TaxMatters@EY – February 2011

Non-compliance with employment tax rules may be a result of the employer and employee not knowing the Canadian income and employment tax requirements. There is a host of things to know about Canadian withholding, remitting and reporting for employees who frequently work in Canada but reside in a foreign country and get paid by a foreign employer.

Know the obligations

Remuneration paid to non-resident employees who provide services in Canada is subject to the same income tax withholding, remitting and reporting obligations as income paid to Canadian-resident employees. Employers also have a responsibility to determine Canadian social security, employment insurance, workers’ compensation and other provincial employment tax obligations.

These obligations also apply to non-resident businesses with either resident or non-resident employees working in Canada. The foreign employer needs to establish a Canadian payroll and obtain a business number from the Canada Revenue Agency (CRA). Alternatively, a related Canadian business may act as an agent of the foreign company for payroll purposes.

A company’s biggest obstacle seems to be identifying its frequent business travellers. This is not an easy task, since cross-border employees may not come into contact with either the Canadian or foreign HR department.

This may occur when a project manager in Canada needs a few more resources to deliver on a commitment and calls the US counterpart to get a team on site the next day for a month or so.

Gather the right information

Once the cross-border employees have been identified, the next step is to gather information to determine how frequently each employee is travelling to Canada on projects and meetings annually.

The amount of remuneration subject to tax in Canada is generally determined on a proration of salary or wages earned, based on the number of workdays in Canada as a proportion of workdays in the year. The employee’s wages can be paid by the home country, some allowances and per diems can be paid by Canada, and other items, like housing, can be paid or provided by a third party, like a relocation company. Yet another option is that accounts payable may be making payments as part of an expense reimbursement.

Then there are tax preparation fees. And if the employer is subsidizing any additional taxes because of cross-border work, then tax reimbursements must be considered. Last but not least, equity compensation that would in part be taxable in Canada years after the employee has left the country is also a possibility. Compensation accumulation is a major project when you have cross-border employees.

Cross-border tax conventions

The next step is to determine whether employment income earned in Canada may be exempt from taxation pursuant to an income tax convention between Canada and the employee’s home country. The employer will have to examine the various criteria of the applicable convention to determine if the remuneration earned here may be exempt from Canadian tax.

When looking at a convention, consider if the employee is working in Canada for less than 184 days in a period; if the payment being made to the employee is paid by or on behalf of a resident of Canada; or if the remuneration earned in Canada is borne by a permanent establishment in Canada or there is a cross-charge to Canada.

Terminology plays an important part in analyzing the applicable tax conventions. In some cases, “period” means calendar year. In others, “period” refers to the taxation year or any 12-month period beginning or ending in the calendar year.

That said, if an employee is exempt from tax on the employment income they earned in Canada, they can request a tax deduction waiver to reduce their employer’s required Canadian income tax withholding (note that Quebec has a separate process).

It’s also important to review the social security agreement, if any, between Canada (Quebec has its own) and the respective foreign home country, and obtain an exemption from Canadian/Quebec social security contributions where possible. There could be significant savings if there is an agreement in place and the exemption criteria are met.

T4s, SINs and TINs

What happens if a non-resident’s income is taxable in Canada? It may be difficult to calculate and remit the income tax withholdings if the employee works in Canada on a sporadic basis. In these cases, the employer may consider remitting income taxes based on estimated employment income to be earned in Canada during the respective pay period. These calculations can be reviewed monthly once actual travel information is available. Many employers don’t realize that even if the individual is exempt from Canadian tax, they must still issue a T4 for the Canadian-source taxable income.

Employees have responsibilities too. Every employee needs a social insurance number (SIN) to work in Canada. If someone does not have a valid work visa and thus is not eligible for a SIN, they need to apply for a taxpayer identification number (TIN).

Once the SIN or TIN is obtained, employees need to provide it to the employer. The employer is responsible for making a reasonable effort to obtain a SIN/TIN, as the employer may be penalized if one is not obtained.

