Articles

  Newsletters

  Tax Newsletters

My Holiday Tax Reading

By: David Louis, J.D., C.A., Tax Partner.
Minden Gross LLP, a member of MERITAS Law Firms Worldwide.

(*This release is based on an article published in Tax Notes # 552, January 2009, CCH Canadian Limited)

___________

Report on International Tax

Now in Effect: the Canada-US Protocol

The protocol to amend the Canada-US income tax treaty came into effect on December 15.  A number of provisions have differing effective dates.  Interest paid between related parties in Canada and the US is subject to a withholding tax rate of 7% (reduced from 10%), effective January 1, 2008. If tax was withheld at 10% rate, it is possible to get a refund of the extra 3%.  In calendar 2009, the rate will reduce to 4% and will be phased out starting January 1, 2010.   Interest between unrelated persons would be subject to a zero rate of withholding effective January 1, 2008, but effective the same date, Canada changed its tax laws so that similar rules apply to interest payments to residents of all foreign countries.  Other changes to withholding tax take effect on February 1, 2009 (e.g., the nil withholding rate for guarantee fees).

The protocol rules that limit the availability of treaty benefits to hybrid entities – particularly ULCs - are effective January 1, 2010.  A 25% withholding rate will apply to cross-border dividends paid by these entities.

Before relying on the treaty, Canadians should make sure that the new “limitation on benefits” provisions now applying on the “Canadian side” do not knock out favourable withholding rates or other benefits.[12]  The basic thrust of these provisions is that the benefits of the treaty apply to “qualifying persons”, including natural persons, publicly-traded companies and their subsidiaries, and government bodies.  Companies controlled by qualifying persons may qualify for the treaty but must meet “base erosion” rules designed to protect against siphoning income outside of the US[13].  In other cases, two other exceptions may apply: (i) an “active trade or business test” whereby the treaty may apply to income derived in Canada, provided that the US resident or a related person carries on a business which is substantial in relation to the Canadian activities; (ii) a “derivative benefits test” applying to interest, dividends or royalties, where the US company is owned by a resident of a third country which has a treaty with Canada with applicable rates at least as favourable as under the Canada-US treaty, provided that the third-country resident would be a “qualifying person” if resident in the US.[14]

Ontario Harmonization – Get Out Your Reading Glasses

Readers in Ontario who are tax advisors or corporate tax return preparers will be interested in learning more about federal and provincial harmonization.  This will come online for Ontario taxpaying corporations with taxation years ending after 2008 – so the first filing deadlines will start cropping up this summer.   Sometime between now and then, it will be advisable to develop a working knowledge of the new system, especially the transitional debits and credits. 

Replacing the old provincial tax forms are a series of federal forms starting at schedule 500, which is used to calculate basic Ontario tax (e.g., the small business deduction and clawback, but excluding tax credits and additional taxes which are calculated on other 500 series schedules).  Schedule 506 is a computation of transitional debits/credits, which arise because Ontario tax balances are replaced by federal balances.  The general idea is simple: you tally up various Ontario balances, such as non-capital and net capital losses, UCC, etc., and likewise for federal balances[15].  If Ontario tax balances exceed federal balances, so that the company loses coverage, it gets an Ontario tax credit based on 14% of the difference, which is normally amortized over five years[16].  If the opposite is the case – Ontario tax balances are less than federal balances, so that the company gains coverage - there will be a transitional tax debit (i.e., extra tax) based on 14% of the difference, which is also normally amortized over five years.

While this sounds simple enough, the devil, as they say, is in the details.  And a good way to get a flavour for them is to go to the CRA’s website, www.cra-arc.gc.ca, and pull the form.  You will see that it is eight pages long, with the first page devoted to new and unfamiliar terminology and definitions.  Some of the complications arise from wind-ups and amalgamations occurring within the amortization period[17].  There is also a special adjustment to Ontario SR&ED balances, whereby federal investment tax credits may be added, as well as an election to defer transitional debits in respect of SR&ED.  One possibly time-consuming requirement is to calculate the adjusted cost base of partnership interests, for both federal and provincial purposes, the rationale being to pick up differences in partnership-level balances.  This, of course, could be particularly burdensome for older partnerships.  The transitional credits/debits are entered on schedule 5[18] which deals with provincial tax (in the new section for Ontario), along with the results of schedule 500.[19]   

Tax return preparers should make sure they have budgeted extra time to cope with these new forms.   Hopefully, PD courses and additional explanatory material will be available in coming months.  

