TaxMatters@EY – March 2012

You’ll also find helpful 2012 and comparative 2011 personal tax planning tools:

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The Canadian income tax system does not support donation schemes. The Canada Revenue Agency (CRA) will often reduce donations made under a donation scheme to "no more than the taxpayer’s cash donation," although in many cases it will reduce the donation even further or deny it altogether. Interest and penalties may also apply.

Given the tax ramifications of these schemes, what are some of the red flags a potential donor should be on the lookout for?

What are charitable donation schemes?

Charitable tax planning schemes may be organized in a variety of ways. But as a general proposition, a potential donor is promised a charitable tax credit based on a donation far exceeding the actual cash contribution.

A good example is the case of Maréchaux v The Queen (2009 TCC 587, aff’d 2010 FCA 287), which effectively illustrates the operation of a "leveraged donation" scheme:

• The taxpayer pledged a $100,000 donation to a registered charity.
• The taxpayer paid 30% of the pledged amount (a cash outlay of $30,000) to the promoter.
• The taxpayer borrowed 80% of the pledged amount (i.e., $80,000) as an interest-free loan from a capital corporation (the lender) that was controlled by the promoter.
• The taxpayer used $10,000 of the borrowed amount to pay the following:
  • A security deposit to the lender, which was to be invested for the purpose of accumulating an amount equal to the original loan over a 20-year period
  • A fee to the lender for arranging the loan
  • An insurance policy premium to insure against the risk that the deposit would not accumulate sufficient funds.
• The taxpayer was entitled to assign the insurance policy and the security deposit to the lender as full payment for the loan, and the lender was obliged to accept.
• The promoter transferred 100% of the pledged amount, comprising $30,000 of the taxpayer’s own money and $70,000 of the borrowed amount, to the charity.
• The charity issued a charitable donation receipt to the taxpayer in the amount $100,000.

The end result was that for a cash outlay of $30,000, the taxpayer received a charitable donation tax receipt for $100,000 and claimed a tax credit of $44,218. The CRA disallowed the credit in its entirety, a decision that was upheld by the Tax Court of Canada and the Federal Court of Appeal.

One charitable donation vehicle that pops up frequently in the case law involves the donation of art prints. Typically, a promoter makes bulk purchases of limited edition prints and sells them to clients at a discount. Clients then donate the prints to various educational institutions in return for tax receipts for the prints’ purported market value, often several times higher than the actual amount paid. (See Lemberg et al v Perris et al (2010 ONSC 3690) and Klotz v The Queen (2004 TCC 147, aff’d 2005 FCA 158)).

In addition, several cases describe schemes where taxpayers were able to "purchase" charitable tax receipts with inflated face values, such as Paterson v The Queen (2011 FCA 12), Sarsonas v The Queen (2011 TCC 559) and Abouantoun et al v The Queen [2001] T.C.J. No. 653.

While such tax shelters may vary in the specifics, the case law confirms this basic rule of thumb: be wary of donation schemes promising returns greater than your donation.

CRA warnings

 
For its part, the CRA specifically cautions against making charitable donations through tax shelter arrangements such as gifting trust arrangements, leveraged cash donations and buy- low/donate-high arrangements.

The CRA offers the following advice to taxpayers concerning charities:

• Confirm that the organization is a Canadian registered charity by using the CRA’s searchable list of Canadian charities. Taxpayers can also use the list to review a charity’s Registered Charity Information Return.
• Research the charity by visiting the charity’s website to learn about its activities.

The CRA cautions taxpayers not to rely on the fact that a promoter possesses a tax shelter number. While a promoter is required to obtain a tax shelter number from the CRA for identification purposes, this is no guarantee that the arrangement will not be audited.

The bottom line: if it looks too good to be true – it probably is.

Here's how a similar scam might work in Canada. A taxpayer would receive an email using "Canada Revenue Agency e-audit" as the subject line, giving the appearance that it was sent by the CRA. The recipient/taxpayer would be instructed to fill out a questionnaire and return it within 48 hours to avoid penalties and interest. The fraudulent questionnaire would require the taxpayer to provide his or her social insurance number, bank account numbers and other confidential information. Once the scam artist has this confidential information, the taxpayer is a potential victim of fraudulent activities.

The CRA does not notify taxpayers about pending audits by email, nor does it conduct "e-audits." Taxpayers should never respond to a request for confidential information without first confirming the identity of the requestor and assuring themselves that the requestor is legally permitted to request such information.

