TaxMatters@EY – May 2011

Capital gains exemption

The first opportunity is the capital gains exemption (CGE). With this exemption, up to $750,000 of capital gains realized by a Canadian individual on the disposition of qualified small business corporation (QSBC) shares can generally be tax free.

To be eligible, shares must fulfill the following conditions: they must be Canadian-controlled private corporation (CCPC) shares and, at the time of disposition, more than 90% of the corporate assets (based on fair value) must be used in an active business carried on primarily in Canada.

In addition, the CCPC shares must generally have been owned by the individual or a related person throughout the 24-month period preceding the sale. In that time, more than 50% of the corporate assets (based on fair value) must have been used in an active business carried on primarily in Canada (the rules become complex when there are controlled or connected corporations). This means that newly issued shares generally must be held for at least 24 months.

There are exceptions, however, for shares acquired in exchange for other qualifying shares — through a previous reorganization or freeze, for example — and shares issued in exchange for the transfer of an unincorporated active business to a corporation. v

The purification process

It’s not unusual for an active business to accumulate non-active assets over time (such as portfolio investments purchased with excess cash). If these assets represent more than 10% of the total business assets, the shares won’t qualify as QSBC shares. In these cases, in order to access the CGE, it may be necessary to divest the company of its non-qualifying assets or purify before the disposition.

The simplest way to purify is to pay out the excess cash or investments as dividends. This method is cost effective if there is refundable tax in the company, in which case the dividend refund to the company effectively offsets the tax payable by the shareholder receiving the dividend. Or, in cases in which there is a capital dividend account balance representing the non-taxable portion of capital gains realized by the corporation, it can be paid out to shareholders tax free. If the company has significant liabilities, including amounts due to shareholders, these can be paid with excess cash and the liabilities can be reinstated once the CGE has been used.

If these simple methods aren’t sufficient, more complex purification transactions may be necessary.

Even if the QSBC test is met, there are other factors that may limit the CGE claim. For example, cumulative net investment losses (CNILs), allowable business investment losses (ABILs) and capital losses reduce the capital gains eligible for the exemption.

Finally, keep in mind that this is a lifetime exemption. If any amount has been used in the past, or if you claimed the $100,000 general capital gains exemption before 1995, the maximum $750,000 exemption will be reduced accordingly.

If you’re a business owner and you claimed the exemption prior to 2007, when the maximum exemption was only $500,000, you should contact your advisor to discuss alternatives for crystallizing the increase in the lifetime exemption.

Capital gains reserve

In addition to the CGE, there are opportunities for tax deferral in certain cases. If company shares are sold in exchange for debt, a capital gains reserve may be claimed in relation to sale proceeds not payable until after the end of the year in which the disposition takes place. The reserve may be claimed for up to five years, with a minimum cumulative income inclusion of 20% per year.

A more generous reserve is available to the person’s children or grandchildren for gains realized on the disposition of small business corporation shares. In these cases, the reserve may be claimed over 10 years with a minimum income inclusion of 10% annually on a cumulative basis.

The workaround may have been on the sales-invoicing side, so that the company could be sure to bill the correct rate of tax starting on the transition date. Or it may have been on the purchase-processing side, so that the company would pick up the provincial portion of the HST for recovery purposes.

During the implementation of GST, Quebec sales tax and the Atlantic HST, many businesses put workarounds in place but neglected to revisit them, and were often subjected to significant audit assessments later on.

If you put in a workaround and meant to go back to properly fix the problem later, don’t worry. There’s still time to make corrections — as long as you can remember where you made the quick fix.

Here are some of the possible areas where your workaround could be hiding:

Sales invoicing – Did you do something to your invoicing so that you could bill the new multiple rates of tax? If so, make sure that the appropriate rates are being charged to your customers, and that the tax charged is rolling up to the HST-payable account and not to a revenue account.

Payables processing – Did you make a fix so that the provincial portion of the HST would be flagged for pickup? If so, make sure the extra tax is rolling up to the HST-receivable account and not to an expense or capital account.

