In 2014-0528021E5, the CRA usefully discussed the taxation of timber limits. Some quick observations:
- A timber limit typically represents the right to cut timber which arises from fee simple ownership of the underlying land (page 3).
- A timber limit which is not held on income account (i.e., is not inventory) may be treated as a depreciable capital property. As such, capital cost allowance (CCA) may be claimed separately in respect of the cost of each timber limit under s. 1101(3) and Schedule VI of the Regulations (pages 3-5).
- A sale of the (residual) land after timber has been removed could result in recapture for proceeds up to the original capital cost, and a capital gain for proceeds in excess of original capital cost (page 6).
- Timber limits are not included in Class 15 (page 5). Assets typically included in Class 15 are those acquired for the purpose of cutting and removing merchantable timber from a timber limit in a situation where the property is likely to be of no further use after all merchantable timber has been removed (page 5).
In 2014-0536331E5, the CRA ignored a technical timing problem on the liquidation of a foreign affiliate. In the CRA’s view, the deemed disposition of active business assets at fair market value under s. 88(3)(b) should not generate foreign accrual property income (FAPI) for the liquidating affiliate, notwithstanding that such disposition technically occurs at a time when the foreign affiliate no longer owns the property.
Distributions from a partnership in excess of a partner’s basis in its partnership interest can generate a deemed gain to the partner (s. 40(3.1)). In 2011-0417491E5 (recently released) the CRA said that technically such a gain realized by a non-resident partner would not be taxable in Canada – even if the partnership interest was “taxable Canadian property”. The CRA considers this technical (tax free) result to be contrary to tax policy. Accordingly, the CRA has advised the Department of Finance and would seek to tax any such gain under the general anti-avoidance rule if a transaction resulting in the gain was an “avoidance transaction” (under s. 245(3)). Furthermore, in the CRA’s view, the partner would still have an obligation to file a Canadian tax return reporting the deemed gain (under s. 150(1)(a)(i)(C)).
In Inter-Leasing, Inc. v. Ontario (Revenue), 2014 ONCA 575, rev’g 2013 ONSC 2927, the Ontario Court of Appeal (OCA) upheld an internal group financing arrangement which eliminated provincial income tax on interest paid by Alberta-based companies (Alberta Cos) to a BVI-incorporated company having a permanent establishment (PE) in Ontario (BVI Co). The Alberta Cos deducted the interest for both federal and Alberta income tax purposes (on this point, see Husky Energy Inc. v. Alberta, 2012 ABCA 231, leave to appeal refused  S.C.C.A. 411). BVI Co paid federal tax on the interest received, but claimed it was exempt from any Ontario tax on that interest. Ontario reassessed BVI Co for provincial income tax on the ground that either (1) its interest income was “income from a business” carried on in Ontario, or (2) the arrangement was abusive tax avoidance which could be set aside under Ontario’s general anti-avoidance rule (GAAR). Ontario won at trial. On appeal, the OCA soundly rejected both arguments:
- The interest income was not income from a business, but rather was income from property – having regard to the Supreme Court of Canada’s decisions in Canadian Marconi Company v. The Queen,  2 S.C.R. 522 and Ensite Ltd. v. The Queen,  2 S.C.R. 509. The rebuttable presumption that a corporation carries on a business was “not helpful” (paragraph 31), and the activities associated with earning the interest income were virtually non-existent (paragraph 35).
- The internal financing did not result in abusive tax avoidance. Prior to 2005, Ontario made a clear and deliberate choice to tax corporations based on place of incorporation – not residence (paragraph 55). That is, under the applicable provision a corporation incorporated outside Canada (and having a PE in Ontario) was subject to tax on its income from business, but not on its income from property (paragraph 56). Here was a clear example where the underlying rationale of the provision was no broader than the text itself (paragraph 61). Accordingly, the internal financing arrangement did not produce a result that the provision sought to prevent, did not defeat the underlying rationale of the provision, and did not frustrate the object, spirit or purpose of the provision (paragraph 62). The fact is that provincial tax systems can differ, and the risks of differential tax treatment which can arise as a result have long been recognized (paragraph 58).
