs is at odds with reasonable expectations. 3 P a g e

52 Common problems in determining the tax treatment of Transaction Costs Whether it is CRA auditors (who are for the most part accountants) or practitioner accountants there exist some general misconceptions when it comes to determining the income tax treatment of a particular transaction cost. In the search for the answer to the tax treatment of a particular transaction cost often time the standard methodology is to search through a number of sources to determine the treatment in other words to rely upon someone else s opinion or viewpoint set out in tax articles, textbooks, newsletters, tax services etc. Another popular approach is to track down any case law where the issue appears to have been examined. CRA auditors search their own internal databases such as Rulings documents to find something that they can quote in support of a reassessment. Other CRA publications including IT bulletins, internal communiques, audit manuals, appeals memorandum etc are sometimes used. The thought process or the implication is that identical transaction costs must be treated the same way in each and every case. This is not only incorrect but potentially dangerous in assuring accurate supportable reporting of any expenditure let alone transaction costs. If you are a practitioner discussing a proposal to reassess a client concerning a transaction cost reassessment or the CRA auditor it is always informative to ask the other party the basis and support they have taken for determining the tax treatment of a disputed transaction cost. The response will often be telling and enlightening providing valuable insight as to whether a thorough expenditure analysis has been undertaken or not. 4 P a g e

53 Expenditure Analysis The legislative scheme Expenditure Nothing No ITA 9(1) Is the expenditure deductible within the meaning of profit in ITA 9(1)? Yes No ITA 18(1)(a) Is the expenditure made or incurred for the purpose of gaining or producing income from the business or property? Yes Yes ITA 18(1)(b) Is the expenditure capital in nature? No ITA 20(1) No Does ITA 20(1) (other than (b)) provide a specific deduction? Yes Deductible in full, subject to other restrictions (e.g. ITA 67) Does it qualify as an eligible capital expenditure within the meaning of ITA 14(5)? Yes No Generally nothing unless the expenditure represents the cost of acquired capital property or the cost of a disposition of such property. Nothing Deductible in part under ITA 20(1)(b) Note on eligible capital property: References to ITA 14(5) and 20(1)(b) apply to costs incurred prior to January 1, These provisions are repealed after 2016 and are replaced with new depreciable property Class P a g e

54 Transaction Cost Analysis overview There is a systemic approach to determining the income tax treatment of an expenditure. The approach is not only reliant upon the words of the Income Tax Act but is dependent, in many instances, on what I will refer here to as judicial doctrine which I broadly define as interpretative rules, principles and concepts developed by the courts that act as guides to assist in the identification of the appropriate income tax treatment of a specific cost or expenditure. Some of the more important and commonly referenced judicial doctrine employed in transaction cost analysis include the following Transaction based approach 5 ; This doctrine requires us to first look at the transaction at issue which simply means understanding the nature of each transaction. It is not enough to say that since the transaction relates (or appears to relate) to a capital expenditure that the transaction automatically will be considered capital in nature although another doctrine will move in that direction. Over the last decade courts have indirectly used this doctrine when saying that no capital asset was acquired, nor capital asset preserved etc. No guaranteed Symmetry 6 ; Tax symmetry implies that if two parties transact that the tax treatment to one is mirrored in the other in other words that if the nature of a transaction is capital to one it must be capital to the other or if the nature of an amount to one party is income then it must be an expense to the other. The courts have clarified that symmetry is not a rule in tax law. The tax treatment of a break fee to the recipient is a practical example of this doctrine as was demonstrated in Morguard Corporation (FCA) 2013 DTC Accurate Picture/Running expense 7 ; These two concepts go hand in hand. The accurate picture concept is concerned with the notion that income is properly determined and reflected. To determine the accurate picture (e.g. of income) one then has to be aware that certain expenditures, that may meet an accountant s notion of capital often time because it is perceived as having a life expectancy that exceeds the current reporting period, may be fully deductible in the year incurred even though they may in fact relate to future years. The analysis is both fact-based and based in legal concepts (a combined question of fact and law). Much of the case law in this area is with respect to tenant inducement payments (TIPs) which are payments by an owner of property to entice tenants to sign multi-year leases 5 Singleton (SCC) 2001 DTC Ikea (SCC) 98 DTC Canderel (SCC) 98 DTC P a g e

