TaxMatters@EY – December 2011

Pay tax-deductible or tax-creditable expenses in 2011: A variety of expenses can only be claimed as deductions in a tax return if the amounts are paid by the end of the calendar year, including interest expense, investment counsel/management fees, safety deposit box fees, professional dues, spousal support and child-care costs. In addition, expenditures such as charitable donations, political contributions, medical expenses, child fitness program costs, child arts program costs (newly eligible for 2011), tuition fees and transit pass costs that give rise to tax credits must be paid in the year in order to be creditable. If these amounts would otherwise be paid early in 2012, consider paying them by the end of this year, to get the benefit of the tax deduction or credit in 2011 returns.

And remember to keep receipts. Although none are required for electronic filing and only some for paper returns, the CRA randomly requests receipts as part of its post-assessment review.

Review investment portfolio: Year end is a good time for investment portfolio review. You may want to sell loss securities to reduce capital gains realized earlier in the year. If the losses realized exceed gains realized earlier in the year, they can be claimed against net gains in the preceding three years and you will receive the related refund. But keep in mind, if you, your spouse/partner, a corporation that either of you control, your RRSP or your TFSA acquire the same security within 30 days of the sale, the loss will be denied. Moreover, where an RRSP or TFSA acquires the replacement, any tax benefit from the loss is effectively eliminated.

If you have capital loss carryforwards from prior years, you might consider cashing in on some of the winners. By applying unused capital loss carryforwards against 2011 realized gains, the tax cost associated with the gains can be reduced or eliminated.

For all security sales, keep in mind that the trade must settle in 2011 to be considered a 2011 disposition. For Canadian exchanges, the final trade date for 2011 settlement is 23 December, and for US exchanges it’s 27 December.

If you own shares in certain Canadian small business private corporations, you might want to trigger capital gains to benefit from your remaining capital gains exemption (maximum $750,000 lifetime exemption). However, if such shares have declined in value or are worthless, any related loss is a special class of capital loss that can be claimed against any source of income, not just capital gains.

There are a couple of warnings in relation to purchasing investments in December. If you are considering buying bonds or long-term GICs this month (perhaps from the proceeds of security sales), keep in mind that even if the investment pays no interest in 2012, tax will be payable on the interest that accrues to the first-year anniversary date (December 2012) with the 2012 tax return. By delaying the purchase to January 2012, that tax can be deferred one year.

In the case of mutual funds that regularly make distributions near year end, the distribution amount is effectively included in the purchase price and will be taxable in the 2011 return. It might be better to wait until after the distribution to purchase those funds; the cost may be lower and tax will be deferred.

If you’re looking for opportunities to reduce a significant tax liability you expect to have for 2011, you might consider a flow-through share investment before year end. Flow-through shares provide for a current tax deduction roughly equal to the amount of the investment and they may also give rise to federal and provincial tax credits, resulting in significant current tax savings. The deductions and credits reduce the cost base of the investment and, therefore, a capital gain will likely arise when the investment is sold. But before you make the plunge, take note that these investments do carry risks and should be assessed on the merits of the operation and not the tax attributes.

Flow-through shares have often been used in tax donation strategies. However, the 2011 federal budget removed the ability to donate flow-through shares acquired under an agreement entered into or after 22 March 2011 without realizing taxable capital gains. The donation of flow-through shares, which would not be subject to tax, will generally be limited to an amount that is the excess of the value of the shares at the time they are donated over the cost of the shares.

Consider income-splitting loans: The prescribed interest rate applicable to the exemption from income attribution on intra-family loans is still 1% for the final quarter of 2011. That means income-splitting loans are still an excellent tax-saving opportunity for those who have liquid or certain other assets, and are interested in income splitting with spouses/partners and/or children or grandchildren. And for those with outstanding income splitting loans, keep in mind that interest must be paid by 30 January 2012 to avoid income attribution.

