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Tax Notes – April

Closer Encounters with the CRA

 

In last month’s article – “Close Encounters with the CRA” - I talked about some recent developments pertaining to CanRev.  This month, I would like to continue on the same theme, but this time around, with more of a focus on what could be increasingly Draconian strategies on the part of the CRA in an effort to bring in much-needed tax revenue. 

Self-Assess Or Else – Or Else What?

Just after last month’s article came out, one of our readers asked a couple of interesting questions about the CRA’s “self-review” letters I discussed in the article.  First question: If a taxpayer gets a CRA letter, will he or she be eligible to make a voluntary disclosure, or would this be disallowed by the CRA on the grounds that the taxpayer is already under review?  While it is not categorical, the February 4th CRA release pertaining to the self-review letter initiative seems to suggest that a self-review letter will not preclude a voluntary disclosure, indicating that the CRA wishes to “provide taxpayers the opportunity to amend their income tax returns by completing an adjustment request and/or by making a voluntary disclosure in cases where the taxpayer may have claimed deductions in error or provided inaccurate information”.[1]  

The reader also asks: If the taxpayer is reassessed down the road on an item contained in a letter, will the client immediately be hit with a gross negligence penalty?  For what it’s worth, I think that if it turns out that the taxpayer has no proper basis for the claim, the fact that it has been brought to the taxpayer’s attention by the CRA without a response would help to provide a basis for contending that he or she is deliberately disregarding the tax rules[2].   

Lipson Aftermath 

Just over a year ago, I wrote an article on the effect of the Supreme Court of Canada decision in the Lipson case on personal tax planning[3].  A Lipson-type strategy could be used, for example, to make mortgage interest deductible, as well as to achieve asset protection.  Although the tax rules brought into play in Lipson have a certain degree of sophistication, the Lipson fact situation itself couldn’t be simpler: Wife borrows to buy shares[4] from husband, which are flipped over to wife on a tax-deferred basis – in my view, that’s the simple kernel of Lipson.  Ignoring GAAR for the moment, because the shares roll over to the wife, the attribution rules trip in, leaving the interest deductible by the husband.   

In Lipson, the taxpayer was GAARed on the basis of a misuse of the attribution rules, with the result that the husband could not deduct the interest expense.[5]  Trouble is, you can’t “GAAR yourself” – the CRA must do this.  So if you are in the Lipson situation, how would you file - in view of the fact that the highest court in the land has nixed the transaction (albeit, in a split decision)? 

This question was put to the CRA at the 2009 APFF Financial Round Table[6]; an English translation of the answer was released a few days ago.  The CRA indicates that, in a Lipson replay, the individual and his spouse would be taking part in transactions that have already been “deemed abusive” by the Supreme Court of Canada.  The CRA indicates that, in the circumstances, it “might consider” applying the 50% “gross negligence” penalty.  In addition, the application of third-party civil penalties might be considered.   

While I can’t say that the CRA’s answer is wrong in the technical sense, the fact situation that could get a taxpayer into a Lipson-type situation is very simple and straight forward – so much so that one could unwittingly stumble into it. [7]   

So how do you avoid the CRA’s hellfire and brimstone, for example, if a Lipson-style flip was done before the Supreme Court of Canada verdict came out?  Unfortunately, the CRA doesn’t really answer the APFF’s question – i.e., how do you file a return if you can’t GAAR yourself?  Alternatives were canvassed in my article last year:  For example, one possibility is to take the position that the subsection 75.5(11) anti-avoidance rule applies, so that both the income or gain on the transferred asset itself, as well as interest on the indebtedness in question, would be taxable/deductible to the transferee-spouse.[8]  Another alternative is to take the position that Lipson does not apply, e.g., perhaps the strategy was structured on a different basis or was undertaken for non-tax reasons.  However, in view of the CRA’s harsh statements, this alternative should be considered very carefully.[9]  

What if the transferor opts-out of the spousal rollover – e.g., wife borrows to buy the shares or other appreciated property, but husband flips the property to the spouse on a taxable basis, so that there is a deemed sale of the property at fair market value?  The CRA’s view is that this situation differs from Lipson.  The transferee-spouse could deduct the interest on the borrowing made to acquire the shares, to the extent that the normal tax conditions relating to interest deductibility are met[10].  Of course, paying tax on a transfer may not be desirable; however, if the deferred tax exposure is modest or non-existent, or the capital gains exemption is available to shelter the gain, this may not be a bad move. 

Ten Years After 

As I noted, the CRA says it might invoke the third-party civil penalties in the case of a Lipson replay.  The same topic caught my eye earlier last month in a CRA release pertaining to “shady” tax preparers and promoters.[11]  The release notes that, since the civil penalties legislation was introduced close to a decade ago, close to 100 third-party penalty audits are either in progress or have been completed.   

Frankly, I am surprised that the number is that high.[12]  Although these penalties attracted a lot of fuss when they first came out – including from the author - in recent years relatively little has been written about them.  At the time, my guesstimate was that it would be about a decade before the program started to get a full head of steam. 

 While it has been stated that the CRA would apply the civil penalties only where there has been egregious conduct[13], my prediction, based in part on the CRA news release I mentioned earlier, is that as the decade goes on, the imposition of these penalties will become at least somewhat more common.  (For example, one area which has been cited for the application of these penalties could be where the tax preparer becomes “complicit” in his or her client’s hiding income offshore.[14])  Whether they will proliferate - like the director’s and joint-and-several-liability penalties[15] - which were also supposed to be used sparingly - remains to be seen.  Hopefully, “egregious” means “egregious” – like claiming fake charitables - not a big business use on a car.  But I find the APFF statement a bit troubling, especially if the way forward isn’t clear. 

David Louis, tax partner, Minden Gross LLP, a member of MERITAS law firms worldwide. David's practice focuses on tax and estate planning for entrepreneurs and their corporations (dlouis@mindengross.com).