The OCA also rejected Ontario’s claim for corporate minimum tax. The debt instruments held by BVI Co were situated outside Canada, and the GAAR did not apply to alter that result.
A Tax Evasion Prosecution, an Acquittal and a Civil Action for Malicious Prosecution and Negligent Investigation Against CRA
The facts in the recent case of Samaroo v. Canada Revenue Agency, 2014 BCSC 1349 are not complicated. An investigator for CRA obtained a search warrant and the warrant was executed at the plaintiffs’ business and residence. Then CRA reassessed the plaintiffs. Tax evasion charges were also approved, a trial was conducted and the plaintiffs were acquitted. The plaintiffs then commenced an action for malicious prosecution and negligent investigation against both CRA and the prosecutor who had conduct of the prosecution.
The plaintiffs applied for the production of documents and the documents sought included communications between the CRA investigator and a lawyer at the Public Prosecution Service of Canada (PPSC), communications between PPSC lawyers and communications between PPSC and the lawyer who had been retained as agent to PPSC to conduct the prosecution.
The application was resisted on grounds that included relevance, crown immunity privilege, public interest immunity and solicitor client privilege.
In ordering production of a large number of the documents sought, the court noted that for an action for malicious prosecution to succeed, the plaintiff must prove that there was a prosecution that ended in the accused/plaintiff’s favour, that the prosecution was commenced without reasonable and probable cause and, that the prosecution was motivated by malice. According to the civil rules, documents that “are or have been in a party’s possession or control that could, if available, be used by any party of record a trial to prove or disprove a material fact” must be produced.
Against this legal framework, the court held that it is relevant to know what information the prosecutor had about the case “including any weaknesses in the evidence, both in the lead-up and during the prosecution. All of his communications on those points (and even communications among the PPSC counsel regarding the evidence that lead to the charges being laid) are relevant to that point.” Further, the court held that documents relating to the phase of charge approval, the prosecution and the post-acquittal phase are all relevant.
The court also rejected the argument that Crown immunity privilege could serve to block production of the documents. Crown immunity refers to prosecutorial independence and the discretion of the Crown with respect to the commencement and conduct of prosecutions. However, the existence and recognition of Crown immunity privilege does not act so as to prohibit claims against the Crown for malicious prosecution.
In Samaroo, the court held:
In a malicious prosecution claim the court is permitted to examine the exercise of prosecutorial discretion, not for the purpose of interfering with it in some way, but for the purpose of determining whether there has in fact been some “abuse or perversion of the system of criminal justice for ends it was not designed to serve” (Nelles). Given that Crown immunity does not bar a claim for malicious prosecution, Crown immunity cannot prevent disclosure of charge approval materials in such cases.
The court similarly rejected the argument based upon public interest immunity.
In cases involving an allegation of unconscionable behaviour by the government or its agents, there is an argument in favour of disclosure as the government cannot be permitted to hide behind secrecy in order to facilitate improper conduct; in that case, releasing the documents helps to support the public interest in seeing that justice is done…
In this case, non-disclosure may lead the public to infer that there is something being “hidden” from public view, thereby undermining their view of the justice system.
In the result, the court found that one document was protected by solicitor client privilege and one, which contained a password to an internal website was also not subject to the order for production. With respect to the others, the court found: “Although some of these documents appear to set out some of the PPSC policies as regards tax evasion cases, I think the balance tips in favour of disclosure.”
A decision to commence an action for malicious prosecution is not to be taken lightly because an acquittal alone does not necessarily prove that there was no proper basis for the prosecution or that the prosecution was conducted for an improper purpose. More is needed.
However, the broad authority given to CRA to conduct the investigation of tax evasion offences, and to the Crown to conduct the prosecution of those offences requires accountability. Malicious prosecution and negligent investigation are important causes of action because, in appropriate cases, they help to ensure the accountability of government actors in the exercise of their powers.
