Tax Blog

Federal Charities that Haven’t “Continued” under New Legislation Risk Triggering Tax Liabilities

October 17, 2014, three years from the date the Canada Not-for-profit Corporations Act (CNCA) generally came into force, is the deadline under the CNCA for federal charities and non-profits incorporated under the old Canada Corporations Act to formally “continue” under the CNCA.  The requirements for the transition are described here.  Corporations Canada intends to start the dissolution process immediately for charities and non-profits that have not continued by the deadline.

For an active charity, dissolution could involve disastrous GST/HST implications in addition to potentially crippling income tax implications.  The charity would cease to exist as a legal person, which would generally lead to the revocation of its status as a registered charity.   Consequently, supplies by the charity that were previously GST/HST exempt because of that status could become taxable.

Steps should be taken immediately by any federal charity that has not yet continued under the CNCA.

This blog was co-written by Noah Sarna and Rosemary Anderson.

CRA confirms that a two-partnership structure would not constitute a tiered partnership

In 2014-0528001E5, the CRA was asked to consider a situation where an existing partnership (Partnership A), having an off-calendar fiscal year end, formed a second partnership (Partnership B) indirectly through a subsidiary of Partnership A (A Co).  The other partners of Partnership B dealt at arm’s length with the members of Partnership A.  The CRA confirmed that s. 249.1(1)(c) would not apply to force Partnership A to have a fiscal year end of December 31.  Partnership A’s indirect investment in Partnership B – through A Co – would not in and of itself engage s. 249.1(1)(c), because that provision contemplates a membership interest in one partnership that is held, directly or indirectly through one or more partnerships, by another partnership.  Here the interposition of A Co would break the required link between Partnership A and Partnership B.

CRA says non-interest-bearing loan may engage s. 69

In 2014-0532651E5, the CRA said that a non-interest-bearing loan from one Canadian corporation to another (the latter, a charitable foundation) may engage s. 69(1)(a) if the loan were not repayable on demand.  In these circumstances, the CRA is of the view that the cost of the loan may be less than the principal amount – engaging other rules such as the interest accrual rules in s. 12(9) and Regulation 7000.  However, I find it difficult to see how s. 69(1)(a) could apply in these circumstances.  Even if the two corporations are not dealing at arm’s length, it would seem difficult to conclude that the corporation which makes the loan actually acquires the loan “from” the other corporation (as required by the text of s. 69(1)(a)).

Finance releases revised back-to-back financing rules

Canada has long had an inbound financing rule designed to ensure that Canada’s thin capitalization rules could not be circumvented through a back-to-back loan – phrased in terms of one non-resident member of a group lending funds to another person (an intermediary) on condition that the intermediary in turn lend funds to a Canadian member of the group. In the February 11, 2014 federal budget, the government announced expanded rules designed to capture certain variations of back-to-back loans and their economic equivalents, not only for thin capitalization purposes but also for withholding tax purposes. These rules were further revised when released as draft legislation in August 2014. My Quick Report contains is a very high-level description of these rules, as applied to a foreign-controlled corporate group.

CRA confirms assignment of debt does not constitute repayment

In 2013-0482991E5, the CRA was asked to consider a situation where a Canadian subsidiary (Canco) of a foreign parent (Parent) had lent funds to a foreign company in the group (Debtco). Canco owed Parent a like amount. Rather than Debtco repaying Canco and Canco repaying Parent, Canco simply assigned to Parent the debt owed by Debtco. The CRA confirmed its view that this assignment would not constitute “repayment” of the debt by Debtco for purposes of s. 15(2.6). Accordingly, if the debt remained owing by Debtco for more than one year after the end of the taxation year of Canco in which the loan was made, the loan would be deemed to be a dividend paid by Canco under s. 15(2) and s. 214(3)(a) – triggering Canadian withholding tax (see page 4). Furthermore, if the loan owed by Debtco were instead “novated” to avoid this withholding tax, the CRA would consider applying the general anti-avoidance rule in s. 245 (see page 5).

McKesson: Appellate Advocacy and the Recusal of a Trial Judge

The rules which govern the adversarial trial and appellate process, as distinct from the inquisitorial process, have evolved to help ensure that the issues, as defined by the parties, are decided on the evidence as led by the parties and the applicable law. Counsel are advocates on behalf of the parties and the judge is an impartial adjudicator who hears the evidence, listens to submissions, decides the facts on the basis of the evidence, applies the law to the facts and renders a decision. The appeal process is to ensure that error on the part of the judge may be identified and, where necessary, remedied.