Recaptured input tax credits – Did you need to put a workaround in place to ensure that the provincial portion of the HST that needs to be recaptured was actually being clawed back? If so, check to see that those input tax credits are being restricted. In many cases, this does not happen correctly, and it’s definitely an area that auditors scrutinize.

Expense templates – Did you need to put in a quick fix to expense reporting template formulas? If so, go back and make sure that the fix is actually working the way it needs to — ensuring that the correct amount of HST is being coded to the input tax credit account and that the correct amount is being expensed.

Budget templates – Did you need to put in a workaround to ensure your budgeting process continued to work? If so, make sure that your budgeting spreadsheets are still accurate and that they are handling the HST correctly.

These are just a few of the areas where you may have put in a workaround when the HST was implemented, with the full intention of going back to test it later. Well, this is later, and now is the time to go back and check.

Taking the time to revisit any HST workarounds will help ensure there are no unpleasant surprises.

It’s also important to understand the links between tax policy and tax administration. Changes in tax policy and legislation tend to foreshadow future controversy, as tax administrations seek to understand and test the operation of new legislation.

Companies that are proactive about these changes are able to make tax decisions with a greater degree of certainty, a hallmark of good corporate governance.

The following leading practices can help satisfy both business objectives and tax administrators’ requirements.

Tax policy leading practices

Monitor and assess possible future tax policy shifts. Develop processes and channels to stay up to date with tax legislation and the tax policy environment in key jurisdictions. Communicate this process to your organization’s key stakeholders. These steps can help you anticipate potential adverse policy changes and identify potential opportunities.

Be an active participant in tax policy development. In such a rapidly shifting economic, legislative and regulatory environment, new tax laws may sometimes impede commercial decisions in ways unintended by policymakers. Companies faced with this issue can either adapt their business plans accordingly or work collaboratively with the government to explain the impediment, model the potential outcomes and develop alternative policy choices.

Join forces. Consider whether forming an industry or trade group is appropriate to develop a collective voice. Alternatively, assess opportunities to join an existing group.

Assess the impact of change. If change is clear and documented, create an impact assessment that contains economic modelling. Policymakers need information to develop good tax and economic policy. Comparative tax studies and insightful analysis of the effects of tax policy proposals on competitiveness can help in this effort.

Tax controversy leading practices

Stay connected with tax administration shifts. By developing “tax administration intelligence,” companies can better understand the key focus areas of the tax administration in jurisdictions in which they operate. Companies should also understand what tools and techniques can lower overall risk levels. Risk ratings models, risk assessments, advance pricing agreements, rulings and new dispute-resolution tools are all evolving and useful for these purposes.

Adopt a global approach to tax controversy and risk. Companies should develop and assess their tax controversy and risk management strategies and actions from a global perspective, because that’s how tax administrations are increasingly viewing them.

At a high level, companies should establish a global vision and strategy for tax controversy and risk management. The strategy should consider how to develop enhanced relationships with tax administrators in key jurisdictions, weave in all available tax administration intelligence, understand the methods that can be used in the jurisdiction to achieve a lower risk rating, and encompass — where culture permits — a more transparent, collaborative and responsive relationship with tax authorities.

Evaluate global systems and resources for tax risk management. Managing future controversy requires an understanding of both the scope and direction of a likely tax audit or examination. Companies need to ensure the right processes are in place to manage the risk of potential tax controversy. Global tax risk management systems should have processes to identify, assess, measure, mitigate and monitor actions and strategies.

While many tax functions may have designated “tax risk manager” and “tax controller” positions to monitor and manage tax risks on an ongoing and proactive basis, controls and procedures should be integrated into the various tax and business processes as far upstream as possible — and not be treated as separate activities within the tax function.

Manage any controversies at a strategic level. For issues that advance to the controversy stage, it’s necessary to assess the relative merits and weights of each issue and analyze the nature of disputes with tax authorities. For cross-border issues, it’s important to evaluate how a settlement or adjustment in one jurisdiction will affect others.