55 by offering up front cash incentives. Accountants would often prorate the payments over the life of the underlying leases for accounting purposes while not including anything in income for tax purposes on the basis that the amounts were not income but capital and therefore not taxable. Law not accounting 8 ; This principle is well established clarifying that accounting has little relevance to the issue of what constitutes income and expense deferring instead to a question of law and may be influenced by commercial common-sense (what the Supreme Court referred to as well-accepted principles of commercial trading or business practice you will sometimes hear the courts talk about expenditures in particular and how the industry would typically treat or view such an amount from a common sense appreciation (The Supreme Court decision in BC Power 9 is an example of this with respect to corporate costs of communicating with one s own shareholders). This principle also supports the previous one on accurate picture and running expenses. The relevance of this to CRA auditors is to downplay the accounting treatment and look instead to legal concepts and to commercial acceptability. Source of income 10 ; The concept underscores the source concept that applies to Canadian tax that essentially says that without a source no expenditures are deductible whether they are capital or income related. Generally if an expenditure (or receipt) does not relate to a source it is non-deductible or non-taxable generally failing the ITA 18(1)(a) test and potentially representing a personal type expenditure for individuals (ITA 18(1)(h)). An example of the relevance to transaction costs would be expenditures that relate to a new business that has not yet commenced. Since a source of income cannot exist prior to the commencement of a business any pre-business expenditures would typically fail the source of income test and would not receive any recognition. Capital vs Income 11 ; An often critically important concept that requires stepping back from accounting principles and looking at an entity in an entirely different manner. We discuss this further in this paper. Expense Characterization 12 ; Again this is more of judicial guidance than a hard and fast concept. This guidance recognizes that the courts have already 8 Hickman Motors (SCC) 97 DTC 5363 & Symes (SCC) 94 DTC (SCC) 67 DTC Stewart (SCC) 2002 DTC Numerous including Johns Manville (SCC) 85 DTC Numerous including Canada Starch (EC) 68 DTC P a g e

56 commented upon the deductibility of certain expenditures many of which practitioners would debate from a capital versus income perspective. Advertising, promotion, market surveys, industrial designs, legal expenses and communication expenses with one s shareholders are some of the areas where the courts have consistently already ruled in favour of deductibility. The one exception are legal expenses where what the courts have said is something like, legal expenses are assumed to be current expenses (non-capital) but the facts could lead to a different conclusion. The entity concept 13 ; This concept recognizes that the Canadian tax system separately identifies with certain entities even though they may be economically regarded as part of another entity. The classic example would be corporate groups (e.g. Parent-subsidiary). This concept looks to potentially apportion the benefit of expenditures among those who economically benefit meaning that an expenditure at the parent corporate level may not entitle that parent company to full tax benefit in its own right if that expenditure serves to benefit or accommodate others. This concept was discussed in both the Tax Court of Canada decisions in Potash Corporation of Saskatchewan 14 and Rio Tinto Alcan 15 ; Nothings 16 : Rather than a strict principle this is more a judicial guideline where courts have categorically stated that where options or alternatives exist with one providing nothing and another providing some form of relief (e.g. through a deduction) then the courts will, in the right circumstance, choose relief. In other words the courts are not typically supportive of CRA reassessments that fail to provide some relief for a recognized expenditure. This was an issue for pre-1972 taxation years when the eligible capital expenditure rules did not exist. One of the most hotly debated of the above doctrine is capital versus income. This particular doctrine includes a large subset of its own which was relegated to a three-test approach of (i) recurring expense, (ii) enduring benefit and (iii) the purpose test as set out by Tax Court judge Hogan in the 2016 Rio Tinto Alcan Inc decision. Judge Bowman in the International Colin Energy decision framed capital versus income in a slightly different albeit abbreviated version that looked to another modified three-step query of (i) whether an asset was acquired, (ii) whether something of an enduring benefit came into existence and (iii) whether a capital asset was preserved. 13 Merban (FCA) 89 DTC DTC Ibid footnote 4 16 Elaborated upon in the Supreme Court of Canada decision in Johns Manville 85 DTC P a g e

57 Keeping the relevant doctrine in mind the attention is first directed to the actual facts and, considering the transaction based doctrine, looks to specific individual transactions with an appropriate connection to a given source of income where the entity responsible for incurring the particular expense is itself the beneficiary of that expense. The capital versus income concept then comes into play the result of which is dependent upon the outcome of that particular transaction including, depending upon the situation, the intention behind the transaction. One cannot fully appreciate the intention behind a transaction without first understanding the nature of the business and being able to conceptually divide the business into two pieces a capital structure which includes the core of a business such as its work force, its long-term financing, its share structure, its fixed assets as opposed to its revenue generating or income structure. The courts have distinguished these two structures with expressions such as selling versus production, fixed versus circulating capital and structure versus the money earning process to name a few of the more common expressions 17. Where the expenditure exhibits characteristics of both capital and income the courts have applied a common sense appreciation to break the tie. Some of the more pertinent commentary in this regard follows The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a common sense appreciation of all the guiding features which must provide the ultimate answer. Although the categories of capital and income expenditure are distinct and easily ascertainable in obvious cases that lie far from the boundary, the line of distinction is often hard to draw in border line cases; and conflicting considerations may produce a situation where the answer turns on questions of emphasis and degree. BP Australia Ltd [1966] A.C. 224 Depends on what the expenditure is calculated to effect from a practical and business point of view rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process. Hallstroms Pty. Ltd. (1946) 72 C.L.R. 634 In summary transaction cost analysis includes (i) a thorough understanding of the business, (ii) the ability to conceptually delineate the business into its capital and income components, (iii) understand the purpose, intention and expectations with respect to the expenditures, (iv) Look at the actual transactions individually and apply the expenditure analysis separately to each transaction, (v) compare the outcome to judicial principles and guidelines and other case law, (vi) determine whether your analysis is consistent with 17 Johns Manville (SCC) 85 DTC P a g e