For additional details on income-splitting loans, see the February 2009 issue of TaxMatters@EY.

Request reduced source deductions: If you regularly receive tax refunds because of deductible RRSP contributions, child-care costs or spousal support payments, consider requesting CRA authorization to allow your employer to reduce the tax withheld from your salary (Form T1213). Although it won’t help for 2011 taxes, in 2012 you’ll receive the tax benefit of those deductions all year instead of waiting until after your 2012 tax return is filed.

Make capital acquisitions for business: Self-employed individuals and unincorporated business owners expecting to make capital purchases (such as furniture or equipment) in the near future should consider buying before year end to get a depreciation deduction for 2011.

Consider corporate year-end remuneration strategy: Corporate business owners should make decisions about final remuneration from the company. If there is a plan to pay salary, remember that bonuses can be accrued and be deductible by the company in 2011, but don’t have to be included in the business owner’s personal income until paid in 2012 (the bonus must be paid within 180 days of the company’s year end). This allows for a deferral of tax on salary. And because federal and some provincial corporate tax rates are declining, the tax benefit of the salary deduction to the corporation may be greater in 2011 than it will be next year.

In determining the amount of salary to pay, business owners may want sufficient earned income for 2011 to maximize their 2012 RRSP contribution.

In some cases, paying dividends may be a very tax-efficient way of getting funds out of the company. Capital dividends are completely tax free. Taxable dividends that will generate a dividend refund in the corporation (1/3 of the dividend paid), particularly if they are eligible dividends (subject to a preferential tax rate), can also be paid out with essentially no net tax cost.

And eligible dividend tax rates will be increasing in 2012, so you can achieve tax savings to the extent that you can pay dividends before the end of 2011. To ensure the dividend qualifies as an eligible dividend, the entire dividend must be designated as an eligible dividend when paid.

For additional information on eligible dividend designation requirements, see the November 2010 issue of TaxMatters@EY.

Age 71?: If you are 71 at the end of the year, your final RRSP contribution must be made no later than 31 December (not 60 days after the end of the year), and an RRSP maturity option must be selected by the end of the year.

Reduce automobile taxable benefit: If you are an employee who uses an employer-provided car primarily for business, you may be eligible for a reduced standby charge (in respect of the availability of the car) and a lower alternate operating benefit, computed as one-half of the standby charge. Update your travel log to determine if you are within the thresholds for reduced benefits and advise your employer in writing before year end in order to have the alternate operating benefit apply.

Contribute to education: Remember to make RESP contributions before the end of the year. With a contribution of $2,500 per child, the federal government will contribute a grant (CESG) of $500, and if you have prior non-contributory years, the annual grant can be as much as $1,000 (in respect of a $5,000 contribution). If you have a child who is 15 this year but have never contributed to an RESP on his or her behalf, 31 December is the last chance to make a contribution and earn a CESG for that child.

Contribute to a TFSA: Make your $5,000 tax-free savings account contributions for 2011. And if you haven’t contributed before, you can contribute up to $15,000 before the end of the year. Remember that you can also fund your spouse’s/partner’s contributions without attracting the attribution rules.

If you’ve withdrawn funds from your TFSA in 2011, keep in mind that the contribution room created by the withdrawal is not available until 2012.

For more information on these and other tax-planning and tax-saving ideas, please call your Ernst & Young professional advisor.

In a recent technical interpretation, the CRA confirmed its view that the Minister’s discretion to extend the time for filing a return does not permit the Minister to extend the three-year filing deadline for granting a dividend refund. In addition, the unrefunded balance cannot be transferred to another year.

Extension of filing time – CRA’s view

Subsection 220(3) of the Income Tax Act (the Act) grants the Minister the discretion to extend the time for making a return. The wording of the provision is broad and there’s no restriction on the scope of its application. Nonetheless, the CRA’s position is that subsection 220(3) is limited to extending the time for making a return under subsection 150(1) of the Act, thereby allowing for a reduction of interest and penalties, but does not have the effect of extending the three-year period in subsection 129(1), which permits the claiming of a dividend refund.