Within this, the conduct of counsel is to be governed by applicable professional rules of conduct including civility and the process, as between counsel and as between counsel and the judge is not to be personal and is not to be personalized. That said, advocacy may be forceful, trials may be fiercely contested, opposing counsel may disagree with one another and counsel and judges may also at times find themselves in disagreement.

And while disagreement will generally be couched in appropriate legal language, such as that a trial judge has erred in his or her interpretation or application of law or has misapprehended the evidence, the legal language and the formal trial or appellate process may not eliminate the fact that counsel who have been ruled against, or a judge whose judgment has been appealed, will feel a personal sting. The robes of counsel and of the judiciary will not always protect against this.

The recent decision of McKesson Canada Corporation v. The Queen, 2014 TCC 266 provides a rare example of where it appears that litigation became, or was perceived as becoming personal as between counsel and the trial judge. In McKesson, the trial ended and appellant’s counsel filed an appeal. However, the trial judge was still seized with the issue of costs and a second incidental issue. On the basis of the notice of appeal and factum that was filed by counsel for the appellant, the trial judge recused himself on his own motion from hearing and deciding the remaining issues.

To begin, it is uncommon that a trial judge would refer to a notice of appeal or factums which have been filed against his or her judgment, but in McKesson the judge wrote:

It is not my habit to review the factums filed in the Federal Court of Appeal in respect of my decisions. In this case, the Appellant’s Factum was drawn to my attention or sent to me by several prominent Canadian tax lawyers as well as by a colleague on the Court.

With the factums having been brought to his attention, the trial judge wrote that he “became aware that the Appellant and Appellant’s counsel… had made certain public written statements about me in its factum in the Federal Court of Appeal…which, upon reflection, appear to me to clearly include:

  1. allegations that I was untruthful and deceitful in my Reasons;
  2. clear untruths about me, what I said and heard in the course of the trial, as well as the existence of evidentiary foundations supporting what I wrote in my Reasons; and
  3. allegations of impartiality on my part.”

It is on this basis that the trial judge decided, on his own motion to consider whether to recuse himself.

In his reasons, the trial judge observed that “[c]ounsel on each side in the appellate court is free to make whatever arguments they wish, including claiming or denying support in the record, the use of emphasis and spin, or even trying to argue a case it thinks it can win instead of the case it has. That is all of counsel’s choosing…” That said, the trial judge did not leave it for the appellate court to decide whether the appellant’s “emphasis and spin” had merit such that the appeal must be allowed. And, for purposes of the recusal motion, the trial judge considered and addressed several of the grounds of appeal advanced by the appellant and it is in this portion of the reasons that the apparent division between the appellant and appellant’s counsel, and the trial judge becomes unfortunate.

To illustrate, under the heading “Where it Appears That the Appellant States in its Factum Untruthful Things About the Trial Judge”, the trial judge referred to the appellant’s factum in which it was pleaded that “the Trial Judge discarded the case pleaded and argued by the parties and decided the appeal on grounds that were not raised in the pleadings or argued at trial, but made their first appearance in the Trial Judge’s Reasons well after the trial was over.”

The trial judge addressed this as follows:

 It appears very clear to me that, while the Appellant may have every right to seek to challenge the evidentiary foundation of my conclusions and findings, they have simply told clear untruths about me and what I did or did not say when they state that McKesson’s tax motivation was not ever put to them during the trial and that they were therefore deprived of any opportunity to address it. (Emphasis added)

The trial judge used similarly strong language as he addressed other arguments advanced by the appellant. For example, in response to whether the trial judge addressed a particular issue in the course of the trial, the trial judge wrote: “One can read what they will into the Appellant’s decision not to argue the point or conduct redirect examination, but it appears to me to be patently untrue that I did not raise it with the Appellant early, at times when they could respond with additional evidence, with a summary of the evidence to change my impression, or with whatever legal argument they chose.” (Emphasis added)

Further, and similarly: “For the Appellant to state in their Factum that I am the one who raised these issues, without them ever being raised at the trial, and that I raised them independently for the first time in my Reasons, appears to me to be the Appellant again telling clear untruths about me.” (Emphasis added)

In a separate section, the trial judge concluded that the appellant’s factum was “deliberately misleading” and “inherently and demonstrably untrue”. “I believe the Appellant was telling untruths about me that go beyond the appellate advocacy craft of colour, spin and innuendo.”

The trial judge concluded that on the basis of the “public allegations” raised by the appellant, “I am unable to decide the remaining matters impartially.”

