Earlier this month, the federal government announced that it had reached an agreement with the U.S. to ameliorate the more drastic effects of the Foreign Account Tax Compliance Act (FATCA). The announcement came mere days before the 2014 Federal Budget was released, and was thus, understandably, lost in the fray – especially considering the significance of some of the Budget’s tax measures. As a result, the intergovernmental agreement received relatively little fanfare and most Canadians remain unaware of how it provides the CRA and IRS with a powerful new tool for collecting personal information.
As many will recall, FATCA was enacted by the U.S. government in March 2010 and was designed to curb international tax evasion by requiring disclosure of information relating to offshore accounts maintained by U.S. citizens, corporations, partnerships, or trusts. Individuals have been subject to self-reporting under FATCA for years, and foreign financial institutions (FFIs) will generally be subject to similar obligations as of July 1, 2014. Failure to adhere to FATCA generally results in a punitive 30% withholding tax rate on outbound, U.S.-source payments (and potentially other consequences such as closure of the recipient’s account).
In essence, the intergovernmental agreement provides for the automatic exchange between Canada and the U.S. of certain information relating to accounts maintained by persons subject to tax in the other country. For example, bank accounts maintained by Canadian residents who are also U.S. citizens will generally be subject to the new reporting regime. One issue with the agreement, however, is that instead of FFIs reporting information directly to the IRS, the CRA is now interposed as an intermediary. While some of the consequences associated with FATCA (for example, the punitive withholding tax) have been mitigated, the concern is that now two taxing authorities are to be given personal banking information instead of just one.
Not all financial institutions are subject to the new rules (for example, smaller credit unions are exempt). Certain types of accounts, such as deferred income plans (e.g., RRSPs, RRIFs, TFSAs etc.) will also be exempt from the reporting requirements. However, given the nature of the Canadian banking industry (dominated as it is by the Big Five), most bank accounts will be caught. In addition, the due diligence procedures to which Canadian banks will have to adhere as of June 30, 2014 (likely resulting in detailed account-opening questionnaires) are exceedingly extensive.
The information to be disclosed by Canada to the IRS in respect of Canadian bank accounts maintained by U.S. Persons (as defined in the agreement) includes:
- the name, address, and federal taxpayer identifying number (TIN) of the account holder;
- the account number and year-end balance/value; and
- the total amount paid or credited to the account holder in the year.
Similar information is to be provided by the U.S. government to the CRA in respect of U.S. accounts maintained by Canadian residents. Pre-existing accounts are grandfathered, but rules requiring FFIs to obtain the TINs of each such accountholder are required to be in place by January 1, 2017. This means that Canadian banks will, in relatively short order, need to obtain and disclose to the IRS the SIN of each existing accountholder.
Draft legislation amending the Income Tax Act (Canada) to implement the intergovernmental agreement was released the same day. The legislation proposes to introduce new Part XVIII, which, among other things, requires Canadian financial institutions not exempt from the new reporting regime to file a prescribed form by May 2nd of the following year. Comments on the draft legislation are open until March 10, 2014.
Ultimately, those who should worry most about the new intergovernmental agreement are U.S. citizens living in Canada. The time for them to voluntarily get up to speed with their U.S. tax filing obligations is quickly diminishing, and the new agreement is just a sign of the increasingly pervasive nature of governmental scrutiny.
On February 11, 2014, the Minister of Finance released the federal government’s 2014 Budget. The Budget continued last year’s theme of “closing tax loopholes” and “improving the fairness and integrity of the tax system,” and to that end proposed a number of specific amendments to the Income Tax Act (Canada) (the “Act”). The Budget also announced the federal government’s intention to consult on the possible introduction or elimination of certain significant income tax rules and regimes.
Below is a summary of the more significant income tax proposals outlined in the 2014 Budget.
- Kiddie Tax Extension – The so-called “kiddie tax” limits the ability to income-split with minors by applying the highest marginal tax rate to certain types of income earned by that minor, including: taxable dividends received from private corporations; capital gains realized on the disposition of private company shares to a non-arm’s length person; and income earned through a partnership or trust from the provision of property or services to a business carried on by a related person.