The CRA is committed to safeguarding the confidentiality of all taxpayer information. Because the internet is not a secure medium of communication, the CRA does not use it to communicate with clients unless the taxpayer has first provided permission.

If you receive such an email, please contact your tax services office.

The CRA’s advice is a useful reminder that you should always be very cautious in the information you disseminate based on email requests from any party — particularly when it comes to sensitive or confidential information.

• Resources assigned to the indirect tax function often have responsibilities that are limited to day-to-day compliance and occasional “firefighting” when a problem is identified. Typically, few resources, if any, are allocated to the ongoing review of controls, risk assessment and mitigation, standardization of processes, and the exploration of planning opportunities to reduce tax costs and enhance cash flow.
• Indirect taxes often have little, if any, visibility with senior management, and their relevance compared to income taxes is often dismissed until a significant government audit assessment is levied.
• Processes and controls for indirect taxes within an organization or corporate group are often inconsistent from one jurisdiction to another, and leading practices are not shared among business units.
• Lack of global oversight and integration and communication with income tax resources can result in unnecessary costs becoming embedded in a company’s supply chain, making it less competitive relative to organizations that have exercised the necessary due diligence and implemented tax-effective structures.
• Indirect taxes are often managed within a business unit at local or regional levels, with little, if any, information readily available to management to provide a meaningful bird’s-eye view of inherent global compliance risks, audit activity and planning opportunities throughout all jurisdictions in which the business operates.

Trends toward globalization, increasing rates of VAT, and governments’ increased scrutiny and risk-profiling strategies are accelerating the need for businesses to dedicate appropriate resources to effectively manage their indirect tax functions.

Many businesses could reap real benefits by undertaking an objective assessment of the organization’s current indirect tax function to identify ways in which existing risks can be mitigated and potential planning and recovery opportunities can be explored to reduce embedded tax costs.

Sometimes relatively simple changes to the way an organization manages its indirect tax function can produce significant gains. For example, an organization can define and develop a global standard for managing indirect taxes that can be implemented throughout all relevant geographies with clearly defined governance and ownership roles and the identification of a person or team in the global tax department with responsibility for indirect taxes. Such a standard can be implemented without significant cost or disruption to the organization. However, this change in itself can reduce the risk profile of the organization in the eyes of tax authorities.

Equally important, as the new structure and processes are implemented, an organization can experience increased accountability through defined ownership, improved efficiencies through automation, and a coordinated approach to planning and compliance for indirect taxes and other taxes that will be equally appealing to the organization’s own board and shareholders.

Child care expense deduction

Briefly, an individual who meets the eligibility requirements is permitted to deduct child-care costs that are incurred to earn income or receive an education. Generally, child-care expenses must be claimed by the parent with the lower net income, and the deduction is limited to the lesser of the following:

• The amount of eligible child-care expenses paid;
• Two-thirds of the taxpayer’s earned income; and
• $4,000, $7,000 or $10,000 per child, depending on the age and health of the child.

The value of the benefit depends on the tax bracket of the lower-income parent claiming the deduction.

Caregiver tax credit

An individual providing qualifying in-home care for a related dependent adult may be eligible to claim the caregiver tax credit and, beginning in 2012, the family caregiver credit. The combined credit amount is reduced when the dependent’s net income for the year exceeds $15,033.

For 2012, the maximum amount eligible for the federal caregiver credit is $4,402, plus an additional $2,000 where the dependent is eligible for the new family caregiver credit. This results in a maximum federal credit of $660.30 for 2012, plus an additional $300 where the dependent is eligible for the family caregiver credit.

The amount of the provincial caregiver credit varies by province.

Child care provided by a live-in grandparent

The CRA was asked whether payments made by parents to their children’s grandparents for the provision of child-care services were eligible for the child care expense deduction. The grandparents lived with the parents and provided child-care services for their two children on weekdays when the parents were at work.

In its response, the CRA confirms that, provided all other conditions are met, payments to a grandparent are eligible for the child care expense deduction, as long as the parent has not claimed a tax credit under section 118 (which includes the caregiver credit) in respect of the grandparent.

Although the CRA did not comment on the tax implications to the grandparent, it is important to note that any amount paid to the grandparent as a child-care provider and claimed as a deduction by the parent would be required to be included in the grandparent’s income for tax purpose.