Regardless of residency status, any employee receiving salary, wages or other remuneration for performing services in Canada is required to file a Canadian income tax return by 30 April of the following taxation year. If the income is exempt under a tax treaty, the employee should file a return even if no taxes are payable.

In cases in which an employer has a non-resident employee and has not remitted any taxes, the employer could be responsible for paying 100% of the employee’s taxes, since it may be easier for the CRA to get the employer to pay rather than the employee.

Financial risks are not the only exposures. Frequent business travellers may create a permanent establishment for corporate tax purposes in places where one is not wanted. There could also be reputational risk, both internal and external, if it becomes apparent that an employer knowingly does not comply with the tax laws.

An employer should ensure it has a policy and process in place so it can track the activities of frequent international business travellers.

Employment tax rules are very complex and the employer may need an external tax service provider to help ensure compliance.

While income and capital gains earned in a TFSA are free of tax, there are very specific rules that govern both contributions to a TFSA and recontributions of funds withdrawn from a TFSA.

In very general terms, the maximum TFSA contribution room is the sum of three amounts:

1. The annual TFSA dollar limit (currently $5,000);
2. The unused TFSA contribution room from a previous year; and
3. The total amount of withdrawals made from the TFSA in the previous year.

Unfortunately, this third provision has caught a number of individuals by surprise.

In the spring of 2010, the Canada Revenue Agency (CRA) issued enquiry letters to a number of individual taxpayers regarding apparent excess contributions and subsequently outlined resolution procedures on their website. In a recent newswire, the CRA reminded taxpayers of the importance of adhering to the TFSA contribution room provisions.

In the newswire, the CRA noted an important exception from the withdrawal rule, the direct transfer of TFSA funds from one financial institution to another. To be eligible for this exception, the transfer must be completed by the respective financial institutions. Where the taxpayer withdraws the funds from their TFSA with one financial institution and recontributes those same funds to a TFSA with a second financial institution, the recontribution will be considered a new contribution and the withdrawal ignored for purposes of the contribution room limit until the following taxation year.

Exceeding TFSA contribution room – It is important not to exceed your TFSA contribution room for the year, as excess contributions are subject to a 1% tax per month on your highest excess TFSA amount in each month. This tax continues to accumulate each month until the excess amount is withdrawn.

To learn more about TFSAs, see our helpful annual tax guide, Managing Your Personal Taxes 2010–11: a Canadian perspective.

How to report and value a delayed gift

The CRA was asked how to report and value a gift by will, where the donation is not made by the filing due date of the deceased’s terminal return. Based on the provisions of the Income Tax Act (the Act), which deems a gift by will to have been made immediately before the individual died, it is CRA’s position that the delayed gift should be included in the deceased’s final return (or prior-year return) for purposes of claiming the charitable donation tax credit.

Administratively¹, the CRA will accept a copy of each of the following documents as support for the donation:

1. The will
2. A letter from the deceased taxpayer’s estate to the charitable organization to which the gift is being made, advising of the gift and its value
3. A letter from the charitable organization acknowledging the gift and stating that it will accept the gift

In situations when the value of a gift increases (or decreases) between the date the gift was deemed to have been made (i.e. the date of death) and the moment of the actual transfer of the gift to the charitable organization, in the CRA’s view the value of the gift is its fair market value at the date of death, irrespective of when the gift is transferred to the charitable organization.

The CRA also commented on the potential issue that arises when the value of a specific gift cannot reasonably be determined at the date of death. This may occur, for example, when it is unclear whether or not the estate will have sufficient funds to make a designated gift to the donee after all of the estate’s liabilities are satisfied. The CRA’s position is that where the value of a gift at the time of death cannot reasonably be determined, the gift will not be allowed for purposes of claiming the donation tax credit².