What the documents which were ordered to be produced in Samaroo might or might not prove, and whether liability will be found on the facts of the case is a separate matter. Time, and the unfolding of the litigation will tell. What makes the decision of interest is that on the basis of a careful legal and factual analysis of each of the grounds advanced for resisting production, the court ordered production of documents and allowed the litigation to proceed on the basis of all relevant evidence.
Further, what this case illustrates is that a claim of privilege or immunity is just that – a claim. More importantly, these are claims which can at times be defeated through carefully conducted litigation.
In 2014-0523041C6, the CRA was asked whether a US Limited Liability Limited Partnership (LLLP) should be treated a foreign partnership, a foreign corporation, or some other type of arrangement (for Canadian tax purposes). The CRA applies a two-step process to characterize foreign business arrangements. First, the characteristics of the foreign business association are examined under foreign commercial law, as well as any other relevant documents such as a partnership agreement or other contracts. Second, these characteristics are compared with those of recognized types of business associations under Canadian commercial law, in order to classify the foreign business association under one of those categories. The CRA said it had not previously considered the tax character of a US LLLP, but would do so in the context of an advance income tax ruling. (In fact, the CRA has previously ruled that an LLLP was a partnership in a tower financing structure: see 2010-0386201R3, Ruling K.)
In C.A.E. Inc. v. Canada, 2013 FCA 92, the Federal Court of Appeal (FCA) said that the change-in-use rules in s. 13(7) and s. 45(1) should apply when property, initially held as inventory, begins to be used as depreciable property (and vice versa). In 2013-0493811C6, the CRA disagreed with this view. The CRA will therefore continue to apply its position outlined IT-102R2 and IT-218R, i.e., that these change-in-use rules apply only where the use of property changes, in whole or part, from a personal use to an income-earning use (and vice versa). The CRA adopts this position because:
- The FCA’s view would require the same words to be interpreted differently for business property and personal use property; this problem was acknowledged by the FCA (page 3).
- The FCA’s interpretation may not be consistent with the “object, spirit and context” of the provisions (page 3).
- Reporting requirements and potential tax liability for every change from inventory to income-earning capital use, and vice versa, could represent a significant compliance and administrative burden (page 3).
- The FCA’s comments were obiter dicta (page 4).
In McLarty v. The Queen, 2014 TCC 30, the Crown took another run at a tax-structured acquisition of seismic data, having previously lost at the Supreme Court of Canada in respect of a reassessment of the same taxpayer for an earlier taxation year (2008 SCC 26). This time, the Crown advanced different legal arguments – and lost again. The Crown argued, in part, that the transaction was a “sham”: in particular, that a limited recourse promissory note issued as partial consideration for the seismic data was never intended to be paid (paragraphs 14(o) through 14(q)). In rejecting this argument, the Tax Court of Canada said:
- The Crown cannot apply the doctrine of sham to only part of a transaction, while considering another part of the same transaction to be valid and effective. That is, the Crown could not accept the cash portion of consideration paid for the seismic but reject the promissory note portion as a sham (paragraph 78).
- A limited recourse promissory note is – by its very nature – an enforceable legal obligation which ultimately might not be realized upon. Accordingly, possible non-repayment of such a note could not be advanced as evidence of a sham (paragraph 82).
- The transactions were not mere window dressing. The legal rights and obligations created were not different from the actual legal rights and obligations of the parties (paragraph 88; Stubart Investments Ltd. v. The Queen and Snook v. London and West Riding Investments, Ltd.).
The recent decision of Gervais c. La Reine (2014 CCI 119; available only in French) gave the TCC an opportunity to review a common planning technique that spouses use to multiply the use of their lifetime capital gains exemption (CGE) on a sale of qualified small business corporation (QSBC) shares to a third party. Unfortunately for the taxpayers, the TCC decided in favour of the CRA and cast serious doubt on the validity of the technique.