Conclusion

In certain circumstances, paying a grandparent to care for grandchildren can serve as an effective income-splitting strategy for reducing a family’s overall tax burden. This is particularly true where the parents are high income earners and the grandparents are relatively low income earners eligible for the age credit but not the guaranteed income supplement.

In the case of live-in grandparents, some families may be faced with the question of whether to claim the child-care expense deduction or the caregiver tax credit. While most families faced with this question will find it more beneficial to claim the child care expense deduction over the caregiver credit, this may not always be the case. For example, if the additional income places the grandparent in the same tax bracket as the parent claiming the child-care deduction, the benefit of the deduction may be offset by the additional tax payable by the grandparent.

In addition, it is necessary to consider the effect of the additional income on any income-tested benefits available to the grandparent (such as the guaranteed income supplement). The cost of any clawback on benefits can be significant.

In summary, careful analysis is needed to ensure any additional income to the grandparent for providing child care to their grandchildren does not end up costing, rather than saving, money for the family as a whole.

The following key principles can be drawn from the case:

• Goodwill can exist in a regulated industry.
• There is no set legal definition of goodwill. It is a flexible concept that arises from the expectation of future earnings, returns or other benefits and must be assessed on a case-by-case basis.
• The residual value method of valuing goodwill is to be preferred. Under this approach, the more easily valued assets are first given a fair market value, and any consideration in excess of this fair market value is assigned to goodwill.
• The Minister or the court cannot substitute its judgment for what is a reasonable amount to pay for goodwill. The test is what a reasonable business person would have paid in the circumstances. Regulatory and industry practices are relevant to determining the reasonableness of a goodwill valuation for income tax purposes.

Facts

In 2002, TransAlta "sold its regulated electricity transmission business in Alberta to AltaLink, L.P. at a price negotiated as 1.31 times the net regulated book value of its tangible assets. The parties allocated the bulk of the 31% premium over net regulated book value (an amount of $190,824,476) to goodwill.
The Minister reassessed TransAlta under section 68 of the Act on the basis that this allocation was unreasonable, taking the view that no goodwill exists in a regulated industry, and therefore allocated the premium to tangible assets. This resulted in the recapture of capital cost allowance ("CCA) to TransAlta.
TransAlta’s appeal to the Tax Court of Canada "was allowed, in part. Justice Campbell Miller concluded that goodwill can exist in a regulated industry and that TransAlta did, in fact, sell goodwill. However, he considered that $50 million of the amount allocated to goodwill should be allocated instead to tangible assets. In his view, this amount represented the value of two items: the potential for leverage and a potential tax allowance benefit, both of which were attached to the tangible assets.
TransAlta appealed to the FCA and the Crown cross-appealed.

FCA decision

The FCA looked at whether goodwill could exist in a regulated industry, whether the allocation between TransAlta and AltaLink was unreasonable under section 68 of the Act and, if so, whether the Tax Court judge could substitute his own allocation based on his own valuation.

Concept of goodwill

FCA Justice Robert Mainville rendered the reasons for judgment. He noted that there is no clear legal definition of goodwill. Instead, he said that various characteristics of goodwill should be identified and then used to ascertain goodwill on a case-by-case basis.

He set out three characteristics that should be present for goodwill to exist:

1. Goodwill must be an unidentified intangible, as opposed to a tangible, asset or an identified intangible such as a brand name, patent or franchise.
2. It must arise from the expectation of future earnings, returns or other benefits in excess of what would be expected in a comparable business.
3. It must be inseparable from the business to which it belongs and cannot normally be sold apart from the sale of the business as a going concern. (para 54).

Justice Mainville further noted that an established reputation, customer satisfaction, a unique product or process leading to a monopolistic position, good or astute management, favourable location, manufacturing efficiency, harmonious labour relations, advertising, quality of products and financial standing have all been found to constitute goodwill.

The existence of goodwill in a regulated industry

The Crown’s expert argued that what is acquired in the purchase of a regulated business is the revenue stream generated by the tangible regulated assets of that business. Therefore, even though the purchase price in this case reflected a multiple of the net regulated book value of the assets, the entire purchase price should have been allocated to those assets.

The taxpayer’s expert argued the opposite, basically that regulatory restrictions limit the fair market value of rate-regulated assets to their net regulated value, so that any premium above that amount should be attributed to goodwill or other intangibles.

