TaxMatters@EY – July 2011

The CRA has established a program called the Related Parties Initiative — also referred to as the High-Net-Worth Project — which targets individuals with a net asset value of more than $50 million, and related groups comprising 30 or more entities, for in-depth audit. You or someone in your family could still be targeted if your net worth falls below these stated threshold levels. The CRA has significantly increased its resources in this area and is casting a wider net than ever before.

The Related Parties Initiative started as a CRA pilot project in 2005. It was based on a similar initiative of the Australian Taxation Office in 1996 called the High Wealth Individuals Taskforce.

Tax administrations in different countries communicate with each other frequently and share best practices, and since the Australian taskforce was achieving good results, the CRA decided to implement a similar program. Thus the Related Parties Initiative was born.

While traditional audits have a relatively limited scope that tends to focus on a particular entity, the Related Parties Initiative is much more comprehensive, encompassing all related entities.

And even though the initiative has been around for a few years, it has become more visible recently as a result of past audits being concluded and new audits being imposed.

Its profile was also raised with the publication of a 2009 Organisation for Economic Co-operation and Development (OECD) study called Engaging with High Net Worth Individuals on Tax Compliance, which was commissioned by the OECD’s Forum on Tax Administration, composed of about 40 tax authorities, including the CRA.

Among other things, the study recommended that tax authorities establish an appropriate structure to deal with perceived tax compliance issues with wealthy individuals. It noted that nine countries, including Canada, had already done this. A number of additional tax administrations have followed suit since then, most notably the US Internal Revenue Service, which set up a high-wealth unit in 2009.

The Related Parties Initiative has also gained a higher profile because of the tax authorities’ general and growing concerns over the possible “offshoring” of unreported income by wealthy individuals in low-tax jurisdictions, including so-called “tax havens.”

Are you ready if the CRA comes knocking?

To learn more about the Related Parties Initiative, why wealthy Canadians are being targeted now, what to expect if you’re targeted and whether this is a sign of things to come, see our publication Wealth under the spotlight and the “High-net-worth individuals fall under the spotlight” in the April 2011 edition of TaxMatters@EY.

Restricted and recaptured input tax credits

One of the most common errors is neglecting to restrict the 50% recovery of GST/HST on reimbursements of meals and entertainment expenses incurred by employees. This process became more complex with the 1 July 2010 harmonization of sales taxes in Ontario and British Columbia, where, in addition to restricting 50% of the HST paid for federal purposes, large businesses must generally recapture and report separately the provincial portion of the HST, subject to certain exceptions.

There is no recapture of the provincial component of HST to consider in the harmonized Atlantic provinces.

Full input tax credits (ITCs) can be claimed on a monthly basis, with a recapture calculation performed at year end. This recapture calculation can become complex in cases where purchases are made in several provinces with different GST/HST rates. The year-end adjustment can easily be overlooked, so many businesses prefer to restrict the 50% throughout the year.

Determining the HST recapture amount for meals and entertainment is often approached incorrectly. It is important to multiply the total amount of ITC to which a business is entitled by 50% before calculating the 7/12th or 8/13th provincial component that is subject to recapture. Doing otherwise results in reporting double the amount of recapture for BC or Ontario. Even though the net GST/HST payable will remain unchanged, those errors are subject to reassessment.

In addition to meals and entertainment expenses, the provincial recapture provisions in Ontario and BC extend to telecommunication services, the purchase or lease of a licensed road vehicle weighing less than 3,000 kg, and energy not used in manufacturing or farming.

ITC recapture applies to gasoline for licensed road vehicles in Ontario (BC has a point-of-sale rebate, so the provincial component is not paid). A gradual phase-out of the recapture requirements is scheduled to begin on 1 July 2015 and continue to 1 July 2018, when all the tax will be recoverable.

These recapture items mirror Quebec’s input tax refund restrictions for large businesses for the same categories of expenses, including fuel. Many organizations face challenges with capturing these restrictions and many QST assessments arise as a result.

In addition, no ITC is available for GST/HST paid on membership fees or club dues when their main purpose is to provide dining or recreational facilities. However, if expenses are incurred at these clubs for meals and entertainment, the tax is recoverable, subject to the restrictions noted above.

ITC documentation

To recover GST/HST paid to suppliers, businesses are required to have sufficient documentation on hand (e.g., a valid GST registration number matching the supplier, among other things) prior to claiming an ITC.