58 those guidelines and case law and if not the supportable reasons underlying the different treatment. Is transaction cost analysis being properly applied? The recent Tax Court of Canada decision in Rio Tinto Alcan Ltd and appeal by the CRA reminds us that the disputes over transaction costs are far from over. This presents an opportunity to look at both the CRA and practitioners to determine any ongoing issues in how transaction costs cases are pursued. Practitioners There are three main concerns with how many practitioners determine the tax treatment of transaction costs. The first is the over-reliance upon one of the four cases mentioned earlier of International Colin Energy, BJ Services, Boulangerie Ste-Augustine and Truckbase Corporation. Some appear to be of the view that the existence of these cases stands for the proposition that all transaction costs are fully deductible given the apparent perceived relaxing of the expense denial rule of paragraph 18(1)(a) of the Income Tax Act 18. There is unfortunately an abundance of tax literature that reinforces this notion. To get an idea of the success of this approach one only has to look at the case law where practitioners defended their clients referring to one of the four cases. In five Tax Court of Canada decisions 19 it was argued that full expense deductibility was justified based on these cases. In each of those cases the court dismissed the claim outright by declaring that those cases had either nothing to do with the issues before the court or were otherwise irrelevant. To be fair two decisions quoted the decisions with favour however the fact patterns of all of the cases was markedly different. 20 The second concern is that some practitioners incorrectly apply accounting principles and concepts to transaction cost issues. The classic example is attempting to define capital in terms of accounting rather than in legal terms. In terms of accounting an expenditure that is considered to have benefits that extend beyond the year incurred are generally categorized as capital but the legal concept of capital can be significantly different resulting in an outcome that is often found confusing to many. The Supreme Court of Canada case in Ikea 21 that dealt with the tax treatment of a tenant inducement payment 18 In BJ Services the Tax Court referred to paragraph 18(1)(a) as being met if the expense was not personal and met a need of the of the company the effect of which was to render the restriction porous. 19 Hanmar Motor (TCC) 2007 DTC 1773 para. 14; Potash Corporation (TCC) 2011 DTC 1163, paras. 94 & 96; Arpeg holdings (TCC) 2007 DTC 131 paras 82-84; Ironside (TCC) 2014 DTC 1002 para. 45 & Rio Tinto (TCC) 2016 DTC 1144 para Pantorama Industries (FCA) 2005 DTC 5230 para. 25 & Morguard (TCC) 2012 DTC 1099, para DTC P a g e

59 stands out as one of the prime examples of this difficulty. 22 In that case Ikea was the recipient of a tenant inducement payment (TIP). An agreement was signed with respect to the TIP stipulating that the payment was to induce Ikea into a multi-year lease and that it was free to use the amount for any purpose it desired. For financial statement purposes Ikea reduced some of the costs of fixtures in the leased premises and amortized the remainder over the period of the lease. For tax purposes Ikea did not reduce the capital costs of depreciable property nor bring any amount of the TIP into its income. Ikea claimed that the amount was a non-taxable capital receipt. As justification Ikea claimed that the amount was capital because the payment represented a lump-sum that provided an enduring benefit over the term of the lease and because the lease was long-term (beyond the current year) the TIP goes to the structure of the business. In effect the arguments attempted to talk about structure (e.g. capital versus income structure) but unfortunately employed accounting rather than legal concepts in doing so. The Supreme elaborated that part of the TIP may have been treated as capital if the agreement with the landlord had legally obligated Ikea to use part or all of the TIP to defray fixtures but failing to do so the TIP fell into the income category. The third and final concern is that practitioners at times fail to properly consider the source of income concept particularly in small privately owned corporations. Transaction costs may be incurred for a variety of corporate reorganizations but the key to determining whether related transaction costs connected with a particular reorganization often are answered in terms of what the reorganization is designed to achieve and whether it is the needs of the corporation or its shareholders that are being met. For example an internal crystallization is a common tax planning technique where a shareholder undertakes a share exchange using the rollover provision of ITA 85(1) in such a manner as to trigger a capital gain to access the capital gains deduction. The CRA has commented upon this planning technique by stating that any transaction costs incurred by the corporation are considered personal to the corporation and therefore non-deductible. 23 On the flipside the same denied amount is then added to the income of the shareholder as a shareholder benefit under ITA 15(1). In effect you then have the arguable double taxation of a denied corporate expense and shareholder income inclusion. Other reorganizations that potentially fall into this category include estate freezes, purifications, the establishment of family trusts etc. The determining factor influencing the income tax treatment of any related transaction costs is dependent upon the justification for the particular reorganization in terms of its meeting a business need of the corporation. 22 It is important to clarify that in this paper we have focused upon expenditures and not the income side of the equation but the capital versus income concept is applicable to both. See the case of Morguard Corporation (FCA) 2013 DTC Rulings documents & P a g e