In addition, businesses should consider the following suggestions:

• Establish criteria to identify business transactions that require proactive management to avoid or mitigate controversy (e.g., documentation, pre-filing agreements).
• Track current controversies, as well as business transactions and decisions that may result in controversy.
• Establish priorities for jurisdictions that have significant or potentially significant controversy issues.
• Understand key tax jurisdictions’ legislative and regulatory environment, information exchange policies and strategic direction.
• Conduct, for each key jurisdiction, a technical risk assessment of tax return positions, considering existing documentation and recent enforcement activity.
• Use resolution tools and processes to facilitate closure of disputes and issue resolution.
• Understand the potential multiyear and multijurisdictional impact of the issues and the means by which they are resolved.

Include global tax risk as a corporate governance issue. Tax administrations are working diligently to elevate tax strategy to the boardroom agenda. Policymakers and tax administrators expect corporate boards to understand their responsibilities with regard to their business tax strategies and outcomes. Some tax administrators are engaging CEOs and CFOs, as well as corporate boards, in dialogue regarding tax risk.

In response, companies should consider ways to address the following issues:

• Educate the board about the tax implications of business decisions as well as the structure, processes and policies related to tax controversy and risk management within the company.
• Prepare for board-level inquiries related to tax risk management strategies.
• Actively engage the C-suite and board in discussions related to tax risk management.

The facts

The taxpayer had a business loan from a bank, which enrolled the taxpayer (and other clients to which it had made loans) in a group creditor life insurance policy. Under the policy’s terms, the sum insured was the amount outstanding on the loan from time to time.

The taxpayer paid the premiums to the bank, which remitted them to the insurance company. On the death of a “key person,” the insurer would pay the proceeds of the policy to the policyholder, the bank. The bank would then be contractually obliged to use those proceeds to discharge the taxpayer’s debt.

The taxpayer’s founder died in 2002 and the bank was paid the insurance proceeds. At the time of his death, the taxpayer owed the bank $196,922. Between the time of his death and the receipt of the insurance proceeds, the taxpayer reduced the loan principal by $21,422. The bank used the proceeds of the policy to discharge the then-outstanding balance of the loan ($175,500), and credited the taxpayer’s bank account with the rest ($21,422).

The issues

The taxpayer included the insurance proceeds in the calculation of its CDA, declared a capital dividend and filed a capital dividend election with the Canada Revenue Agency. The Minister, however, reassessed the taxpayer on the basis that the dividend was in excess of its CDA, and the taxpayer appealed to the Tax Court of Canada.

The taxpayer argued that the definition of a CDA in the law does not require that the taxpayer be a beneficiary of the policy. It only requires that the taxpayer “receive” the insurance proceeds. In this case, the taxpayer received the proceeds in the sense that the loan was paid off, with the bank acting merely as a conduit.

In the Crown’s view, the bank was the beneficiary of the insurance policy, and the taxpayer did not receive the death benefit as required in order for it to be included in the taxpayer’s CDA.

In support of its argument, the Crown cited the following from the ITA:

Decision based on clarity of the legislation

The Tax Court judge disagreed with the Crown’s interpretation and allowed the taxpayer’s appeal. He held that when, as in this situation, the wording of the ITA is clear and unambiguous, there is no need to go beyond the words of the statute. Being a beneficiary was not a prerequisite, and the taxpayer corporation only needed to have received the proceeds. The term “received” does not require that proceeds pass directly to the taxpayer; notional or constructive receipt is sufficient. In this case, the taxpayer derived the benefit of the insurance payout, and therefore received the proceeds.

The FCA dismissed the Crown’s appeal. The FCA was not persuaded that the Tax Court judge had erred. In the FCA’s view, the Tax Court’s conclusion was consistent with the terms of the contract between the bank and the insurer, and also between the bank and the taxpayer. Once the insurer paid the proceeds to the bank, the bank was bound to pay them to the taxpayer’s benefit by discharging the loan.

The Crown has not appealed the decision to the Supreme Court of Canada.

What the decision means

The CDA provisions do not require that a corporation receive the proceeds directly from the insurer, or that it be named as a beneficiary of the policy.

Accordingly, the insurance proceeds are added to the balance of the CDA and, subject to the determination of the cumulative balance at a point in time, may be distributed as a dividend to the Canadian-resident shareholders exempt from Canadian income tax.

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