In his concluding remarks, the trial judge addressed the personal attack which he perceived had taken place against him:

Canadians should rightly expect their trial judges to have broad shoulders and thick skins when a losing party appeals their decision, but I do not believe Canadians think that should extend to accusations of dishonesty by the judge, nor to untruths about the judge. Trial judges should not have to defend their honour and integrity from such inappropriate attacks. English is a very rich language; the Appellant and its counsel could have forcefully advanced their chosen grounds for appeal without the use of unqualified extreme statements which attack the personal or professional integrity of the trial judge.

Within the law governing the circumstances under which a judge must recuse him or herself, there is a presumption that members of the judiciary are impartial and it is a presumption that is not easily set aside. The test as characterized by one court is to ask: “What would an informed, reasonable and right-minded person, viewing the matter realistically and practically, and having thought the matter through, conclude?”

The McKesson case will almost certainly prompt discussion and debate within the legal community and it might be that the community will one day have the benefit of the wisdom and guidance that might flow from the decision of an appellate court. Until then, informed, reasonable and right-minded people will likely view it as altogether unfortunate that the appellate advocacy of senior and respected counsel has caused a senior and respected trial judge to find that he has been accused of dishonesty, and in so finding, to also conclude that statements which are untrue have been made against him. For the parties to the litigation who hope to have the legal issues addressed and resolved, for the legal community which is generally close knit and collegial, and for the public who is looking in, this is unfortunate indeed.

CRA issues another favorable ULC ruling under the Canada-US treaty

When the Canada-US tax treaty was amended by the Fifth Protocol (effective 2010), new Article IV(7)(b) was added to eliminate treaty benefits for certain hybrid entity arrangements which generated deductions in Canada but no corresponding income pick-up in the US.  The actual wording of the new rule inappropriately extended to simple Canadian unlimited liability company (ULC) structures, which did not achieve this mischief.  For example, Article IV(7)(b) applied to deny the treaty withholding tax rate on interest and dividends paid by a Canadian ULC to its a US parent company, notwithstanding that the ULC was disregarded for US tax purposes and therefore all of the ULC’s income was (immediately) taxed in the US.  The Canada Revenue Agency (CRA) has since issued favorable rulings which allow such US parent companies to restructure and thereby avoid the technical application of Article IV(7)(b).  Ruling 2013-0491331R3 (recently released) is the latest of such rulings:

  1. The US parent formed a limited partnership with one of its shareholders, and thereafter transferred to the partnership its interest-bearing noted owed by the ULC.
  2. This simple step meant that the actual wording of Article IV(7)(b) would not be engaged, and interest paid by the ULC to the partnership would be exempt from withholding tax under Article XI(1) of the treaty.
  3. The CRA further confirmed that Canada’s general anti-avoidance rule would not apply because all of the ULC’s income would continue to be subject to tax in the US.  In other words, no abuse arose because the restructured arrangement did not result in the mischief to which Article IV(7)(b) was directed.

Canada Revenue Agency Won’t Follow Court of Appeal on Change in Use Rules. Is This Right?

Suppose you disagree with a CRA assessment and appeal the issue to the Tax Court. Suppose you lose the case. And suppose you decide the court is wrong in its reasoning and file your next tax return on the basis that your interpretation of the law is the correct one, what would you expect the CRA to do with your return? Exactly: a reassessment disallowing your position.

Now suppose that the decision went the other way and it’s the CRA who lost. Like you, the CRA believes the court got it wrong and that its position is correct. It publishes a technical interpretation to this effect. What happens now? In a nutshell, this is what’s happened following the decision last year in the Federal Court of Appeal in the CAE Inc. v The Queen case.

One of the issues considered by the court was the proper application of the change in use rules in subsections 45(1) and 13(7) of the Income Tax Act. Very generally, those rules provide that when property that has been acquired for an income earning purpose is used for some other purpose (and vice versa), then there is a deemed disposition of that property at its fair market value. If the property has appreciated in value, there will be an income inclusion and additional tax to be paid even though there is no actual sale and no receipt of any sale proceeds with which to pay the tax. Until the CAE case, the CRA’s administrative position was to limit the application of these rules to cases in which the use of the property changed in whole or in part from a personal use to an income producing use, or vice versa. Importantly, the rules were not applied when property was converted from inventory to an income earning capital use, and vice versa. (See Interpretation Bulletins IT-102R2 and IT- 218R.)

Frankly, the CRA’s administrative position here made a lot of sense. As long as the property continued to be used for income earning purposes, it was not essential to treat the change as a realization event. Certainly this was so for taxpayers, since it avoided what otherwise might have been a difficult valuation exercise. And the CRA benefited too in that enforcing a change in use disposition could raise significant compliance and administrative burdens. But the FCA says the CRA was wrong in interpreting the Act this way, so what should the CRA do?