Further, the CRA is of the view that subsection 129(1) requires a factual determination of whether the return of income was filed within three years after the end of the year, without regard to any extension permitted by the Minister under subsection 220(3).

According to the CRA, the granting of an extension to file a return under subsection 220(3) does not have the effect of extending the three-year filing deadline for purposes of claiming a dividend refund under subsection 129(1).

There currently appears to be no case law that confirms or refutes the CRA’s position on the Minister’s ability (or inability) to use subsection 220(3) to extend the three-year filing deadline for dividend refunds. However, based on case law that does exist on subsection 220(3), it would appear that a broader interpretation of its application may be warranted.

For example, in Kutlu et al v the Queen (1997 DTC 5180), the Federal Court Trial Division implied that subsection 220(3) should be given broad application to remedy injustices that can result under the Act. In addition, the Kutlu decision confirms the application of subsection 220(3) to retroactively extend a filing deadline that has already been missed.

Re-appropriation of a dividend refund – CRA’s view

The CRA also confirms that relief for a statute-barred dividend refund is not available in the form of a re-appropriation under section 221.2. The CRA’s position is that, where a dividend refund is statute barred because of a corporation’s failure to file its tax return within the three-year filing deadline, the amount of the dividend refund is not an amount that was appropriated (applied) to a debt, and therefore cannot be re-appropriated (transferred) to reduce a debt payable for another taxation year or under another tax account.

The CRA distinguishes this situation from one involving a refund of a tax overpayment that is statute barred because of a similar three-year filing deadline in subsection 164(1) of the Act. In the latter situation, the CRA’s view is that, if the amount of the tax overpayment has been appropriated to a debt and the refund is statute barred due to the lapse of the three-year period in subsection 164(1), the taxpayer would be permitted to request a re-appropriation of the amount to another tax debt.

Impact of denied dividend refund on RDTOH

It is the CRA’s position that a corporation’s RDTOH balance must be reduced by the amount of a statute-barred dividend refund because it is a dividend refund whether or not it is actually received. This position results in double taxation due to a permanent loss of the dividend refund.

The resulting double tax — essentially, the additional tax cost on investment income earned through the corporation — is not consistent with the intent of the refundable dividend tax mechanism. The refundable dividend tax mechanism is intended to facilitate integration on investment income earned through a private corporation by ensuring that the total tax paid on investment income earned through the corporation and distributed to an individual shareholder approximates the tax that would have been paid if that income were earned directly by the individual.

While the legislation is intended to limit the time frame for claiming a refund in respect of taxable dividends paid in a particular taxation year, there is no policy rationale for imposing additional tax as a penalty tax on the corporate taxpayer and its shareholder. The good news for taxpayers is that the Tax Court of Canada agrees.

In a very recent decision, Tawa Developments Inc. v The Queen, 2011 TCC 440, the Tax Court of Canada held that the corporate taxpayer’s RDTOH balance should not be reduced by the amount of a statute-barred dividend refund. The Tax Court of Canada stated that the Minister’s “position that an unrefunded ‘refund’ may represent a ‘deemed’ or ‘notional refund’ is not supported by a textual, contextual and purposive analysis of [section 129].”

The time period for the Minister to appeal this case has expired.So, for the time being, this is the current law.

Dealing with the CRA’s interpretation

Given the CRA’s views, private corporations and their advisors should be vigilant in ensuring that the corporation’s tax return for a taxation year is filed no later than three years after the corporation’s taxation year end. This three-year deadline is relevant not only for purposes of claiming a dividend refund but also for claiming tax overpayment refunds under subsection 164(1).

For corporations that have already missed the three-year deadline, follow the current case law and make sure the corporation’s RDTOH balance is not reduced by the amount of the denied dividend refund. This will ensure the dividend refund is available in a future taxation year in which the corporation pays taxable dividends.