The 2014 Budget announced the extension of the kiddie tax to a new type of income: income earned through a partnership or trust from business or rental activities conducted with third parties, if a person related to the minor either, in the case of a partnership, has an interest in the partnership or is actively engaged on a regular basis in the activities of the partnership or trust. In essence, these amendments further restrain the ability to income-split with minor children through a partnership or trust. This measure will apply to 2014 and subsequent taxation years.
- Loss of Graduated Rates for Testamentary Trusts – Following the announcement made in the 2013 federal budget, the 2014 Budget proposes to apply flat top-rate taxation to all testamentary trusts (including estates), except to estates during their first 36-month “administration period.” In addition, testamentary trusts (except estates during their first 36 months) will lose their entitlement to certain tax-related benefits, including the ability to choose an off-calendar year-end, the basic exemption in computing alternative minimum tax (AMT), and the exemption from the income tax instalment rules. These measures will generally apply to 2016 and subsequent years.
- Loss of Immigrant Trusts – Under the Act, a non-resident trust is deemed to be a resident in Canada if, generally, a Canadian resident has contributed to the trust. A main, long-standing exception to this rule is with respect to a so-called “immigrant trust,” which is a trust the only contributors to which are persons who have been resident in Canada for fewer than 60 months.
The 2014 Budget proposes to eliminate the 60-month exemption on the basis that it raises “tax fairness, tax integrity and tax neutrality concerns.” As such, immigrant trusts have effectively become a thing of the past. The measure will apply to taxation years that end after 2014 for existing immigration trusts and that end on or after Budget Day in any other case.
- International Back-To-Back Loans – The thin capitalization rules generally limit the deductibility of interest expenses by a corporation or trust where the total of all debts owing to specified non-residents exceeds a 1.5-to-1 debt-to-equity ratio. In addition, Part XIII of the Act generally imposes a 25% withholding tax (subject to reduction under a tax treaty) on interest paid or credited to a non-arm’s length, non-resident person.
According to the 2014 Budget, some taxpayers have attempted to circumvent the application of those rules by establishing so-called “back-to-back” loan arrangements with an intermediary. That is, a third party (e.g., a foreign bank) is interposed between two related taxpayers in order to avoid the thin capitalization rules and withholding tax imposed by Part XIII. The 2014 Budget proposes to curtail the use of those arrangements by treating those arrangements as loans made directly by the relevant non-resident. These measures will generally apply after 2014.
- Offshore Regulated Banks – The foreign accrual property income (FAPI) regime requires that certain types of passive income, including income from an investment business, earned by a non-resident corporation that is controlled by a Canadian resident (a “controlled foreign affiliate”) be included in the Canadian taxpayer’s income on an accrual basis. One of the exceptions to this rule is for an investment business carried on by the non-resident as a foreign bank where the activities are regulated under the laws of the country in which the business is carried on.
Certain Canadian taxpayers that are not financial institutions have qualified for this exception by subjecting their controlled foreign affiliate to regulation under foreign banking laws. Budget 2014 indicates that the purpose of this rule was not to allow the affiliates to invest or trade securities on their own account and thus will add new conditions for the availability of this exemption, including that the Canadian resident be a regulated financial institution or that more than 50% of the taxable capital employed in Canada by the taxpayer is attributable to taxable capital employed in Canada by regulated financial institutions. This measure will apply to taxation years that begin after 2014.
- Consultation on Proposed Treaty Shopping Rules – The 2014 Budget reiterated the government’s opposition to “treaty shopping” and proposed to introduce a “main purpose” provision in the Act whereby a tax benefit provided under a treaty would not be available to a party involved in a transaction if the main purpose of that transaction was to obtain the benefit. In the absence of proof to the contrary, the requirement would be presumed satisfied if the relevant income is primarily used to make transfers to others who would not have been entitled to an equivalent treaty benefit.
Parties interested in providing comments on the proposed treaty shopping rules are requested to do so within 60 days after Budget Day.
- Consultation on the Possible Elimination of the Eligible Capital Property (ECP) Regime – The 2014 Budget announced the government’s intention to consult on the possible elimination of the ECP regime, which generally deals with property such as goodwill and other intangibles not included in a class of depreciable property. The rules relating to ECP have been in place for decades, and the government’s stated impetus for seeking their removal is because those rules have “become increasingly complicated” and certain stakeholders have apparently suggested simplifying the regime.