60 The CRA In a similar manner and to achieve a sense a fairness there are also three concerns with the CRA and transaction costs. The first is that some would argue that the CRA s approach to transaction costs in general fail to consider the commercial realities of business today in a timely fashion. In this instant two Ruling positions immediately come to mind. The first is the old CRA position on transaction costs incurred by the target in a bidding war in a hostile takeover environment. The position used to be that such costs were denied as personal shareholder benefit expenses because they indirectly resulted in shareholders receiving higher selling prices. In effect the CRA saw such target corporations incurring expenditures that appeared to have as their purpose obtaining the highest selling price possible for their shareholders. This position was put before the courts by the CRA in the International Colin Energy case. Judge Bowman was offended by the CRA approach and made more than a few unflattering comments as to what he thought of that mindset including a reassessment that left the corporation with nothing insofar as tax recognition of the expenditures. 24 The CRA now accepts the decision in International Colin Energy in that regard. A second example relates to costs incurred by corporations in communicating with their shareholders. The Supreme Court in BC Power 25 made it clear that the furnishing of information by a corporation to its shareholders was properly deductible but in Boulangerie Ste-Augustine ( Boulngerie ), again in a hostile takeover situation, the CRA was prepared to disallow the costs of communications to its shareholders with respect to the takeover bids on the basis they had nothing to do with the income earning function of Boulangerie. Boulangerie argued that the Quebec Securities Act imposed a legal obligation on the company to communicate the takeover bids with its shareholders and that as a result that fact should entitle them to a deduction. The court agreed. The CRA subsequently announced its general agreement with the decision but restricted the deductibility of such communication costs to corporations legally obligated in a manner identical to Boulangerie. In other words in the absence of such legal obligations the CRA would maintain their previous non-deductibility position. 26 The CRA now accepts that such costs are generally deductible. 27 A second concern is that the CRA sometimes fails to apply a transaction based approach to transaction costs where the belief is that the costs eventually lead to a capital event such as amalgamation. In other words the view is that transactions costs are tainted by 24 Paragraph DTC Rulings document & Rulings document I7 12 P a g e

61 an outcome unknown at the time of the initial transaction. This approach was followed in the Rio Tinto decision and likely underlies the basis for the appeal by the CRA along with their view that the interpretation of select provisions of ITA 20(1) were much too liberal. The Rulings Directorate of the CRA has always been a strong advocate of the transaction by transaction based approach but appears to be less supportive in the case of certain transaction costs. The current state of the jurisprudence fails to support the CRA view in this regard. A third and final concern is twofold and relates to training and education of its auditors together with informative useful guidance to the practitioner community reminiscent of the informative examples provided in certain publications such as the original GAAR circular 28. On the training and education forefront in the introduction I alluded to an auditor concern with respect to the importance of responsibly being in a position to address transaction costs. More than a decade ago the CRA took the appropriate steps in an attempt to determine shortfalls in the training requirements of its most experienced auditors then dropped the proverbial ball to carry the results through to its requisite conclusion. Untrained auditors who then attempt to address transaction costs or other tax issues do so with a high level of uncertainty and lack of knowledge failing to appreciate the analytical nuances and, as a result, may then pursue unwarranted reassessments which result in considerable cost in resources to all concerned. Lastly we will take a quick look at the transaction cost guidance provided by the CRA to practitioners. Let s start with the 2016 Capital Gains guide (T4037). Chapter one of the guide contains the following statement, When you dispose of a property you need to determine if the transaction is a capital transaction or an income transaction. The guide goes on to elaborate that it only deals with capital transactions. While the capital gains guide does not directly answer the question as to how to make the capital versus income determination it provides instead a reference to three interpretation bulletins (IT218R on real estate transactions; IT459 on adventures in the nature of trade and IT479R on transactions in securities). In all fairness the capital gains guide does address the numerous capital gain provisions throughout the ITA and is directed towards reporting an accurate amount but the most crucial question is sidelined. The publications provide lengthy lists of factors considered by the courts over decades of case law in a multitude of sometimes unique situations without any direction as to how or when any of the tests would apply to typical transactions. Unfortunately the utility of the information provided is low and may, as a result, be cause for confusion and misunderstanding as to how the capital versus income determination is to be made. I 28 IC P a g e

62 have seen CRA auditors (myself among them) who in the course of an audit dealing with an income versus capital issue mindlessly apply every single listed factor without truly appreciating or understanding why such tests were being applied in a given set of facts. Given that the CRA is slowly replacing their IT bulletin publications with a series of folios we can only hope that the information provided will include some examples that help to illuminate the application of this important concept. A few words on the Rio Tinto Alcan decision In Rio Tinto the judge introduced what appears at first glance to be a novel idea in terms of drawing a line separating capital and income based transaction costs. The concept is referred to as oversight and execution costs. Oversight costs represent those costs considered a normal part or function of the management of a corporation in deciding upon a course of action whereas execution costs are those costs incurred once the decision has been made to pursue a particular capital transaction. The judge considered oversight costs as deductible whereas execution costs would be non-deductible capital costs unless a specific provision within subsection 20(1) permitted the deduction. Many have touted the analysis in this case as something knew although in my view the decision simply puts new terminology to the established judicial doctrine particularly that which delineates the revenue and capital structure. In the decision the judge notes that the type of decisions made by the Board are historically a part of the everyday function of the corporation in the pursuit of its business. In other words the oversight expenses are seen as a component of the revenue structure based on a factual determination. Once the decision had been made to undertake a specific capital course of action, which includes structural changes consistent with the commentary of the Supreme Court in Canada Starch 29, the capital structure is impacted. I believe that the basis for the CRA appeal aside from the concern about the expansion of certain deductions within ITA 20(1) has everything to do with labelling a transaction as capital even prior to the time that a decision has been made to pursue a course of action particularly where the justification for the added expenditures would lead to the potential to alter the structure of that corporation in some capital manner. I believe that the decision in International Colin left this issue unsatisfactorily resolved in the view of the CRA given that monies expended to ensure the survival of the company were clearly aimed at a structural change. Judge Bowman had stated that the disputed transaction costs were intended to improve the ability of the company to earn income by combining its resources with that of another entity 30. Isn t that the purpose of any reorganization 29 (EC) 68 DTC DTC 2185, Para P a g e