The Canada Revenue Agency (CRA) has a website where a GST/HST registration number can be validated. Documentation should also show the vendor’s name (especially the correct legal entity), a description of the goods being purchased, the payment terms, the amount payable for the supply and the total amount of GST/HST applicable to the sale. It is important to note that the input tax credit to recover the GST/HST may be claimed only by the recipient of the supply — that is, the person who is legally liable to pay for the supply.

Bad debts

While businesses will periodically write off small, uncollectible account balances from their books and impute an amount as being GST/HST, the CRA requires that all or part of the consideration and tax in respect of the supply must have become bad, and the supplier is able to recover the tax only in proportion to the unpaid balance. Therefore, in circumstances where an invoice has been short-paid by only the amount of tax, for example, only a pro-rated component of the short-paid amount may be recovered. In addition, if an amount that was written-off as a bad debt is subsequently recovered, and the supplier reduced its net tax owing at the time of the write-off, the supplier must remit to the CRA the tax component of the amount recovered.

Rates of tax

The transition to the new HST place of supply rules in 2010 continues to present challenges for organizations, especially for determining the tax rate applicable to services. The applicable tax rates for services in Canada now follow a general rule: the tax rate is determined based on the customer’s business address, so it’s important that registrants update their customer master profiles to ensure the appropriate rate of tax is collected. There are several exceptions to the general rule, so careful attention is required for each type of transaction.

The applicable tax rate for goods delivered in Canada is generally dependent on where the goods are actually delivered. However, in cases where documentation shows that goods are delivered to a customer at its supplier’s dock, but the vendor has contracted with a carrier to deliver the goods to another province, the tax rate of the destination province will apply rather than the tax rate of the province where the document states the delivery occurs.

Intercompany charges

It’s common for businesses to make intercompany charges by way of journal entry without an invoice and not account for GST/HST as part of the entry. It’s important that the appropriate elections be made or on file, as the case may be, not to collect GST/HST on taxable intercompany supplies. Although there may be no net tax loss to the CRA, an auditor may raise an assessment for the incorrect reporting.

Imports

In cases where goods are imported into Canada, a broker’s invoice is issued showing the duty paid and any related taxes. Occasionally, only the amount of GST/HST charged on the broker’s fee will be claimed as an ITC, leaving what normally is a far larger amount of tax on the duty-paid value of the imported goods unrecovered. For some businesses, these amounts can be significant, so it’s important that attention be paid to these invoices to ensure that the correct amounts are recorded as input tax credits.

Accounting for GST/HST

When a GST/HST return is completed, incorrect amounts are often reported on the return. To help reduce this error, it can be helpful to record GST/HST collected from customers in a separate GST/HST payable account, all amounts paid to suppliers in a GST/HST recoverable account and all recaptured amounts in separate accounts by province. Provided these amounts are reported as such and the accounts are reconciled each month, there should be less confusion as to the correct amount that needs to be remitted or recovered.

Conclusion

Everyone involved in your organization’s commodity tax processes — from billing and accounts payable to invoice approval and internal audit — should know about the relevant rules. That will help relieve the anxiety around a commodity tax audit and reduce the potential for an assessment.

With so many obligations and recent changes to the rules, it’s also prudent to have training and other learning resources available to help your people navigate the complex issues.

In technical interpretation 2010-0383021E5, the CRA provided only general comments rather than specific reasons to back up its position. A review of the legislation is necessary in order to determine its rationale.

Generally, under paragraph 118.2(2)(m) of the Act, a medical expense includes an amount paid for any device or equipment for a patient’s use that meets the following criteria:

• Is of a prescribed kind;
• Is prescribed by a medical practitioner; and
• Meets any prescribed conditions as to its use or the reason for its acquisition.

Under section 5700(x) of the Income Tax Regulations (the Regulations), a prescribed device includes a “Bliss symbol board, or similar device, designed to be used to help an individual who has a speech impairment communicate by selecting the symbols or spelling out words.” [emphasis added]

Blissymbolics is a concept-based language of symbols used by non-verbal individuals. A Bliss symbol board displays a number of symbols, allowing an individual to communicate by selecting the appropriate symbols.

A number of currently available iPad applications are designed to help special needs children communicate by tapping on symbols displayed on the screen of the device. Therefore, it could be argued that an iPad is a “similar device” to a Bliss symbol board for purposes of section 5700(x) of the Regulations. However, it could also be argued that since the iPad is capable of many other uses, it is not specifically designed for special needs individuals to communicate.