Generally, the 2014 Budget proposes to replace the ECP regime with a new class of depreciable property to which the capital cost allowance (CCA) rules would apply. Instead of 75% of an eligible expenditure being included in the taxpayer’s cumulative eligible capital pool, which may be deducted at the rate of 7% per year on a declining-balance basis, the proposals would see 100% of any eligible expenditure being included in a new CCA class of which 5% may be deducted per year on a declining-balance basis.
Specific legislation, including transitional rules, is expected to be released for public consumption in the near future, after which stakeholders will be invited to submit their comments to the Department of Finance.
CRA narrowly interprets foreign affiliate income recharacterization rule. In 2012-0439661I7 (released February 5, 2014), the CRA narrowly construed the foreign affiliate income recharacterization rule in s. 95(2)(a)(i), which can operate to convert income from property (FAPI) of a foreign affiliate (FA 1) into active business income where: (A) the income from property is directly related to the active business activities of another foreign affiliate (FA 2), and (B) such income would be included in the active business income of FA 2 if that income had instead been earned by FA 2. The facts involved passive income generated in FA 1 from the investment of surplus funds which were earmarked for future (active business) projects in FA 2. The CRA said this did not meet the threshold for recharacterization on either branch of the above two-part test. More specifically:
- The concept of “directly related” in (A) requires a relationship of immediate closeness or causality, such that the investment of funds would not have occurred but for current active business activities in FA 2. The asserted link here was to a future activity in FA 2, which was not sufficient to meet the first test.
- In any event, in order to satisfy the hypothetical in (B) of otherwise being included in FA 2’s active business income, the active business of FA 2 must have a substantial financial relationship of dependence on the surplus funds – such that the funds are truly employed and risked in the existing business, and their removal from the existing business would have a decidedly destabilizing effect (Atlas Industries Ltd. v. MNR; Ensite Ltd. v The Queen; March Shipping Ltd v. MNR). The simple holding of surplus funds for future projects of FA 2 would not meet this hypothetical second test.
In the recent decision of Nottawasaga Inn. Ltd. v. R. (2014 DTC 1021), the Tax Court of Canada (“TCC”) held that it had no jurisdiction to hear an appeal from a reassessment of arrears interest where there exists a nil assessment of taxes and the sole basis for the appeal is not the calculation of the interest itself but the computation of the underlying taxable income on which the interest was calculated.
The taxpayer in Nottawasaga reported nil income for the 2007 taxation year after claiming a deduction for capital cost allowance and other expenses. The Minister of National Revenue (the “Minister”) reassessed the taxpayer to deny various expenses and also reduced the taxpayer’s capital cost allowance claim after reclassifying the taxpayer’s capital assets into different classes that had a lower rate of depreciation. The result of the reassessment was to increase the taxpayer’s taxable income from nil to $144,166 and to require payment of arrears interest of $6,027.
Faced with this reassessment, the taxpayer requested that a loss carry-back of $144,166 from the 2010 taxation year be applied against its 2007 taxation year, thereby reducing the taxable income to nil. The Minister agreed with the taxpayer’s request and issued another reassessment that showed the income inclusion of $144,166 being offset by the loss carry-back, with the result that no tax was payable for the 2007 taxation year. The reassessment, however, made no adjustment to the arrears interest of $6,027. The taxpayer appealed the arrears interest on the basis that the Minister erred in her reclassification of the taxpayer’s assets which, as a result, set the wrong tax amount on which arrears interest was calculated.
The TCC decision only deals with the jurisdictional issue of whether the taxpayer can challenge arrears interest by asserting that the underlying tax amount was incorrectly calculated where there is a nil assessment of taxes. The Minister argued that such a challenge was prohibited as it would effectively amount to a challenge of the underlying tax amount which the taxpayer has no right to appeal because no tax was payable.
As a general rule, it is true that taxpayers do not have the right to object or appeal an assessment of a nil amount. This is simply because there is nothing to appeal if there is no tax, interest or penalties payable. On the other hand, if the Minister issues an assessment to a taxpayer for interest payable, but there is otherwise no tax payable and the nil assessment of tax is not in dispute, the TCC acknowledged that taxpayers are entitled to object or appeal the assessment of interest. However, in dealing with a challenge to interest assessments, the court’s jurisdiction is generally limited to the following issue: whether the interest was properly calculated mathematically speaking or whether the interest was imposed in accordance with the Income Tax Act (Canada).