The planning in Gervais relied on the technical application of the spousal rollover in subsection 73(1), the attribution rules in section 74.2, and the averaging rule for identical properties in subsection 47(1). Prior to Gervais, it was accepted that the rules could allow spouses to share their respective CGEs before selling QSBC shares to a third party (subject to the potential application of GAAR).
The general idea behind this type of planning was as follows. Assume that a husband owns 1.6 million QSBC shares with a nominal ACB and an FMV of $1.6 million. His wife owns no shares. The husband wants to sell his QSBC shares to an arm’s-length third party. Instead of selling the shares directly to the third party and realizing a capital gain of $1.6 million ($800,000 of which would be sheltered by the husband’s CGE), the husband first transferred all of his shares to his wife by way of two separate transactions: (1) a sale of 800,000 shares for FMV proceeds payable by a promissory note bearing interest at the prescribed rates (the purchased shares) and (2) a gift of the remaining 800,000 shares (the gifted shares). The husband elected out of the spousal rollover in subsection 73(1) in respect of the purchased shares but not in respect of the gifted shares.
The sale of the purchased shares to the wife was treated as a taxable disposition to the husband; it triggered a capital gain of $800,000 in his hands for which he claimed the CGE. The cost of the purchased shares to the wife became $800,000. In contrast, the transfer of the gifted shares took place on a tax-deferred basis under subsection 73(1) and gave rise to no gain or loss to the husband. The cost of the gifted shares to the wife was nil. Under the averaging rule in subsection 47(1), the wife’s ACB of her 1.6 million QSBC shares was averaged among all of the shares such that she had an aggregate ACB of $800,000. The wife then sold all of her QSBC shares to the third-party purchaser for FMV consideration of $1.6 million and repaid the note owed to her husband. The wife realized a capital gain of $800,000, half of which was attributed to her husband under section 74.2; the other half was included in her income and was offset by her CGE. Overall, this planning strategy technically allowed both spouses to claim the CGE and shelter $1.2 million of capital gain (instead of only $800,000).
The taxpayers in Gervais, a husband and wife, implemented a strategy similar to that in the example before they sold their QSBC shares to an unrelated third party. The CRA reassessed the taxpayers on the basis that the gain realized by the wife on the sale of her QSBC shares to the third party was on income account (and not a capital gain) or, alternatively, that GAAR applied to include the gain in the husband’s income as a capital gain.
The TCC ruled against the taxpayers on the first issue, so there was no need to consider the application of GAAR. The TCC’s findings, however, are surprising: even though the sale of the QSBC shares to the third party was one single transaction, the shares were treated in two separate blocks. In effect, the TCC held that the purchased shares acquired by the wife were not capital property but were held on income account. This conclusion was largely based on the following facts: (1) the wife acquired the shares from her husband with the intention of reselling them shortly thereafter; (2) the shares did not generate any income while she held them; (3) she sold the shares less than two weeks after she acquired them; and (4) she did not pay any money to her husband to acquire the shares (rather, she gave him a promissory note repayable over five years). In contrast, the gifted shares were held to be capital property to the wife.
Despite finding that the purchased shares were on income account, the TCC acknowledged that the wife did not realize any gain on the sale thereof to the third party because her cost in the shares (being the purchase price she paid to acquire them from her husband) was equal to the sale price she received. However, since the gifted shares were held to be capital property and therefore had a nil ACB under subsection 73(1), the sale of the gifted shares to the third party gave rise to a capital gain to the wife, all of which was required to be attributed back to the husband under section 74.2. Note that the averaging rule in subsection 47(1) did not apply because the purchased shares were not capital property. Therefore, the end result is that the entire gain, not just half of it, was recognized by the husband as a capital gain and thus was eligible for the husband’s CGE only. On the other hand, the wife was treated as if she had realized no gain on the sale to the third party, and her CGE remained unused.