The iPad’s multipurpose nature is likely the reason the CRA views it as ineligible for the medical expense tax credit.

In another recent technical interpretation, 2011-0394391E5 (available in French only), the CRA gave its view that a student enrolled at an educational institution in a course requiring him or her to acquire a computer cannot include, in a claim for a tuition tax credit under section 118.5(1) of the Act, the cost of a computer purchased under a group purchase scheme administered by the educational institution.

Unfortunately for the student in this case, section 118.5(3)(c) of the Act does not allow charges levied in respect of property to be acquired by students to be eligible for the tuition credit. However, personal computers have become commonplace in educational institutions in recent years, and the student was required to purchase one. This is another example of how technological advances may be ahead of the legislative curve.

Returning to the iPad, although the CRA’s position is defensible, section 5700(x) of the Regulations is also capable of a more expansive interpretation. Anecdotal evidence suggests that the iPad is a very useful tool in allowing autistic and other children with special needs to communicate more effectively.¹ And because the iPad is relatively inexpensive, it’s conceivable that any revenue loss resulting from allowing a medical expense tax credit would be relatively small, especially since the device would still need to be prescribed by a medical practitioner to be eligible for the credit.

As technology advances, single-purpose devices such as the Bliss symbol board are yielding to multi-use devices such as the iPad, for which new applications are constantly being designed.

If the CRA continues to hold its current position, changes to the Act and Regulations would be welcome to allow either the cost of devices that are in fact used for medical purposes, or the medical applications they run, to benefit from the medical expense tax credit.

A charity is required to include a copy of its financial statements with its annual information return, which must be filed no later than six months following the end of its fiscal period. At a minimum, financial statements should include a balance sheet and an income statement. Financial statements should show the different sources of revenue and the expenditures for the fiscal period.

To assist charities in meeting their annual reporting obligations, the Charities Directorate has created completed samples of the following:

• Form T3010-1, Registered Charity Information Return
• Financial statements
• Form T1235, Directors/Trustees and Like Officials Worksheet
• Form T1236, Qualified Donees Worksheet/Amounts Provided to Other Organizations

You can find these samples on the CRA website.

The CRA will consider a return that does not include financial statements to be incomplete, which may result in penalties of various levels, and at the extreme result in the charity having its charitable registration revoked.

Intergenerational family business transfer tax planning

In the first withdrawn ruling document, the taxpayer’s representative was seeking confirmation that the general anti-avoidance rule (GAAR) would not apply to a proposed series of transactions done in the context of an intergenerational family business transfer. The taxpayer’s representative submitted that the series of transactions was similar to a January 2006 ruling document in which the CRA gave a favourable ruling regarding the application of the GAAR.

In denying the confirmation, the CRA indicated that the favourable ruling it gave in 2006 was given in the context of a “true” intergenerational transfer of a family business. It also indicated that the 2006 ruling did not change its general position that it will apply either the anti-avoidance rule in section 84.1 of the Income Tax Act (the Act) or the GAAR when the taxpayer’s goal is to access the capital gains exemption by, among other things, completing a series of internal transactions designed to help them keep the same economic interests as before, or when family members are acting as facilitators or accommodators.

In the 2006 ruling, the CRA was particularly influenced by the situation surrounding the controlling shareholder:

• He was a person of a certain age
• He wished to retire
• He owned all the shares of the corporation carrying on the family business
• He wished to completely sever his economic ties with the corporation (although he would remain an employee while progressively reducing his work hours and, on occasion, would act as a resource-person to his two adult sons)
• He wished to transfer the family business to the two sons, who had been involved in it for a long time (including managing its two branches) and who would, after the transactions, become directors and, respectively, president and vice president.

Although it did not provide specific facts in its withdrawn ruling, the CRA distinguished the case from the “true” intergenerational family business transfer on the basis that, among other reasons, the controlling shareholder was already “pre-retired” at the outset of the proposed transactions, and at the time held only freeze shares of the capital stock of the corporation carrying on the family business. The CRA thus felt that the proposed series of transactions would result in an abusive surplus stripping, and that all conditions to apply the GAAR would be met. There was no further explanation.