It follows that, when there is a nil assessment of taxes, a court has no jurisdiction to hear an appeal from an assessment of interest if the basis for the challenge is an error made by the Minister in computing the underlying tax amount on which the interest was calculated. This is precisely what the taxpayer was trying to do in Nottawasaga: it was not challenging the correctness of the calculation of the interest but the calculation of its taxable income. In other words, the taxpayer argued that its taxable income – not the interest – was incorrectly calculated due to the reclassification of its capital assets into different classes. This, in turn, resulted in the interest being imposed on the wrong underlying tax amount, according to the taxpayer.
The TCC rejected the taxpayer’s arguments and agreed with the Minister that it had no jurisdiction to hear the taxpayer’s appeal in this case. Instead of challenging the interest assessment, the taxpayer should have appealed the initial reassessment that increased its taxable income by $144,166 (i.e., the reclassification of its capital assets). However, the taxpayer chose not to do so and, instead, requested that a loss carry-back be applied to reduce its taxes payable to nil. It is therefore difficult to understand why the taxpayer should have been allowed to attack the reclassification for the purposes of challenging the arrears interest while the reclassification remained valid for the purposes of computing its taxable income.
In 2013-0474431E5, a Canadian parent company (Canco) seconded employees to its foreign affiliate (FA). The seconded employees represented 5% of the FA’s workforce engaged in providing services to arm’s length customers. The FA reimbursed Canco the cost of its seconded employees plus a 25% mark-up. The CRA confirmed that Canco would be viewed as providing a service to the FA, such that 5% of the FA’s income would be considered “foreign accrual property income” (FAPI) under s. 95(2)(b)(ii). Such FAPI would be taxed in Canco on a current basis. The CRA also confirmed that this result could be avoided where the FA merely reimburses Canco’s costs without any mark-up, but only
if such cost-recovery represents an arm’s length fee under Canada’s transfer pricing rule in s. 247. In such event, the activities of the seconded employees would not be considered part of Canco’s business. However, if s. 247 applies to impute a profit element to Canco (under applicable transfer pricing principles), the FAPI result would be the same as if Canco actually charged a mark-up. In other words, where Canco actually earns a profit or is deemed to earn a profit (under transfer pricing principles), Canco would be viewed a providing a service to the FA such that s. 95(2)(b)(ii) would apply to treat 5% of the FA’s service income as FAPI.
In 2013-0512581E5, a Canadian company (Canco) sold shares of a Brazilian company (BrazilCo). The resulting gain was taxed in Brazil. The CRA said a foreign tax credit (FTC) would not be available to Canco under s. 126(1) because the gain was sourced to Canada, not Brazil (the sale contract was negotiated, signed, and executed in Canada and payment was made in Canada). However, the CRA said the gain was deemed to be sourced to Brazil under paragraph 2 of Article 22 of the Canada-Brazil tax treaty. A FTC was therefore available to Canco by reason of the treaty, with such FTC not to exceed its Canadian tax otherwise payable on the gain. (BrazilCo was apparently not a foreign affiliate of Canco.)
In 2013-0505911I7, the CRA concluded that “assembly project” in Article 5 of the Canada-Brazil tax treaty should have a meaning similar to “installation project”. Such terms are typically relevant to the question whether a foreign company has a taxable permanent establishment (PE) in Canada. The term “assembly project” in the Canada-Brazil stems from the 1963 OECD Model Tax Treaty and was not defined at that time. Furthermore, no illuminating comments were made when this concept changed in 1977 to “installation project”. Given the lack of any definition of “assembly project” in any treaty or domestic tax legislation, the CRA concluded it would simply apply its positions on the phrase “installation project”. Specifically:
- An installation typically involves tangible property such as machinery or equipment, and the CRA takes a fairly narrow view of what qualifies as an installation activity.
- Installation should be the main activity of the project. If other significant activities are taking place – consulting, modification, or testing (for example) – the project might not be an installation project.