63 which is clearly structural in nature? In my view these words conflict with the case law on the nature of a structural change which is capital. We sometimes think of capital as something tangible in nature but structural changes can be of an intangible nature. In the Tax Court decision in Potash Corporation 31, for example the judge commented that a tax structure created an intangible holding structure for the flow of cash. Unfortunately the flaw in properly presenting this capital argument by the Crown in the International Colin Energy case led to an abbreviated capital versus income test that I believe incomplete. Unfortunately had the CRA appealed the decision perhaps the difficulty would have been satisfactorily resolved. 32 In any case It is my view that transactions costs will remain in somewhat of a flux until such time as this structural argument is addressed. Perhaps the appeal to the Federal Court in Rio Tinto Alcan will resolve this once and for all in a manner that provides an enduring benefit to all concerned parties. Summary In this paper I have attempted to set out some of the more important issues that remain to this day in regard to determining the income tax treatment of transaction costs. There is an analytical methodology that must be employed to arrive at a tax treatment conclusion that is justifiable and supportable given the current state of the law and jurisprudence which unfortunately remains unsettled to some degree. Income tax analysis is not simply a matter of a quick google or other search engine choice but a matter of precise professional judgement and analysis supportable by decades of judicial doctrine. Both practitioners and the CRA have not always used the requisite approach in a consistent manner in support of their respective positions and hopefully this paper has assisted in illuminating some of that difficulty. 31 Ibid footnote The CRA refused to appeal the International Colin Energy case preferring instead to rely upon the outcome in the BJ Services decision. When the CRA lost the income tax case in BJ Services they then accepted that outcome without any serious consideration to an appeal. 15 P a g e

64 Recent Developments in Corporate Taxation Greg Bell, KPMG Chris Jerome, EY 7 June Ottawa 2017

65 Agenda Budget overview Business income tax measures Personal income tax measures 2016 CTF Annual Conference Roundtable Q.1 Avoidance of 104(5.8) Q.11 Computation of earnings for LLC Q.12 Support for U.S. FTC claims Q.6 Application of (2) various technical interpretations and roundtable questions 2

66 Tax planning using private companies No measures introduced as part of Budget 2017 that change tax rules for private companies or their shareholders Budget 2017 continues to emphasis that it is a priority of the Liberal government to eliminate the benefit of tax planning available to wealthy Canadians using private corporations Examples cited in the Budget Papers included: Income splitting through private companies to use the lower personal tax rates of some direct or indirect shareholders Earning of investment income through a private corporation on after-tax business income that was not distributed to shareholders or reinvested in the business Conversion of other income to lower tax rate on capital gains 3

67 Tax planning using private companies Hopefully the system of corporate integration available to CCPCs will be preserved Presumably the target is non-conventional tax planning Finance to release paper in the coming months to outline the nature of issues in detail and address how they propose to implement new rules that will target this planning 4

68 Billed basis accounting Currently professional practices of certain professionals can deduct expenses as incurred and report revenue only when billed WIP reserve available to defer taxation of unbilled revenue until it is actually billed Finance considers this an inappropriate mismatching of the revenue and expenses related to the business Budget 2017 introduces a phase out of this WIP reserve 50% of unbilled WIP may be deducted in 2018 and fully phased out in

69 Meaning of factual control Control defined for various purposes of the ITA defined as either de jure or de facto control De jure control is generally the right to elect the majority of the board of directors De facto control is a broader test that takes influence into consideration Generally relevant for association rules for SBD sharing and enhanced SR&ED credits Recent McGillivray decision of FCA determined that influence must be limited to circumstances that include a legally enforceable right and ability to change the board of directors or its powers or to exercise influence over the shareholders who have that right and ability 6

70 Meaning of factual control Budget 2017 includes draft legislation that will remove the restrictions established by FCA Proposal is that in determining whether factual control exists factors may be considered that are not limited to the constraints established by the FCA but include all factors that are relevant in the circumstances Effective for tax years that begin on or after 22 March

71 Timing of recognition of gains and losses on derivatives Elective use of the mark-to-market method Uncertainty as to whether a taxpayer is able to apply a mark-to-market method for derivatives held on income account Budget 2017 proposes to introduce an elective mark-to-market regime for derivatives held on income account An election will allow taxpayers to mark-to-market all of their eligible derivatives. Once made, the election will remain effective for all subsequent year unless revoked with the consent of the Minister of National Revenue. 8

