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:
- 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.
- 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.
- 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.
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.
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.
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.
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.)