TaxMatters@EY – May 2012

What is a prohibited investment?

A prohibited investment is generally an investment to which the annuitant of an RRSP or RRIF is closely connected such as the following:

• A debt obligation of the annuitant
• A share of, interest in or debt of a private or public corporation, trust or partnership in which the annuitant (or a non-arm’s-length person) has a significant interest (generally 10% or more)
• A share of, interest in or debt of a corporation, trust or partnership with which the annuitant, or any entity in which the annuitant has a significant interest, does not deal at arm's length.

Specifically excluded from prohibited investments are certain regulated mutual fund investments and certain insured mortgages (and similar instruments).

Tax on prohibited investments

The new prohibited investment rules impose a penalty tax of 50% of the fair market value of a prohibited investment held by the RRSP or RRIF. This tax applies to prohibited investments acquired after 22 March 2011 and those acquired before 23 March 2011 that became prohibited after 4 October 2011.

This tax does not apply to a pre-23 March 2011 prohibited investment that is transferred to another RRSP or RRIF of the same annuitant after 22 March 2011.

This 50% penalty tax may be refunded if the investment is disposed of by the end of the year following the year in which the tax applied (or such later time as the minister of national revenue considers reasonable), unless the annuitant knew or should have known when acquiring the investment that it was, or would become, prohibited.

If an investment held by an RRSP or RRIF was subject to this penalty tax and subsequently ceases to be a prohibited investment, the RRSP or RRIF is deemed to have disposed of the investment for proceeds equal to fair market value and to have reacquired it at a cost equal to that fair market value.

Non-qualified investments are subject to similar rules. If an investment is considered to be both a prohibited investment and a non-qualified investment, the rules ensure the annuitant is not subject to double tax by deeming the investment to only be a prohibited investment.

Under transitional rules, a prohibited investment can be removed without tax from an RRSP or RRIF by swapping the investment for cash or other property of equal value before the end of 2021. After 2021, a swap transaction may still be used to remove a prohibited investment from an RRSP or RRIF, but only in situations where the annuitant is entitled to a refund of the 50% penalty tax (e.g., where the annuitant didn’t know at the time the property was acquired that it was, or would become, a prohibited investment).

Advantage tax

A 100% tax applies to the value of certain “advantages” received in relation to an RRSP or RRIF. Advantages include benefits that constitute income (including capital gains) that are reasonably attributable, directly or indirectly, to a prohibited investment held in a RRSP or RRIF.

The advantage tax applies to income earned, and realized capital gains accruing, after 22 March 2011, regardless of when the prohibited investment generating the income or gain was acquired.

Transitional relief available via election

Some transitional relief from the advantage tax is available for income and gains attributable to a prohibited investment held on 23 March 2011, but the annuitant must file an election to qualify.

In particular, the 100% advantage tax will not apply to any income earned after 22 March 2011 and before 2022, nor to any capital gain on the investment accruing after 22 March 2011 and realized before 2022, as long as the amount of the advantage is withdrawn from the RRSP/RRIF. The total income and gains qualifying for this relief is reduced by any capital losses realized on the same investment, and the qualifying amount is referred to as a “transitional prohibited investment benefit.”

To take advantage of the transitional relief, the annuitant must do the following:

• File Form RC341, Election on Transitional Prohibited Investment Benefit for RRSPs or RRIFs, on or before 30 June 2012
• Withdraw the qualifying income or gains from the RRSP or RRIF within 90 days after the end of the calendar year in which they were earned or realized
• Ensure the withdrawal is not paid by way of a transfer to another registered plan of the annuitant

The transitional prohibited investment benefit is included in the annuitant’s income for the year in which it is withdrawn, and is subject to the annuitant’s marginal tax rate (just like any regular RRSP or RRIF withdrawal).