By attributing two different characterizations to the same sale of shares, the TCC effectively prevented the spouses from using their respective CGEs to shelter a portion of the gain realized on the sale of their QSBC shares to the third-party purchaser. Some tax practitioners have questioned the correctness of the TCC’s finding that the purchased shares were on income account in light of the fact that the wife had no intention of reselling the shares at a profit, a factor often considered crucial to such a conclusion. That said, although the Gervais decision seems to put a brake on strategies designed to multiply the use of the CGE between spouses, one could argue that this type of planning should nevertheless remain available when the facts support a determination that the purchased shares are on capital account.
* Note: this article was first published by the Canadian Tax Foundation in Tax for the Owner-Manager, vol. 14, no. 3, July 2014.
Murphy’s Law is, as everyone knows, the proposition that “Anything that can possibly go wrong, does.” There are many variants of this. Among tax practitioners, a well known one is the proposition “There is no equity in a tax statute.” Roughly translated, this means that as a taxpayer, you may not rely on the fairness of your position when contesting a tax assessment – fairness has nothing whatever to do with the correctness of the assessment, and Tax Court judges will be quick to remind you of this. Almost always this version of Murphy’s Law is applied against the taxpayer, so it is refreshing to be reminded that from time to time it will be applied against the tax department, too. The recent Tax Court Decision in Henco Industries Limited is a very recent example of this. (See the July 2 blog post “Tax Court finds settlement payment was a non-taxable capital receipt” by my colleague Ian Gamble for a discussion of some of the technical issues in the case.)
The Henco case evolved out of a very difficult set of circumstances at the Town of Caledonia in Ontario. Henco was in the course of building a residential subdivision on lands to which it held legal title, but which a local Aboriginal Band claimed as sacred territory. Certain Band members embarked on a course of conduct designed to halt the development. Initially, this involved acts of civil disobediance, but these quickly escalated into acts of violence against individuals and serious property damage. Acting on orders from the provincial government of the day, the provincial police force declined to take action against the lawbreakers. This was done in full recognition of the consequences for the developer and other property owners in the community. Rightly or wrongly, they were regarded as collateral damage in the larger issue involved, namely, the government’s desire to avoid an all out confrontation with the Band. (The sad circumstances are outlined in detail in a book on the subject by Christie Blatchford, titled Helpless: Caledonia’s Nightmare of Fear and Anarchy, and How the Law Failed All of Us).
The government decided to buy out Henco’s interest in the development and made the company a payment of some $15.8 million. In a short agreement evidencing the settlement, it was stated that the payment was compensation for Henco’s interest in the land and for its release of all its claims of whatever kind in respect of the circumstances leading up to the settlement. Not surprisingly, I suppose, the CRA took the position that the payment should be taxed as net profit from the real estate development. This is what tax departments do when business taxpayers receive substantial sums of money. However, the Tax Court disagreed and decided that not only was the payment of a capital nature (notwithstanding that it was paid to a developer in respect of an interest in its land), but it was not taxable at all under the tax provisions in force at the time. (Those provisions have since been amended.) The decision is of interest to tax practitioners for the judge’s extensive analysis of the distinction between income and capital receipts, and for why he decided that the payment was not subject to tax on any basis. But I like the decision for a different reason.
The circumstances in Caledonia at the time were, to put it mildly, egregious. The government’s decision not to enforce the law in favour of Henco and the citizens of Caledonia was questionable – see the Blatchford book noted above. A direct fallout from the decision as far as Henco was concerned was that it was out of business. The $15.8 million was far less than what it expected to earn from the subdivision. Certainly when looked at from Henco’s perspective, the result was grossly unfair. One level of government chooses not to enforce the law and decides to buy peace by paying off the developer. Then another level of government tries to tax away a significant portion of the payment as if it were income from doing business as usual when whatever business there was had been destroyed as a direct consequence of the first government’s non-action! There’s nothing fair about that, but from the CRA’s perspective I suppose that fairness had nothing to do with the case. While the judge didn’t frame his decision in the context of what’s fair, I can’t help wondering if Murphy, wherever he is, is smiling at this twist on Murphy’s Law of Tax. I know I am.