72 Timing of recognition of gain and losses on derivatives An eligible derivative will be any derivative which includes a swap agreement, forward purchase or sale agreement, forward rate agreement, futures agreement, option agreement or similar agreement held on income account that meets certain conditions Once an election is made by a taxpayer, the taxpayer will be required to annual include in computing its income the increase or decrease in value of its eligible derivatives. Taxpayers that are not financial institutions and do not elect will not be permitted to apply a mark-to-market method. Election will be available for taxation year that begin on or after 22 March

73 Personal tax measures Tax credit proposals Disability tax credit Nurse practitioners permitted to certify eligibility for the credit beginning 22 March 2017 Medical expense tax credit Eligible expenses clarified to include costs related to reproductive technologies Tuition tax credit Extends eligibility criteria to amounts for tuition to a postsecondary institution in Canada for occupational skills courses that are not at the post-secondary level Public transit tax credit Eliminates the credit, effective as of 1 July 2017 Caregiver credits Consolidated into a single Canada caregiver credit 10

74 2016 CTF Roundtable Q.1 Avoidance of 104(5.8) Question A discretionary trust ( Old Trust ) that is approaching its 21 st anniversary distributes property with an unrealized gain under s. 107(2) to a corporate beneficiary ( Canco ) that is wholly owned by a newly-established discretionary trust ( New Trust ). S. 104(5.8) should not affect the timing of the 21 st anniversary of the New Trust since the property was not transferred directly from Old Trust to New Trust. Does CRA agree? 11

75 2016 CTF Roundtable Q.1 Avoidance of 104(5.8) CRA s response The transactions described would result in the Old Trust indirectly transferring property to the New Trust on a tax deferred basis thereby avoiding the application of s. 104(5.8) It would effectively restart the 21 year clock in s. 104(4) The capital gain that would have been realized by the Old Trust would be deferred beyond its 21 st anniversary while the property continues to be hold in a discretionary trust arrangement 12

76 2016 CTF Roundtable Q.1 Avoidance of 104(5.8) CRA s response The New Trust is provided with another 21 years to decide who, from the potential beneficiaries, will receive the property. The could result in deferring the unrealized gain beyond the lifetime of the individual beneficiaries alive on the date of the Old Trust s 21 st anniversary. These proposed transactions were reviewed by the GAAR committee in the context of a request for an advance income tax ruling. 13

77 2016 CTF Roundtable Q.1 Avoidance of 104(5.8) CRA s response The committee was of the view that such planning circumvents the antiavoidance rule in s. 104(5.8) in a manner that frustrates the object, spirit and purpose of 104(4)(b) and the scheme of the Act as a whole as it relates to the taxation of capital gains. The CRA will generally apply the GAAR when faced with a similar set of transactions unless there is substantial evidence supporting its nonapplications. The CRA is also concerned that the proposed transactions may be repeated, such that the realization of the capital gains inherent in the property could be deferred for several generations, or even indefinitely. 14

78 2016 CTF Roundtable Q.1 Avoidance of 104(5.8) CRA s response The CRA is also considering whether the GAAR should apply to a similar situation involving a distribution from a discretionary family trust to a Canco that is wholly owned by the newly established discretionary trust in which the deferral of the gain is extended beyond the 21-year period but the fact pattern is such that the realization of the gain occurs in the lifetime of the existing beneficiaries. The GAAR Committee has yet to actually review that case, and has not taken a definite position. 15

79 2016 CTF Roundtable Q.11 Computation of earnings for LLC Question In 2011, the CRA indicated that a disregarded U.S. LLC that is a foreign affiliate and has a single member which is a regarded U.S. corporation should compute its earnings in accordance with Reg. 5907(1) earnings s. (a)(i). Has this changed following the enactment in 2013 of Reg. 5907(2.03) requiring an affiliate computing its earnings in accordance with Canadian tax law to claim maximum discretionary deductions? Would the answer change if the LLC had one or more members which were not regarded U.S. resident corporations? 16

80 2016 CTF Roundtable Q.11 Computation of earnings for LLC Response As a result of the context provided by subsection 5907(2.03), the CRA is now of the view that the earnings from a U.S. active business of a U.S.- resident, single member LLC that is disregarded for U.S. tax purposes should be computed in accordance with subparagraph (a)(iii) of the earnings definition. The change in the CRA s position is effective for LLC s first taxation year ending after August 19,

81 2016 CTF Roundtable Q.11 Computation of earnings for LLC Response In terms of transition, the CRA acknowledged that the rules do not contemplate a scenario where the earnings of a FA are computed under subparagraph (a)(i) of the earnings definition in one taxation year and under subparagraph (a)(iii) of the earnings definition the next taxation year. However, the CRA indicated that it is prepared to accept that paragraph 5907(2.03)(b) applies under this scenario and that the deductions claimed in preceding taxation years were deductions actually claimed under the Act. 18