The answer from the CRA is that they do not agree with the FCA’s analysis. In its view, it leads to an untenable result, one that does not accord with the object, spirit, and context of the provisions in question. (This is a précis of the CRA’s position as set out in recently published Technical Interpretation,  2013-0493811C6, issued in response to a question put to it at the 2013 Annual Conference of the Canadian Tax Foundation.)  Accordingly, the Agency will continue to apply the change in use rules in accordance with its established administrative practice, notwithstanding the FCA’s decision. What’s going on here? Is the Agency entitled to disregard a decision of the FCA that it thinks is wrong? Taxpayers don’t have this luxury.

In fairness to the CRA, it acknowledges the difficulty here. It can’t just ignore the decision as if it didn’t happen. To side step the issue, it takes the position that the FCA’s comments on the change in use point were obiter dicta – that’s lawyer speak for comments that are not binding because they are not essential to the court’s main conclusion. However, it is not at all clear to me that the comments are obiter. And even if they are obiter, the court deals with the interpretation of the change of use rules at some length, in response to submissions it expressly requested from counsel for both sides. So it’s hard to dismiss the remarks as unimportant.

That being said, as I have indicated, it seems to me that the CRA’s analysis makes a lot more sense than the one developed by the court. So here’s the dilemma. Should we cut the CRA some slack here and ignore the fact that they are disregarding a specific finding of the Court of Appeal, on the basis that it seems to make sense to do so? Does it matter that we are saying that it’s OK for the CRA to ignore the law established in a decision if it thinks the result of that decision is wrong? Is the CRA above the law? I’m not at all comfortable with the CRA’s response in this case. As a professional tax advisor, it puts me in a difficult position. The CRA’s position makes sense, but I have doubts that it is still correct in view of the court case. Can I advise my clients to rely on the Agency’s published position? Not without some reservations. It’s apparent from other cases that the Agency feels free to disregard its administrative practices when it wants to. So I’m between a rock and a hard place in counseling clients on what to expect here.

Could the Agency have approached the matter differently and reached the same result without appearing to put itself above the law? I think so. Instead of saying that the Court of Appeal had misinterpreted the law, the Agency could have published a note saying that it was concerned about the implications of the court’s decision on the change in use rules. It could have said that it was asking the Department of Finance to propose a clarifying amendment to the Act confirming its administrative practice. In the meantime, it could add, it would continue to administer the provisions on the old basis on the assumption that the clarifying amendment would have retroactive effect to the date of the CAE Inc. judgment. By doing so, the Agency would affirm that it respected the decisions of the courts, while achieving the desirable result of continuing its preferred administrative practice. It’s disturbing that the CRA approached the matter the way that it did. Like us taxpayers, it’s subject to the law even when it may not like it.

A Review of Litigation Principles

Simply stated, litigation is the process whereby a legal dispute between parties is resolved by applying the facts to the law. At least in theory, these two factors (facts and law) are to determine the outcome of the dispute and it is on these two fronts that the battles of litigation are waged. Therefore, a litigation strategy must include establishing facts, controlling the evidence that will be presented to a judge, determining what law is applicable and convincing a judge as to the proper interpretation of the applicable law.

The recent decision of Bekesinski v. The Queen, 2104 TCC 245 is generally unremarkable in that it does not establish or clarify any important point of law. However, the decision serves as a good illustration of how litigation is won and lost. The point in dispute was simple – the Appellant was assessed as a director of corporation and his position was that he had resigned and that the assessment should therefore be vacated.  During the trial, the Minister argued that the resignation was backdated and not authentic or valid.

In allowing the appeal, the court addressed a number of commonly encountered tax litigation issues. To begin, the court set the framework which is that in the appeal, the Appellant was required to “demolish the Minister’s assumptions by making out a prima facie case on a balance of probabilities”. Citing the Federal Court of Appeal, the court defined a prima facie case as “one supported by the evidence which raises a degree of probability in its favour that it must be accepted if believed by the Court unless it is rebutted or the contrary is proved.” If the Minister’s assumptions are rebutted, the onus moves to the Minister to prove the assumptions on a balance of probabilities.

Next, the court held that a fact is not “inherently”, or as a matter of law, probable or improbable. Instead, whether a fact or event is probable or improbable is to be determined, by the judge, on the basis of the relevant evidence.

That said, experience in litigation reveals and the following passage from Bekesinski illustrates that fact finding may also very much be based upon judicial experience. On the issue of backdating the notice of resignation as a director, the court stated: “I do not believe that the alleged backdating of the Resignation is an improbable event as the Appellant Counsel (sic) has characterized it. Documents of convenience are often part of the evidence in tax appeals [and] backdating of a document is not an event I would characterize as a highly unusual allegation.”