Faraggi Appeal Released

Last month, the Faraggi case[20] – which had been dragging through the courts for so long that it pre-dates GAAR - was released by Federal Court of Appeal.  The facts of the case are complex.  But in a nutshell, the taxpayers were - literally – in the business of crafting capital dividends for sale to third-party corporations through an intricate series of gains and offsetting losses, with the capital dividends in between.  The buyers would pay a premium on certain share subscriptions which were paid out as capital dividends to the devisers of the plan.  In the case, the CRA’s focus was on the devisers of the plan and their companies:  it sought to recharacterize the premium paid to the companies as income from a business, and knock out the capital-dividend-account elections which had allowed the devisers to pocket the premium tax free – or so they thought.

The lower court decision was troubling to practitioners for at least two reasons: As has been observed by my MERITAS colleague, Tim Huot[21], the sham doctrine was expanded by including an additional element, namely an abuse of the provisions of the Income Tax Act, contrary to their object and spirit. Potentially, this opened a second line of attack which could complement GAAR.  Also troubling was the attack on the “papering” of the transaction, particularly the daylight loans that were used. The judge attacked the loans on the basis that they were invalid, among other things, because there was no security or interest charged. Trouble is, temporary loans and the like are common in tax planning. Practitioners are left to wonder where this sort of thing stops — when will a loan without commercial terms be vulnerable to an attack? 

The Court of Appeal by and large cleared up these concerns (but it may have opened up another – see below).  The court indicated that the doctrines of sham and abuse are not the same[22] and that “subject to the invocation of the GAAR in a particular case, taxpayers are entitled to arrange their affairs in such a way as to minimize their tax burden, even if in doing so, they resort to elaborate plans that give rise to results which Parliament did not anticipate.”[23]  The court also indicated that it is not possible to conclude that there was a misrepresentation of the relationship of lender/borrower; and the loans in question could not be held to be shams.[24] 

The Court of Appeal held that the share subscription premiums were business income: as no transaction or operation is systematically excluded from the concept of business, the question whether a given operation amounts to a business must be determined in accordance with the particular facts of each case.[25]  Moreover, because the gain-making shares were acquired by the subsidiaries for the purpose of their immediate sale, this excludes the possibility that the shares could have been capital property in the hands of the subsidiaries[26].  Thus, the characterization as a capital gain was a misrepresentation and the resultant capital dividend elections were shams[27].  Accordingly, the taxpayers were grossly negligent for failing to report fully-taxable income at the corporate level as well as taxable rather than capital dividends - so that penalties also applied[28].   

What I find a bit troubling is penalties being imposed as a result of reporting capital gains rather than income - and the reasoning that led to this result.[29]  The court observed that capital gains status was out of the question because the acquisition of the gain-making shares by the subsidiaries and their sale had been “pre-ordained”[30]  The concept that a pre-ordained sale pre-empts capital gains status could be troublesome, e.g., in respect of a series of transactions involving a pre-sale reorganization which ultimately leads to a sale of an asset.[31] 

Hopefully, this will be clarified in another case.  Personally, however, I am not really fussed about the issue.  The real point may be that the court was not sympathetic to the appellants, so that this line of reasoning could end up being largely confined to the case.  On that note, I think that Faraggi is also indicative that the Federal Court of Appeal – usually the court of last resort – is not particularly sympathetic to taxpayers.  In a very unscientific attempt to check this out, I counted the last 50 Federal Court of Appeal decisions on my system (other than those dealing with procedural-type issues).  I counted only three which went in favour of taxpayers.