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

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

2 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

3 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

4 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

5 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

6 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

7 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

8 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

9 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

10 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

11 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

12 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

13 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

14 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

15 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

16 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

17 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,

18 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

19 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

20 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

21 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

22 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

23 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

24 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

25 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

26 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

27 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

28 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

29 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

30 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

31 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

32 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

33 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

34 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

35 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

36 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

37 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,

38 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

39 E5 Attribution of Safe Income Question Under the terms of the Class B shares, the FMV of the shares is reduced by the amount of the discretionary dividend. If Opco pays a discretionary dividend of $1 million on the Class B shares and then purchases the Class B common shares of Opco for cancellation for a nominal amount, what are the consequences? Response The safe income attributable to each class is $500,000. The dividend received by Holdco 2 would exceed safe income by $500, (5)(f) would apply to treat the dividend as two separate dividends of $500,000 each. The safe income attributable to the Class A shares would be $500,

40 CTF Roundtable Q2 SI Discretionary Dividend Shares Facts In year 1, Holdco A and Trust B subscribe for 50 Class A common shares and 50 Class B common shares of Opco. At the end of year 2, the shares of Opco have FMV or $2 million and safe income of $2 million. At the end of year 2 Holdco C subscribes for 50 Class C common shares for $1 million and Holdco D borrows $500,000 from Opco and acquires $500,000 from Trust B. At the end of year 3 OPCO had safe income on hand of $5.6 million. OPCO pays a $3 million dividend on the Class C common and $2.6 million on the Class B common. 40

41 CTF Roundtable Q2 SI Discretionary Dividend Shares Question Can the CRA comment on whether each of the dividends paid in Year 3 would fall outside of the safe income exception and if so, how much would be recharacterized as a gain? Would the response be different if, at the same time as the subscription by Holdco C, Holdco exchanged its Class A shares of on a tax deferred basis for preferred shares redeemable and retractable for $1 million? 41

42 CTF Roundtable Q2 SI Discretionary Dividend Shares Response We do not believe that this type of example is, as suggested in the question we have received, representative of situations commonly encountered by taxpayers. There has been a value shift amongst unrelated corporations. A detailed analysis would have to be made to determine if other anti-avoidance provisions applied (15(1), 56(2), 69(1), 246(1) or 245(2). This structure would be problematic in the context of a butterfly because of uncertainty in establishing the FMV of the OPCO shares. Recent comments by CRA on the allocation of safe income to discretionary dividend shares were not intended to suggest that CRA has no concerns about the use of the of those shares. The CRA will study the subject and will not provide additional views until the study is completed. 42