82 2016 CTF Roundtable Q.11 Computation of earnings for LLC Response If a U.S. LLC with two or more members carries on an active business in the U.S. and is required for U.S. tax purposes to compute its income to determine the partners distributive shares, it is the CRA s view that the LLC must compute its earnings under subparagraph (a)(i) of the earnings definition in accordance with the tax laws of the U.S. 19

83 2016 CTF Roundtable Q.12 Support for U.S. FTC claims Question At the 2016 STEP Canada Roundtable, the CRA commented on its recent policy of requiring taxpayers to obtain official transcripts from U.S. federal, state and municipal tax authorities in order to support foreign tax credits that were claimed in respect of U.S. tax paid. Would the CRA accept U.S. Form 1040NR showing a deduction against the U.S. federal tax owed for state tax paid as satisfactory support for the amount of U.S. state tax claimed as foreign tax credit? 20

84 2016 CTF Roundtable Q.12 Support for U.S. FTC claims Response As indicated in the 2016 STEP Canada Roundtable document ( C6), if you are unable to provide a copy of the account transcript from the IRS or the account statement or similar document from the state or municipal tax authority, the CRA will accept proof of payment made or refund received which...may be in the form of bank statements, cancelled cheques, or official receipts It should be noted that proof of payment only replaces the requirement for a copy of the account transcript, account statement, or similar document. Other supporting documentation will still need to be provided to support the claim. 21

85 2016 CTF Roundtable Q & Poulin/Turgeon Question Could CRA comment on what it regards as the differentiating factors in these two cases? Does this decision impact CRA s views on employee buyco arrangements? What is CRA s view of a share sale identical to Mr. Turgeon s, except the holding corporation, an employee buyco, benefits from the involvement by way of dividends? 22

86 2016 CTF Roundtable Q & Poulin/Turgeon Response The sale of the frozen preferred shares arose in the context of a reorganization, the purpose of which was to implement the departure of Mr. Poulin and to integrate a key employee. The Court was of the view that Mr. Poulin wanted to leave, selling his interest at the best price and under the most optimal conditions (i.e. claim the capital gains exemption). Mr. Turgeon wanted to acquire the shares held by Mr. Poulin to acquire control of the corporation. The courts found 84.1 did not apply to Mr. Poulin. CRA generally agrees with the Court when it acknowledges the fact that the transaction was structured so Mr. Poulin could claim his capital gains exemption does not mean the parties acted in concert. 23

87 2016 CTF Roundtable Q & Poulin/Turgeon Response The court, however, found in the case of Mr. Turgeon that the parties were acting in concert. The CRA has always been of the view that the question as to whether unrelated persons are dealing at arm s length at any particular time is a question of fact and requires a review of all facts and circumstances surrounding a specific situation. Depending on the facts for example, it could be assumed that the employee buyco assumes no economic risk. 24

88 C6 Guidance on determination of safe income Question Given the historical records required what type of practical approaches and assumptions are accepted by CRA? Could CRA provide a copy of previous tax returns, assessments and reassessments? What type of audit practices can taxpayers expect in respect of supporting documentation? Could the CRA provide additional guidance on the safe income determination time where a company pays a regular dividend either on a monthly, quarterly, or annual basis, but does not enter into a transaction with an unrelated person under subsection 55(3)(a)? Has CRA s position changed with respect to accounting reserves and contingent liabilities after Kruco? 25

89 C6 Guidance on determination of safe income Response The onus is on the taxpayer to provide support for the calculation of safe income. The taxpayer is expected to organize the documentation as an accumulation on a year by year basis. In some very rare cases the CRA auditor might conclude that retained earnings is a fair proxy for safe income on hand but only after a stringent validation process. An incorrect claim could be subject to penalties under 152(4), 163(2) or 239(1). CRA will attempt to provide the requested documentation but is not under obligation to provide the information and is not in a position to provide assurances that these requests will be actioned in all cases. The audit steps are similar to steps on any other audit issue, each component will be validated utilizing appropriate documentation provided by the taxpayer. 26

90 C6 Guidance on determination of safe income Response In a recent ruling, CRA took the view that regular, recurring annual dividends would not, in the circumstance of the ruling, be part of a series of transactions. FCA s decision in Kruco requires a second stage inquiry to determine whether the income earned or realized was kept on hand. The decision supports the notion that the safe income should be reduced by the actual or potential cash outflows such as non-deductible expenses, contingent liabilities and accounting reserves in determining the safe income contributing to the gain. 27

91 2016 CTF Roundtable Q. 4 55(2) and Part IV tax Question Where a Canadian corporation has been subject to Part IV tax on a dividend received from Opco and the Part IV tax is refunded as a result of the payment of a dividend to an individual such that 55(2) applies could Holdco elect under subsection 83(2) on a portion of a dividend. Holdco receives a dividend of $1,000,000 subject to Part IV tax of $383,333, Holdco then pays a dividend of $1,000,000 Could Holdco report a capital gain of $1,000,000 and pay a capital dividend of $500,000. Dividend Dividend Individual Holdco Opco 28