Possible waiver of tax

The Canada Revenue Agency (CRA) may, at its discretion, waive all or a portion of the 50% penalty tax or 100% advantage tax in certain circumstances if it considers it just and equitable to do so. In the case of the advantage tax, the amounts that gave rise to the tax must be withdrawn from the RRSP or RRIF without delay.

To request a waiver, the annuitant must send a letter to the CRA explaining why the tax liability arose, and why it would be fair to cancel or waive all or part of it.

Locked-in retirement accounts

In the case of a locked-in retirement account (LIRA) where the annuitant is not allowed to make withdrawals before a certain age, it may not be possible to obtain a refund or waiver of the penalty tax or transitional relief from the advantage tax.

Restrictions on withdrawals from a life income fund (LIF) or locked-in retirement income fund (LRIF) may also make it difficult to withdraw amounts giving rise to the penalty or advantage tax.

This issue has been raised with both the CRA and the Department of Finance.

Excluded from Part I tax

To avoid double tax, any amount withdrawn from an RRSP or RRIF that was subject to the 50% prohibited investment tax or the 100% advantage tax under Part XI.01 of the Income Tax Act (and for which no waiver, refund or cancellation is granted) is excluded from the annuitant’s income for Part I income tax purposes.

The financial institution will still withhold tax on the withdrawal, and the amount withheld may be applied against other taxes payable for the year or refunded when the annuitant files his or her personal tax return for the year.

Tax return filing requirement

If an annuitant owes tax under the new anti-avoidance rules for a particular calendar year, he or she must file Form RC339, Individual Return for Certain Taxes for RRSPs or RRIFs, for that year. The return must be filed, along with the payment of any tax, no later than 30 June of the following year.

Typically, a carve-out transaction occurs when part of a business is financially and operationally separated from its parent, usually in advance of an IPO or sale. In the current economic environment, more companies will be seeking carve-out scenarios so they can rethink which assets are core to their future operations and sell those that are not the best fit as a way of raising capital or reducing excess debt.

The earlier a tax director becomes involved in the carve-out strategy, the better. Indeed, even companies with no disposal on the horizon should keep the tax implications of their group structure under review so they can sell businesses quickly and efficiently if they want to.

Our report highlights nine key tax issues for companies to take into account when negotiating a carve-out, and challenges company boards to consider the following key questions:

• Are you considering the associated tax issues early enough to ensure that value is preserved and/or enhanced?
• Have you considered the tax implications of the carve-out from the perspective of a buyer to identify areas of potential value that may be used as a bargaining lever?

Even if you are not currently contemplating a carve-out, is your group structure sufficiently flexible from a tax perspective to allow you to sell a business or alter strategic direction quickly and efficiently?

For more information, read Securing a more valuable carve-out – the role of tax planning.

Nonetheless, certain countries, such as Canada and its customs authority the Canada Border Services Agency (CBSA), are willing to accept a transfer price as the basis for customs valuation purposes (with statutory additions such as royalties, commissions and assists), thereby providing a measure of uniformity to the importer. Unfortunately, there are still differences between the customs valuation and transfer pricing rules concerning periodic downward transfer pricing adjustments.

By way of illustration, further to World Trade Organization (WTO) customs valuation rules, to which most countries adhere, an importer basically has an obligation to report upward transfer pricing adjustments to the COGS to customs authorities. This may happen when it is determined that a related-party importer earned too much profit for income tax purposes and needs to pay more for imported products.

However, in those situations where the reverse occurs (i.e., the importer is required to reduce the purchase price for imported goods), customs authorities have traditionally taken the position that such downward adjustments are to be ignored for duty-refund purposes. This is based on the WTO valuation principle of post-import rebates, which are viewed as adjustments to the price paid or payable after the goods have been imported, and which the customs authorities typically refuse on duty-refund claims.

In other words, customs authorities generally take the position that when upward adjustments occur, “you owe us,” and when downward adjustments occur, “we don’t owe you.”