In Mckesson Canada Corporation v. The Queen, 2013 TCC 404, the Canadian company in the group (Canco) sold its trade receivables to a Luxembourg company in the group (Luxco) at a discount of 2.206% (from their face amount). In an 87-page judgment, the Tax Court of Canada (TCC) held that an arm’s length range for a discount rate in the circumstances was between 0.959% and 1.17%. The CRA had reassessed Canco using a discount rate of 1.013%, which was upheld as being within this arm’s length range. The decision is highly fact-based, but some interesting points may be observed.
- It seems the case landed in the TCC – and had not been resolved at the inter-governmental competent authority level (as is often the case in transfer pricing) – because Luxco did not pay significant taxes in Luxembourg (paragraph 365). Accordingly, the only substantive tax in issue was Canadian tax.
- The Tax Court judge (Judge) clearly took the Supreme Court of Canada’s direction Canada v. GlaxoSmithKline Inc., 2012 SCC 52 at paragraph 61 to heart: namely, “As long as a transfer price is within what the court determines is a reasonable range, the requirements of the section should be satisfied…and the Tax Court judge will be required to exercise his best informed judgment in establishing a satisfactory arm’s length price” (paragraph 120).
- Naturally, opinions may differ as to whether the Judge’s factual conclusions in this case were right or wrong. One thing seems clear however. A Tax Court judge will apply a healthy dose of common sense in these cases. For instance, the Judge could not understand how, from “a common sense point of view”, the parties could assign a forward-looking credit risk to the trade receivables that was “many, many, many times higher” than the multi-year historic performance of those receivables (paragraph 299). Similarly, the Judge found it “completely unacceptable, unreasonable, [and] unsupported on the evidence” that Canco, as an arm’s length seller, would agree to essentially compensate Luxco, as an arm’s length buyer, for Luxco’s own financing costs (paragraph 346). To paraphrase an old line: If the transfer price looks too good to be true, it probably is.
- Finally, the TCC examined an interesting procedural point concerning the secondary withholding tax (WHT) assessment of Canco. The WHT applied to the value of the benefit that Canco conferred on Luxco, which had arisen because Canco accepted too high of a discount on its trade receivables. The TCC held that this WHT was not the kind of income tax to which the 5-year time limitation in Article 9 of the Canada-Luxembourg treaty applied for transfer pricing reassessments (paragraphs 391-392). Accordingly, the CRA was not time-barred when it issued the WHT assessment outside the 5-year period.
In 2013-0512551I7, the CRA confirmed that Canadian GAAP governs a corporation’s retained earnings for thin capitalization purposes, not the income allocation rules for partnerships in s. 96. In broad terms, a Canadian corporation (Canco) cannot deduct interest expense on loans from non-resident group members if such loans exceed 1.5 times to the total of Canco’s contributed surplus, paid-up capital, and retained earnings. In the facts considered, Canco had borrowed money from non-resident group members, and Canco was a partner in a captive Canadian partnership. In the CRA’s view, once the basis of accounting (i.e., consolidation method, equity method, or cost method) is established by Canadian GAAP as being appropriate for Canco’s investment in the partnership, this should govern the determination of Canco’s retained earnings derived from the partnership for purposes of the thin capitalization rules. This view is merely an extension of the CRA’s long-standing position that Canco’s contributed surplus and retained earnings for thin capitalization purposes must be determined in accordance with Canadian GAAP, but may not include unrealized appraisal surplus (2012-0445891E5 and 2010-0384001E5).
In 2013-0514701I7, the CRA confirmed that transactions involving bitcoins should be reported as would any other barter transaction. The bitcoin is a virtual currency used to buy and sell goods and services on the Internet. It is not a recognized currency issued by the government of a country; it is a simple commodity. When the bitcoin is used to purchase goods or services, the transaction is treated as a barter transaction: i.e., the value of the thing received is considered to equal the value of the thing given up in exchange. These values must be translated into Canadian dollars (s. 261(2)(b)), and this determines the Canadian tax liability of the parties. Furthermore, as a commodity, an economic gain or loss may arise on the bitcoins themselves. For instance, if the bitcoins are held on capital account, a capital gain or loss would generally be determined as the difference between their Canadian dollar value on the day the bitcoins were acquired and their Canadian dollar value on the day the bitcoins are used in a transaction. Whether bitcoins are held on income account or capital account is a question of fact to be ascertained in the usual manner, having regard to all the circumstances.