After reviewing the expert opinions, the legal framework of the regulatory system and industry practices, Justice Mainville concluded that returns on equity in excess of those approved by a regulator are possible and could result from exceptional business management, new business opportunities or other strategic factors. In this case, he specifically noted efficient management by TransAlta and the potential for new business opportunities flowing from TransAlta’s transmission business.

These factors resulted in the expectation of future earnings, returns or other benefits in excess of what would be expected in a comparable business. They were inseparable from the business to which they belonged, and they could not normally be sold apart from the sale of the business as a going concern. As such, they were intangible assets that had the requisite characteristics of goodwill.

As mentioned the Tax Court judge had also found that goodwill was sold and purchased in the transaction, but had concluded that the potential for leverage and a potential tax allowance benefit were not part of the goodwill, and that their value, which he estimated to be $50 million, should be allocated to TransAlta’s tangible assets.

FCA Justice Mainville disagreed with respect to the potential for leverage, which he held was an intangible asset that had all the characteristics of goodwill.

The potential tax allowance benefit resulted from the Alberta Energy and Utilities Board’s consideration of taxes for the purposes of setting rates. The purchaser, AltaLink, could expect to receive an allowance for income taxes as part of its annual revenues permitted by the Board. The expectation was that the tax allowance permitted by the Board would exceed the income tax actually paid by at least one of AltaLink’s partners, which was a non-taxable pension fund.

With respect to this potential tax allowance benefit, Justice Mainville noted that the value of that benefit was lower than that determined by the Tax Court judge. And even if a small portion of the premium in excess of net book value could be attributed to the potential tax allowance benefit, it was not unreasonable for the parties to the transaction to allocate that portion to goodwill for the purposes of section 68 of the Act.

Most important, Justice Mainville endorsed the residual value method of valuing goodwill. . Under this approach, the more easily valued assets are first given a fair market value, and any consideration in excess of this fair market value is assigned to goodwill.

Reasonableness of the goodwill allocation under section 68 of the Act

Section 68 of the Act states the following [emphasis added]:

68. Where an amount received or receivable from a person can reasonably be regarded as being in part the consideration for the disposition of a particular property of a taxpayer or as being in part consideration for the provision of particular services by a taxpayer,

1. the part of the amount that can reasonably be regarded as being the consideration for the disposition shall be deemed to be proceeds of disposition of the particular property irrespective of the form or legal effect of the contract or agreement, and the person to whom the property was disposed of shall be deemed to have acquired it for an amount equal to that part; and
2. the part of the amount that can reasonably be regarded as being consideration for the provision of particular services shall be deemed to be an amount received or receivable by the taxpayer in respect of those services irrespective of the form or legal effect of the contract or agreement, and that part shall be deemed to be an amount paid or payable to the taxpayer by the person to whom the services were rendered in respect of those services.

Justice Mainville adopted the concept of reasonableness expressed in Gabco Limited v MNR, 68 DTC 5210 (Ex. Ct.) at p. 5216: "It is not a question of the Minister or his Court substituting its judgment for what is a reasonable amount to pay, but rather a case of the Minister or the Court coming to the conclusion that no reasonable business man would have contracted to pay such an amount having only the business consideration of the appellant in mind."

TransAlta argued that in applying section 68, considerable weight should be given to the fact that the allocation to goodwill was negotiated by arm’s-length parties. Justice Mainville acknowledged that this was an important factor to be considered, but found that the weight to be given to it depends on the circumstances. Obviously, it should be given less weight if one of the parties is indifferent to the allocation, or if the parties’ interests are aligned.

The Tax Court judge found that AltaLink was indifferent to the allocation of the price to goodwill beyond the net regulatory book value of the assets, and substituted his own allocation for that agreed upon by the parties.

Justice Mainville found this inappropriate, based on the evidence presented as to industry and regulatory norms, and accounting and valuation theory for regulated businesses, all of which pointed in the direction of the agreed-upon allocation. Therefore the "reasonable business person" test under section 68 had been met.

In the final result, TransAlta’s appeal was allowed and the Crown’s cross-appeal dismissed — a very significant victory for the taxpayer.

Lessons learned

The purchase or sale of a business is a complex transaction requiring significant technical and industry knowledge. Your Ernst & Young advisors have the tax planning and financing experience to help you meet your goals and objectives. Contact us today.