Background

A TFSA holder is subject to a special tax if he or she has an “excess TFSA amount” in a calendar year. Although contributions to a TFSA are usually taken into account in determining an individual’s excess TFSA amount, there are some exceptions. Notably, payments to the survivor of a deceased TFSA holder may be treated as exempt contributions (and so excluded from the calculation) provided certain conditions are met. The conditions require, for example, that the contribution is made to the survivor’s TFSA during the “rollover period,” that it is designated as a survivor payment on Form RC240, “Designation of an Exempt Contribution Tax-Free Savings Account (TFSA),” and that it is made as a consequence of the deceased’s death.

The wording of the definition of “survivor” in the Act makes it possible for a deceased individual to have more than one survivor. For example, this could happen where a married individual lives separate and apart from his or her spouse and begins living with a new partner, without first getting a divorce. If the second partner becomes a common-law partner for purposes of the Act and the individual then dies, both the spouse and common-law partner will be considered survivors.

In a situation where a deceased individual has two survivors and leaves TFSA amounts to both of them under the terms of a will, a rollover to the survivors’ TFSAs (an exempt contribution) is not automatic. In this case, the amount of the survivor’s exempt contribution is determined as the least of three amounts, one of which is nil, unless the Minister exercises discretion to allow a larger amount.

The CRA’s response

The CRA was asked in what circumstances it would allow a designation of an exempt contribution where the deceased TFSA holder had two survivors. The CRA indicated that it would generally allow an amount greater than nil, provided that the total amount designated by the two survivors is less than or equal to the amount that would otherwise be allowed as an exempt contribution if the deceased had only one survivor.

However, if the two survivors try to designate as an exempt contribution an amount that exceeds the maximum amount allowed, one or both survivors would need to provide additional information to allow a reasonable allocation to be made. Among the factors that may be considered in making the allocation would be the precise terms of the deceased’s will relative to the TFSA.

Guidance from the CRA on this topic is welcome, especially since there is a difference between the automatic rollover that would occur for survivor payments to more than one survivor out of the deceased’s RRSP or RRIF (see 2002-0165285 and 2006-0189141E5) and the discretionary rollover under the TFSA rules. It also serves as an important reminder for individuals to properly consider, as part of their post-mortem tax planning, the treatment of tax-advantaged savings accounts on death and the circumstances in which a tax-deferred rollover may be available.

Such steps can include the following:

• Identifying a range of possible structures and estimating the tax costs and benefits of each for both seller and buyer. The seller will then begin to divest with a clear idea of the structure it would prefer and what (if any) value it might lose if a potential buyer requests a different one.
• Identifying tax features of the business that are likely to enhance or erode value.
• Ensuring that the business is up to date with its tax compliance and has complied with all of its obligations. Any matters in dispute with tax authorities should also be resolved wherever possible, or at least progressed in order to deliver more certainty as to their resolution, before due diligence commences.
• Making sure that the business to be sold can provide all the information that potential purchasers might reasonably be expected to request.

For more information, see Ernst & Young’s 2011 Global M&A tax survey and trends.

Facts

The main issue in the case was whether shares transferred to the appellant by his father as part of a corporate restructuring and estate freeze should have been excluded from his “net family property” under the Family Law Act because they were a “gift.”

John McNamee built the McNamee Concrete Company from a single truck to a company with annual sales of more than $5 million and a fair value of $2 million in 2003. The business employed John’s two sons, one of whom was the appellant, Clayton McNamee.

In 2003, an estate freeze was completed. One aspect of the freeze involved the transfer to Clayton and his brother of 500 common shares each in a new corporation (“Newco”) pursuant to a Declaration of Gift. The Declaration included a provision that any shares transferred to the sons would be excluded from net family property under the Family Law Act.

Four years after the estate freeze, Clayton separated from his wife.