Estate planners and will drafters should be cognizant of this position when drafting the terms of a gift to minimize the risk that the value of the gift will not be determinable at the time of death and to avoid the collapse of the entire gift.

Donation splitting between spouses or common-law partners

Although there is no authority in the Act for donation splitting between spouses, the CRA’s longstanding administrative practice is to attribute a gift made by either spouse or common-law partner to the family unit, regardless of whose name appears on the receipt supporting the gift (provided the marriage or common-law partnership existed at the time of the donation).

This policy allows spouses or common-law partners to make the most beneficial allocation of the donation for tax credit purposes.

The CRA confirmed that this administrative policy also extends to gifts by will. If a marriage or common-law partnership existed at the time of the taxpayer’s death, and the donation otherwise qualifies as a gift under the Act for purposes of the charitable donation tax credit, the surviving spouse or common-law partner may choose to include the gift in his or her tax return rather than in the terminal return (or prior-year return) of the deceased.

This favourable policy allows a surviving spouse (or common-law partner) and the executor(s) of the deceased’s estate to arrange for a donation tax credit claim that is most beneficial to the deceased’s family.

Planning is important

The ability to claim gifts by will on a taxpayer’s final return can carry substantial tax benefits. However, the technical requirements must be met, and there are numerous issues to consider, such as those addressed above. It is therefore advisable to have a professional advisor review the terms of your will to ensure your charitable wishes are carried out in the most tax-effective manner possible.

The CRA stated that there have been indications of non-compliance in the NPO sector. As a result, it established the NPO Risk Identification Project to gather information to identify the nature and extent of the compliance risk. In addition, the project findings will increase the CRA’s intelligence in the NPO sector and will aid in the determination of:

• The level of non-compliance
• Any significant data gaps that might require mandatory filings of prescribed forms
• Whether recommendations to the Department of Finance for more robust legislation are necessary

The CRA also commented that it is possible for an NPO to earn a profit and retain its tax exemption, provided it meets the key requirements of the Act:

• The organization must not be a charity
• It must be organized and operated exclusively for a purpose other than profit
• None of its income can be payable to or made available for the benefit of its members.

An NPO may earn a profit — so long as it is incidental to its not-for-profit purposes. This is not the same thing as an NPO earning a profit in support of its not-for-profit purposes, which has been rejected by Canadian courts. Whether a profit is incidental to an NPO’s not-for-profit purposes is a question of fact that can only be determined with a review of all the facts.

This case involved a typical offshore freeze. While Barbados is not a low-tax jurisdiction per se, it does not impose tax on capital gains realized by Barbadian residents. This factor, in combination with the Treaty exemption, has made Barbados an attractive jurisdiction for offshore freeze transactions. The Canada Revenue Agency (CRA) has regularly listed Barbadian freeze transactions on its items under review for the potential application of the general anti-avoidance rule (GAAR). However, as we will discuss, the GAAR was just one of several grounds of assessment in this case, and did not form the basis of the FCA’s decision.

Facts

In 1998, the owners of common shares of PMPL Holdings Inc., a Canadian corporation, converted the shares to fixed-value preference shares with a redemption amount of $50 million. Two trusts with Canadian beneficiaries were settled by an individual resident in the Caribbean island of St. Vincent.

The sole trustee of each trust was a corporation resident in Barbados. The trusts subscribed for shares of newly incorporated Canadian holding corporations. As a result, these companies were wholly owned by the trusts. The corporations, in turn, subscribed for shares of PMPL. These transactions were effected at nominal consideration.

In 2000, as part of an arm’s-length sale of PMPL, the trusts disposed of the majority of the shares in the holding companies, realizing capital gains of over $450 million. The trusts claimed the Treaty exemption, which provides that “gains from the alienation of any property, other than those mentioned in paragraphs 1, 2 and 3, may be taxed only in the Contracting State of which the alienator is a resident.”