Post-mortem tax planning

In the second withdrawn ruling document, an estate was seeking confirmation that it could use a pipeline strategy to avoid double taxation. The CRA refused to confirm that the estate’s repatriation of the company’s surpluses would not give rise to a dividend treatment to the estate under subsection 84(2) of the Act or the GAAR provisions.

At the time of her death, the taxpayer was the sole shareholder of “Holdco,” a private company. Holdco owned only liquid assets and was inactive. Pursuant to subsection 70(5) of the Act, there was a deemed disposition of the Holdco shares on the taxpayer’s death, resulting in a capital gain.

If Holdco were to subsequently redeem its shares, or be wound up, there could be additional tax payable by the estate.

Assuming that the ruling request involved a typical pipeline strategy, the steps involved would have been as follows:

• A new company (Newco) would be incorporated by the estate.
• The estate would transfer the Holdco shares to Newco on a tax-deferred basis.
• In exchange for the Holdco shares, Newco would issue the estate a promissory note equal to the adjusted cost base of the Holdco shares and additional shares in Newco representing any increase in value of the Holdco shares following the taxpayer’s death.
• The promissory note would then be repaid to the estate tax free, and the estate would distribute the funds to beneficiaries.

Double taxation would thus be avoided, in that tax would only be imposed on the deemed capital gain reported on the deceased’s terminal tax return and not on the redemption of the Holdco shares that would otherwise occur.

As noted, the CRA refused to confirm that the estate’s repatriation of Holdco’s surpluses would not give rise to a dividend treatment to the estate or application of the GAAR provisions. Mention was made of an alternative strategy, the “subsection 164(6) capital loss carry-back strategy,” which could apply to carry back the capital loss triggered by the winding-up or redemption of the shares of the capital stock of the corporation, to offset the deceased’s deemed capital gain.

The CRA Income Tax Rulings Directorate has apparently received many similar requests regarding pipeline planning. This issue was also put forward at the 2011 Society of Trust and Estate Practitioners Conference, where the CRA confirmed that pipeline planning is not necessarily dead, since there are cases in which the facts support such planning.

In light of these comments, taxpayers wishing to implement a pipeline strategy in lieu of, or in combination with, a subsection 164(6) capital loss carry-back strategy may still be able to do so without a CRA challenge. But they should exercise caution and obtain professional advice from their tax advisor.

It should be noted that not all tax advisors agree with the CRA’s approach to the two withdrawn ruling requests. Some argue that the CRA’s views are not technically correct and will ultimately fail before the tax courts. However, even if a taxpayer wins at court, the expense of a dispute with the CRA can be significant in and of itself. When possible, it is advisable to structure transactions so that they meet the CRA’s assessing policies.

Tax Alerts

• 2011 Issue No. 25 - TIEAs with Bermuda and Cayman Islands enter into force
  Recently, the Canadian Department of Finance announced the entry into force of the tax information exchange agreements (TIEAs) with Bermuda effective 1 July 2011 and the Cayman Islands effective 1 June 2011. This tax alert includes a list of all jurisdictions with which Canada is negotiating TIEAs.
• 2011 Issue No. 26 - Federal budget redux: a modest fine-tuning of the original
  As widely speculated, federal Finance Minister Jim Flaherty’s June budget reintroduced the same budget tax measures that he tabled in the House of Commons on 22 March 2011. All measures are effective as of the original budget date, unless otherwise noted.
• 2011 Issue No. 27 - Elimination of partnership tax deferrals
  On 4 May 2011, the Quebec Minister of Revenue tabled amendments to the Mining Duties Act, which were proposed in the province’s 2010 budget. The revised regime is expected to generate additional provincial revenues of approximately $243 million over the next five taxation years.
• 2011 Issue No. 28 - Canada-China treaty to be renegotiated
  The Canadian and Chinese governments have entered into negotiations to update the countries’ bilateral income tax treaty. On 24 June 2011, we responded to the Department of Finance’s invitation for comments on the negotiations, identifying a variety of issues that we’ve encountered in the course of working with clients on bilateral investment or trade activities.

Governance and risk in a global economy
In the June–July 2011 issue of CAmagazine, Ernst & Young National Tax Advisor Fred O’Riordan notes that getting global tax risk management wrong can mean financial disaster, but getting it right can yield many competitive benefits.

Seizing the opportunity in Global Compliance and Reporting: Survey and trends
Global companies must find new ways to manage their statutory financial and tax filings to remain competitive in a globalized world and continue meeting the demands of local regulators and tax authorities.

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.