The issue

The key issue in the case was whether the transfer of the shares of Newco to Clayton was a “gift” as contemplated by subsection 4(2) of the Family Law Act, which reads as follows:

The value of the following property that a spouse owns on the valuation date does not form part of the spouse’s net family property:

1. Property, other than a matrimonial home, that was acquired by gift or inheritance from a third person after the date of the marriage.
2. Income from property referred to in paragraph 1, if the donor or testator has expressly stated that it is to be excluded from the spouse’s net family property.

Ontario Superior Court decision

The case went before the Ontario Superior Court, where Justice Gary Tranmer reviewed the relevant authorities and case law. He found that the essential elements of a gift included the following:

1. The capacity of the donor to make the gift;
2. An intention on the part of the donor to transfer the property without consideration and without the expectation of remuneration;
3. The intention of the donor must be without conditions and “from detached and disinterested generosity, out of affection, respect, charity or like impulses and not from the constraining force of any moral or legal duty or from the incentive of anticipated benefits of an economic nature”;
4. The donor must divest himself of all power and control over the property and give such control to the donee;
5. There must be an intention on the part of the donee to accept the property as a gift; and
6. Delivery of the gift by the donor to the donee must be completed.

In the Superior Court’s view, only the first and last items were satisfied on the facts. John’s capacity was not in question, so the first condition was satisfied. Clayton’s ex-wife conceded that the shares were delivered in the sense that the corporate lawyer properly recorded the transfers in the corporate records, so the last condition was satisfied.

As to the second condition, the court found that John did not transfer the property without consideration and without the expectation of remuneration. According to the evidence, the primary motivating factor for the freeze transaction was creditor-proofing and estate planning. John maintained control of Newco through his holdings of voting preferred shares. He could pay himself dividends without restriction. According to the court, these “unusual” factors in the estate freeze constituted “consideration” flowing back to John as a result of the gift.

The Superior Court also held that the third condition was not met: John did not transfer the shares out of pure affection or generosity, but was motivated by his creditor-proofing and estate planning objectives.

As to the fourth condition, the Superior Court concluded that John did not divest himself of complete power and control over the common shares transferred to his sons. The shares were transferred subject to a condition that they remain free from the control of their spouses. Further, John could control the value of the common shares by stripping out the profits of Newco through the payment of dividends to himself. In addition, the shares could not be transferred without John’s approval.

As to the fifth condition, there was no intention on the donee’s part to accept the gift. Clayton did not understand the corporate restructuring in sufficient detail so as to make an informed decision as to whether to accept the shares as a gift. It was not entirely clear that he understood that the shares had been transferred to him as a gift. He was not shown the Declaration of Gift until after his separation from his spouse.

For all these reasons, Justice Tranmer concluded that there was no “gift” within the meaning of subsection 4(2) of the Family Law Act. 

Ontario Court of Appeal decision

There were concerns expressed in the tax community that this restrictive approach could have implications for a number of provisions in the Income Tax Act and could prove to be advantageous or disadvantageous to taxpayers, depending on the circumstances.

Fortunately, the case was taken to the Ontario Court of Appeal, where Justices Robert Blair, Paul Rouleau and Robert Sharpe disagreed with the trial judge and overturned the decision that there was no gift.

First, on the matter of consideration, the justices noted that the issue was not whether the donor received some benefit from the estate freeze and corporate restructuring. Rather, it was whether the donee provided any consideration to the donor for the transfer.

Additionally, the fact that John’s primary purpose was to accomplish an estate freeze and creditor-proofing did not mean that he did not intend to gift the shares to his sons. The intention on the transfer of the shares was to do so gratuitously. A transfer for commercial purposes is sufficient so long as the act of transfer itself is gratuitous.

Moreover, the fact that John could control the value of the shares following their transfer reflected the nature of the particular estate freeze conducted in this case, but it did not affect whether the shares were transferred as a gift or not.