92 2016 CTF Roundtable Q. 4 55(2) and Part IV tax Response Although one should be able to self assess under subsection 55(2), the application is predicated on the actual payment of Part IV tax and the receipt of the a dividend refund. Although 55(2)(c) deems the dividend received by Holdco to be a capital gain, the deeming has no incidence on the application of section 186 to the dividend received and, consequently on the application of section 129. Based on Ottawa Air Cargo Centre Ltd. v. The Queen the actual refund is required for the dividend to be recharacterized under subsection 55(2). This leads to the requirement to file an original return claiming the dividend refund and then amending the return showing the application of 55(2). However, the application of subsection 55(2) would not change the dividend received by the individual. 29

93 2016 CTF Roundtable Q. 4 55(2) and Part IV tax Response An election under subsection 83(2) would not be valid in respect of the dividend that results in a refund of Part IV tax as it would retroactively impair the application of subsection 55(2). The capital dividend election will only be available in respect of future dividends. 30

94 E5 55(2) & Part IV Tax This technical interpretation appears to be the same fact pattern as in the Roundtable and provides additional clarification of CRA s position. Some key points are as follows: The deeming rule does not change the application of section 186 and section 129. Concluding otherwise would make the Part IV tax condition of the application of subsection 55(2) redundant. Holdco s election under 83(2) that results in a refund of Part IV tax is not compatible with the application of subsection 55(2). A payment of a capital dividend and a taxable dividend would not trigger a full refund of the Part IV tax resulting in a circular calculation. The election under 83(2) will only be available in respect of future distributions. 31

95 E5 Stock Dividend Question Holdco owns 100% of Opco, (100 Class A shares) FMV $1,000,000, safe income $700,000, ACB and PUC $100. Prior to the sale of Opco shares, Opco pays a stock dividend on its shares in the form of preferred shares. The FMV of the preferred shares is $700,000, and the PUC is $1. What are the tax consequences of 55(2.2) and (2.3)? What is the tax impact if the preferred shares are redeemed immediately after the stock dividend? Stock Dividend X Holdco Opco 32

96 E5 Stock Dividend Response For the purposes of 55(2), (2.1), (2.3) and (2.4) the amount of the stock dividend is $700,000..The safe income of the Class A shares would be reduced by $700,000 The ACB of the preferred shares would be $700,000. On the redemption, consideration must be given as to whether there is safe income which would contribute to the capital gain on the preferred shares. As the FMV of the shares equals the ACB, safe income would not contribute to the gain. 55(2) would apply if the deemed dividend of $699,999 was not subject to Part IV tax. There would be no gain as the ACB of the shares would equal to the proceeds. 33

97 Technical Interpretation E5 Stock Dividend Response If 55(2) did not apply because, for example the dividend was subject to Part IV tax, the dividend would be a taxable dividend and the loss of $699,999 would be denied by virtue of subsection 112(3). Observation Does 55(2) apply on the redemption of the preferred shares? 55(2.1) provides that 55(2) applies in the case of a dividend under 84(3) where one of the results of the dividend is to effect a significant reduction in the portion of the capital gain that, but for the dividend would have been realized on a disposition at FMV. As there is no inherent gain in the preferred shares, the dividend does not reduce the capital gain. If the dividend is recharacterized as proceeds, the GRIP pool cannot be moved on the payment of the dividend. 34

98 CRA Round Table October 2016 APFF Q.16 SIOH Facts Holdco owns 100 common shares and preferred shares of Opco. The preferred shares are redeemable for $1M, are non-voting and have a right to a non-cumulative dividend of 8%. The ACB and the PUC of the preferred shares are equal to $100. The SIOH on the preferred shares at the time of the freeze is $700,000. X 1M PS PUC/ACB (SIOH 700,000) Holdco Opco 35

99 CRA Round Table October 2016 APFF Q.16 SIOH Questions What happens if Opco earns $150,000 of SIOH in the year following the freeze and pays a dividend of $80,000 on the preferred shares. Same question but Opco earns no SIOH? Response If the hypothetical gain of the preferred shares is $999,900 immediately before the payment of the dividend, it may mean that safe income earned after the freeze did not contribute to a gain. Therefore, the amount of the annual dividend would reduce the $700,000 of SIOH. 36

100 CRA Round Table October 2016 APFF Q.16 SIOH Response If the hypothetical capital gain was equal to $999,900 plus the annual dividend, it would be necessary to determine the safe income on hand since the freeze. If the safe income was greater than or equal to the dividend subsection 55(2) would not apply and the safe income of the corporation would be reduced by the amount of the dividend. If no safe income was generated since the freeze, the dividend would reduce the SIOH of $700,

101 E5 Attribution of Safe Income Facts X and Y are unrelated. X and Y own all of the shares of Holdco 1 and Holdco 2, respectively. Each Holdco owns 1,000 voting, participating, discretionary shares of a separate class. Each have held the shares of Opco since incorporation. The FMV of Opco is $2 million and safe income on hand is $1 million. Holdco 2 is to dispose of its Class B shares. X Holdco 1 1,000 Class A FMV $1M ACB nil Opco Y Holdco 2 1,000 Class B FMV $1M ACB nil 38