The Minister took the position that the Treaty exemption did not apply, and issued assessments to each of the trusts in respect of the gains. The Minister also assessed the preferred shareholders of PMPL (the other appellants) with respect to the same gains. These latter assessments were made as a protective measure only, with no intention of taxing the same gains more than once.

The Minister based his assessments on the following alternative arguments:

• The trusts were resident in Canada under general principles.
• The trusts were resident in Canada by virtue of section 94 of the Income Tax Act.
• Subsection 75(2) of the Income Tax Act applied to the other appellants.
• The GAAR applied.
• The sale proceeds should be reallocated from the trusts to the other appellants by virtue of section 68 of the Income Tax Act.

Tax Court decision

The Tax Court judge, Justice Judith Woods, held that the Treaty exemption did not apply because the trusts were resident in Canada. Although the corporate trustee of each trust was acknowledged to be a resident of Barbados, Justice Woods concluded that the central management and control of each trust was in Canada based on the evidence as a whole.

She found that the corporate trustee’s role was to execute documents as required, and to provide incidental administrative services. It was generally not expected that it would have responsibility for decision-making beyond that. In her view, “more likely than not,” the corporate trustee had agreed from the outset that it would defer to the recommendations of the Canadian principals.

Among the many factors that the judge considered relevant was the fact that each Canadian principal (and his wife) had the power to replace the trust’s “protector,” the person who had the power to replace the corporate trustee.

This conclusion must be contrasted with the longstanding decision in Thibodeau Family Trust v the Queen (78 DTC 6376), in which the Federal Court found that the residence of the trust for tax purposes was the jurisdiction of residence of the majority of the trustees. The judge in Thibodeau appeared to reject the central management and control test on the basis that the fiduciary duties imposed on trustees would not permit them to take direction from a third party.

Justice Woods noted that if the judge’s comments in Thibodeau were meant to apply to all cases regardless of the facts, she could not agree, since trustees do not always comply with their fiduciary duties. She stated, “I have concluded that the Thibodeau decision is insufficient authority for me to reject a central management and control test to determine trust residence. In fact, as I will explain, in my view there are very good reasons why the judicial test for residence that has been developed in a corporate context should also apply to trusts.” (paragraph 157)

In her view, “adopting a similar test of residence for trusts and corporations promotes the important principles of consistency, predictability and fairness in the application of tax law.” (paragraph 160)

The decision that the trusts were resident in Canada was sufficient to dispose of the appeals, but Justice Woods went on to address some of the other issues raised. With respect to the application of the GAAR, the existence of a tax benefit and an avoidance transaction were conceded, so the only question was whether there was a “misuse or abuse” of the Treaty. Justice Woods disagreed with the Minister’s finding of abuse, stating that this approach would be contrary to that suggested by the FCA in The Queen v MIL (Investments) S.A. (2007 FCA 236). “It does not make sense that a transaction that is subject to tax under the [Income Tax] Act by virtue of an anti-avoidance provision necessarily constitutes a misuse or abuse of the Treaty.” (paragraph 373)

The result was that the Tax Court dismissed the appeals of the trusts and allowed the appeals of the other appellants.

The taxpayers appealed to the FCA.

Federal Court of Appeal decision

In a unanimous decision, the FCA dismissed the taxpayers’ appeals. Justice Karen Sharlow agreed with Justice Woods that a central management and control test should be applied in determining the residence of the trusts. Based on the evidence before her, it was reasonably open to the trial judge to conclude that the trusts were resident in Canada.

Like the Tax Court judge, Justice Sharlow dealt with the alternative grounds of assessment that the Minister raised. Because these matters did not form the basis of the decision, they will not be discussed here.

It is interesting to note, however, that like the Tax Court, the FCA concluded that the GAAR did not apply. The claiming of the Treaty exemption in the face of section 94 was not considered to be a “misuse or abuse.” If the residence of the trust was assumed to be in Barbados for Treaty purposes, the trust could not be considered to have misused or abused the Treaty by claiming the exemption.