Similarly, the fact that there were strings attached to the share issue to Clayton, which he did not know at that time, does not invalidate a gift. What mattered is that Clayton knew about and accepted the transfer of shares to him. The fact that he was mistaken at the time as to the terms and conditions of that transfer does not mean that he did not accept a transfer.

The result was that the shares were transferred as a gift, meaning they would be excluded from the net family property for property equalization purposes.

Even if the gift had failed in this case, the Court of Appeal provided some reassurance by pointing out that if the transfer of shares was not valid as a gift, then the transfer itself would have failed and the shares would have remained with Clayton’s father. The result would then be what John McNamee had wanted — to keep the shares out of the hands of his son’s ex-wife in the event the marriage broke down.

However, the Court of Appeal accepted an argument by Clayton’s ex-wife that the trial judge did not consider the alternative (and logically prior) argument that Clayton had been unjustly enriched, and therefore she had a beneficial ownership interest in the shares. The Court ordered a new trial solely on this issue.

Looking forward

Perhaps the most important work done by the Ontario Court of Appeal in this measured decision was to relax tax and estate planners.

Following the Court of Appeal decision, we can say that a “gift” is a gift again. In its clarifying discussion of the essential elements of a legally valid gift, the court specifically disagreed with the trial judge that a donor must be inspired by affection, respect, charity or similar impulses when making a gift. A commercial or other motivation suffices — it is the free transfer that makes it a gift.

That being said, there are a couple of lessons to be learned from this decision.

First, it may be advisable, in the context of an estate freeze, to arrange for the growth shares to be transferred to the next generation by gift, rather than issued for nominal consideration, if it’s intended that they be excluded from net family property for family law purposes. Of course, you should always obtain advice from a family law specialist in the relevant jurisdiction with respect to this issue.

Second, it is incumbent on tax planners to ensure that all the necessary elements of a gift are present if that is a key element of the estate plan. It would be very unfortunate if an estate freeze were to be unwound due to a finding that a gift was not effective.

Tax Alerts

• 2011 Issue No. 39 - QST harmonization could trigger additional costs for registered pension plans
  On 30 September 2011, the Quebec and federal finance ministers signed a memorandum of agreement regarding sales tax harmonization that provides for further harmonization of the QST and GST. This QST harmonization could trigger additional QST costs for registered pension plans.
• 2011 Issue No. 40 - New protocol concluded to Canada–Barbados Tax Convention
  On 8 November 2011, the governments of Canada and Barbados concluded a new protocol to revise the existing income tax convention between the two countries.
• 2011 Issue No. 41 - Pension plans required to provide information to investment plans by 15 November for GST/HST purposes
  Institutional investors, including many pension plans, that invest in specific types of distributed investment plans must provide those investment plans with specific information by 15 November 2011.
• 2011 Issue No. 42 - Are you ready for the QST rate increase to 9.5%?
  The Quebec sales tax is set to increase from 8.5% to 9.5%, applied to taxable supplies for which tax will become payable on or after 1 January 2012.
• 2011 Issue No. 43 - Highlights from the 2010 -11 APA Program Report
  On 21 November 2011, the CRA released its Advance Pricing Arrangement (APA) Program Report for the fiscal year ending 31 March 2011. The report provides an overview of the program's operations, including statistical analyses of APAs completed and in progress, and discusses policy changes that may impact the suitability of the program for many taxpayers.

Restructuring guidance
In the November 2011 issue of CAmagazine, Ernst & Young partners Alfred Zorzi and Larry Greer discuss the OECD’s July 2010 revisions to its Transfer Pricing Guidelines, including new Chapter IX — “Transfer Pricing Aspects of Business Restructurings.”

Business immigration alerts and updates
For the latest information on Canadian and US business immigration issues from Egan LLP, a business immigration law firm allied with Ernst & Young LLP in Canada, visit EganLLP.com.