While the judgment does not reveal if evidence was led on whether backdating of documents is common or uncommon, it appears that this finding of fact was based upon an impression or, what is at times described as judicial experience.

In addition to judicial experience, “common sense” is also at play. Citing case law, the court in Bekesinski affirmed that in addition to other factors that relate to the assessment of credibility, “common sense” may and should also be used “to determine whether the evidence is possible, impossible, probable or highly probable.”

In the result, the court held that while the Appellant’s explanations about the Resignation and whether it was backdated were “plausible”, there was no expert evidence upon the issue and the Appellant was therefore successful in demolishing the Respondent’s assumptions. The court stated: “Despite the Respondent’s allegation of backdating, the Respondent failed to produce evidence that would prove, on a balance of probabilities, that the Resignation is not authentic…I question the authenticity of the Resignation but, without the appropriate evidence before me, I must allow the appeal.”

In arriving at the result, the court observed that the “Respondent made a series of litigation choices which have resulted in my conclusion.”

The conduct of litigation is very much about making choices based upon law, evidence, procedure and a good dose of common sense mixed with experience. There are good decisions, there are bad decisions, and there are those which must be based upon judgment and which could go either way.

Bekesinski illustrates how “litigation choices” can play out – in that case, unfavourably for the Minister.   Not every case can be won. However, even winning cases can be lost and a successful litigation strategy must be based upon controlling the litigation process and making the right decisions at the outset for it is often the decisions that are made early on that shape the litigation and either increase or decrease the chances of success.

FATCA, Constitutionality, and Canadian Sovereignty

On August 11, two women filed a lawsuit against the federal government claiming that certain legislation enacted in response to the Foreign Account Tax Compliance Act (“FATCA”) is unconstitutional. The case has potentially far-reaching effects for the estimated one million American and dual U.S.-Canadian citizens who reside in Canada.

By way of background, FATCA was enacted in March 2010 and obligates U.S. payors to withhold 30% of payments made to foreign financial institutions (“FFIs”) unless the FFI discloses certain information regarding the recipient accountholder. This information can include the accountholder’s name, SSN or SIN, and residential address.

In February 2014, Canada entered into an intergovernmental agreement (the “IGA”) which alleviates certain of the more onerous aspects of FATCA. For example, the IGA provides that certain accounts are exempt from being reported on, recalcitrant accounts are not subject to immediate closure, and certain smaller FFIs are not subject to the reporting requirements at all. A previous blog piece – “Big Brother Gains a Powerful New Tool” (found here) – discusses the IGA in more detail.

By the lawsuit, the plaintiffs effectively argue that the IGA and the domestic legislation implementing it (the “Impugned Provisions”) are unconstitutional. The plaintiffs claim that the Impugned Provisions violate the Constitution Act, 1867, unwritten constitutional principles (including the principle of Canadian sovereignty), and the Charter of Rights and Freedoms (the “Charter”).

Whether the IGA is constitutional has been the subject of considerable debate recently. Indeed, in December 2012 Professor Peter Hogg (one of Canada’s leading constitutional experts) sent a letter to the Department of Finance alleging that the model intergovernmental agreements promulgated by the IRS at that time would (if implemented) unjustifiably violate the Charter. The IGA is based largely upon the Model 1 version analyzed by Professor Hogg.

The lawsuit essentially asks the Court to declare all of the Impugned Provisions unenforceable. The result of such a declaration, however, could have disastrous consequences. Without the IGA, the full force of FATCA could be felt, meaning that Canadian financial institutions would be required to report directly to the IRS or else be subject to the full 30% withholding tax. It could also mean, among other things, that more accounts (e.g., RRSPs and TFSAs) will become reportable accounts. In short, FATCA itself will continue to exist without or without the IGA.

If the plaintiffs are successful, there are several remedies available to the Court ranging from severing or reading down certain of the Impugned Provisions, to declaring the offending statutes invalid and issuing an injunction against the Canada Revenue Agency from complying with the IGA. Alternatively, the Court could side with the plaintiffs but delay the enforcement of its decision for a reasonable period of time to allow a new, more narrowly-drafted IGA to be signed with the U.S. It would not be surprising if the case eventually reaches the Supreme Court of Canada.

One of the plaintiffs’ claims is that by entering into the IGA, “Canada is forfeiting its sovereignty by facilitating the extra-territorial taxation of Canadian citizens by [the United States].” A serious allegation and one that goes to the core of the Canadian identity.