What the decision means

The most important aspect of this decision is the FCA’s confirmation that the residence of a trust is to be determined by reference to its central management and control, and not necessarily the residence of the trustees. This determination is based not only on the relevant written documentation, but also on the actions of the parties. Proper implementation and follow-through are crucial when tax minimization or tax avoidance strategies are in play.

Tax Alerts

 2010 Issue No. 42 - Federal Court of Appeal dismisses Crown’s appeal in GE Capital
On 15 December 2010, the Federal Court of Appeal released its reasons dismissing the Crown’s appeal in the GE Capital case (2010 FCA 344). In doing so, the court agreed with the Tax Court that the “halo” effect, or “implicit support” of a parent corporation, is a relevant factor in transfer pricing cases — at least those involving financial transactions such as guarantees or loans between non-arm’s-length parties. The halo effect potentially has far-reaching implications in other transfer pricing situations. 

 2010 Issue No. 43 - Government releases revised REIT rules
On 16 December 2010, the Department of Finance released proposed amendments to the real estate investment trust (REIT) rules that would give REITs the ability to hold limited non-qualifying assets and earn more non-eligible revenue than they’re permitted under the current legislation. The proposals also provide more clarity around certain key terms and definitions in the existing legislation. 

 2011 Issue No. 1 - Panel seeking public input on federal support for business R&D
On 21 December 2010, the federal government’s independent expert review panel launched a national consultation process to solicit Canadians’ advice on the effectiveness of current industrial research and development (R&D) programs, and how the federal government can improve its support of these initiatives. Attend our related webcast on 10 February. 

 2011 Issue No. 2 - China issues first annual APA report
On 30 December 2010, China’s State Administration of Taxation (SAT) published the China Advance Transfer Pricing Arrangement Annual Report (2009). The SAT intends to publish the report annually to help to achieve more systematic enforcement of transfer pricing in China and to increase taxpayer transparency. In our analysis, we provide a Canadian interpretation of the report and discuss the potential implications for Canadian companies with operations in China. 

A modest proposal
In the January–February 2011 issue of CAmagazine, Ernst & Young National Tax Advisor Fred O’Riordan comments on the Canada Revenue Agency’s tax dispute settlement practices and contrasts them with those of their US and UK counterparts. As discussed in the article, there are some serious impediments to settling cases in Canada. Read more.

Income splitting strategies: selected aspects
In the Canadian Tax Journal (2010 vol. 58, issue no. 4), Ernst & Young Executive Director Irene Jacob and Senior Manager Evelyn Lee examine the tax benefits of selected income-splitting strategies and ways to avoid many of the hidden traps in the successful implementation of those strategies.

The situations considered include loans to spouses and minors, prescribed-rate loans, payment of salaries to family members, the use of corporations and trusts, and deferred-income plans. Read more (available by subscription only).

Ernst & Young’s Guide to Preparing 2010 Personal Tax Returns
Internet Edition or eBook
Editors: Gena Katz, Maureen De Lisser, Yves Plante, and Vivian Leung

Wealth under the spotlight: Tax administration without borders
Tax policy and tax administration around the world are both experiencing unprecedented levels of change, driven in large part by the global financial crisis. This report highlights some of these global changes and their impact on high-net-worth individuals. We explore current policy direction and the spectacular rise in collaboration and information sharing among tax administrations, and how many high-net-worth individuals are now starting to realize that their relationship with key taxing administrations needs to evolve. Read more.

Climate change and sustainability: Seven questions CEOs and boards should ask about “triple bottom line” reporting
In the face of mounting pressure to be transparent, a growing number of organizations are choosing to report on sustainability or corporate social responsibility (CSR). Sustainability reports help readers understand how well the reporting organization adheres to the “triple bottom line” of environmental, social and economic performance. Read more.

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.