Prepared by Ernst & Young’s US Professional Practice group, 2011 year-end issues audit committees should consider is designed to help audit committee members navigate this challenging environment. The publication lays out 20 questions, including three tax questions, audit committee members should consider asking as they prepare for their upcoming discussions with management and the external auditors.

While every country’s tax rules differ, often markedly, these questions of tax risk transcend national boundaries:

• Does the audit committee understand the processes that management uses to identify, measure and oversee various categories of tax risk? How has recent domestic and global tax legislation affected the company?
• Are the company’s tax-related processes and internal controls sufficient? Does the tax function have clear and close input into major transactions and business plans? Does the company have the appropriate level of tax resources in place?

Have all potential additional tax liabilities been adequately provided for?

Tax Alerts – Canada

• 2012 Issue No. 02 - Alberta budget 2012–13
  Alberta finance minister Ron Liepert tabled the province’s fiscal 2012–13 budget on 9 February 2012. The budget contains no new taxes and no tax increases. The Alberta SR&ED tax credit is to be enhanced by eliminating the federal investment tax credit reduction to the corporation’s eligible expenditures.
• 2012 Issue No. 03 - Ombudsman issues observation paper on SR&ED program
  When it was established in February 2008, the Office of the Taxpayers’ Ombudsman began receiving complaints and criticisms about the Canada Revenue Agency’s administration of the federal Scientific Research and Experimental Development (SR&ED) tax credit program. It launched an investigation into these complaints, and on 10 February 2012 released its long-awaited report on its findings.
• 2012 Issue No. 04 - Finance Canada releases transitional rules for elimination of HST in British Columbia
  On 17 February 2012, the British Columbia government confirmed that it will transition from the harmonized sales tax regime back to the former goods and services tax and provincial sales tax regime as of 1 April 2013, owing to the results of a binding referendum held in the province last August. Finance Canada simultaneously released some preliminary details concerning the legislative and regulatory amendments that it will propose as transitional rules.
• 2012 Issue No. 05 - BC announces enhanced rules for new-housing rebates on transition from HST to PST/GST
  On 17 February 2012, British Columbia Finance Minister Kevin Falcon announced enhanced new-housing rebate rules and the transitional rules that will apply to the sale of new homes during the transition from the current harmonized sales tax system to a combined provincial sales tax and goods and services tax regime.
• 2012 Issue No. 06 - British Columbia budget 2012-13
  BC Finance Minister Kevin Falcon tabled the province’s fiscal 2012–13 budget on 21 February 2012.
• 2012 Issue No. 07 - Nunavut budget 2012 -13
  Nunavut Finance Minister Keith Peterson tabled the territory's fiscal 2012–13 budget on 22 February 2012.
• 2012 Issue No. 08 - Velcro wins beneficial ownership case
  The Tax Court of Canada issued its judgment in Velcro Canada Inc. v The Queen on 24 February 2012, concluding that the non‑resident taxpayer receiving royalties from Velcro Canada Inc. was the “beneficial owner” of those royalties for the purposes of the Canada-Netherlands Income Tax Convention.

Publications

• International estate and inheritance tax guide 2012
  Our annual guide summarizes the estate tax planning systems in 27 countries, providing at-a-glance information as well as details on the types of estate planning in each jurisdiction.
• Global tax policy & controversy quarterly briefing January 2012
  Taxpayers and tax administrators alike continue to tell us that tax policy and controversy issues are becoming a top priority, not just in the tax department, but at the C-suite and board level, too. Our latest issue demonstrates a very significant surge in the pace and volume of tax change and reform over the last few months, with many countries around the world rapidly being forced into significant austerity-related tax measures.
• T Magazine: A new era in transparency – rethinking global compliance and reporting
  In the latest issue, we examine current leading practice in global compliance and reporting, and explore ways in which companies are strengthening their compliance and reporting as part of broader finance transformation efforts. At a time when companies are facing an uncertain tax policy environment and a continuing need to maximize efficiency, compliance and reporting is a vital topic for discussion — not just in the tax function, but among the entire executive team.
• Indirect tax briefing: a review of global indirect tax developments and issues
  In this issue, we look at the evolving and often borderless environment of cloud computing and examine the practical challenges it presents for indirect taxation around the world — which is far from uniform, harmonized or borderless. For example, the 2015 EU VAT changes for services supplied electronically to final consumers will cause indirect tax issues for businesses that provide cloud computing services.

Articles

• 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.