Within this framework, US importers have been provided with a major duty-refund opportunity further to a recent and significant policy shift by US customs authorities. Specifically, US Customs and Border Protection (CBP) has moved a step closer to adopting a policy, first proposed in September 2011, under which it will accept transfer pricing adjustments for refund purposes provided that specified conditions are met.

In September 2011, CBP published advance notice of and invited public comment on a proposed policy change that would broaden its interpretation of a formula for transaction value. Transaction value (sale for export) is the primary customs valuation method and can be used on related party transactions.

CBP has now proposed to revoke a prior CBP ruling and replace it with a new ruling that allows post-importation customs value adjustments to be made under a transfer pricing policy, provided that the transfer pricing policy can be shown to demonstrate arm’s-length pricing under customs-specific tests. If adopted, the revised policy will provide greater flexibility to importers making periodic adjustments to transfer prices after importation.

To take advantage of the new policy, importers of related-party products that may be subject to transfer pricing adjustments should consider the following actions:

• Prepare customs-specific supporting documentation: CBP’s proposal deals only with reporting adjustments made pursuant to transfer prices that are otherwise acceptable for customs purposes. It does not mean that CBP will accept transfer pricing studies as sufficient support for establishment of a customs value. Because the proposed policy will make adjustments easier (including adjustments that would result in customs refunds to taxpayers), it is more important than ever that taxpayers supplement transfer pricing studies with customs-specific supporting documentation.
• Apply for the reconciliation program: CBP specifies that the new proposal is intended to apply to importers using the customs reconciliation program. Reconciliation allows an importer to declare a provisional value at import and adjust to the final value up to 21 months following import. Importers must be approved to use the reconciliation program in advance of the imports whose value may be later adjusted. All importers contemplating transfer pricing adjustments should apply for reconciliation in order to benefit from the new policy.
• Supplement transfer pricing policies: CBP’s proposed ruling adopting the new policy notes five specific criteria that the importer demonstrated. Several of these criteria (e.g., specifying the products subject to customs adjustments) may not be clearly present in current transfer pricing policies. Importers may therefore find it advantageous to adapt transfer pricing policies to clearly meet the customs criteria.

In the absence of any similar Canadian reconciliation program, it remains to be seen whether the CBSA will take a formal position with respect to duty-refund opportunities further to downward transfer pricing adjustments effected post import.

However, in 1996, the Canadian International Trade Tribunal ruled in favour of a Canadian importer essentially finding that the particular downward transfer pricing adjustment at issue in that case should not be viewed as a post-import rebate (and therefore not eligible for duty refund), but rather as an adjustment (which was issued as a credit note) to reflect the actual selling price (price paid or payable) of the imported goods, as contemplated between the parties prior to the importation of the goods.

The recent customs valuation development in the US relating to periodic transfer pricing adjustments is welcome news for US importers, and could very well have a positive ripple effect in Canada and beyond.

For additional information, contact your Ernst & Young tax advisor.

Background

In this technical interpretation, the CRA was asked to comment on the tax consequences of a rewards program a ski club offered its members in return for their volunteering at club activities or events.

Under the rewards program, volunteers received non-transferable, non-refundable reward points with no cash value. Generally, five reward points were awarded for each hour of volunteer time, although the amount varied according to the type of activity or event as well as the volunteer’s shift, schedule and position. One reward point represented $1.00 and volunteers could redeem points for club store merchandise, registrations, trips, lessons or programs.

CRA response

The CRA states that where an employment relationship exists between the volunteer and the organization, volunteer compensation is considered employment income. Where no such relationship exists, volunteer compensation is considered business income unless the compensation is nominal, in which case it is a non-taxable receipt.

In the CRA’s view, volunteer compensation is nominal if it meets the following criteria:

• It is significantly less than the cost of having an employee or independent contractor perform the same duties
• It would likely not be enough to influence the individual’s decision to volunteer
• It does not reflect the fair market value of the services being performed, the amount of work performed or the quality of the services provided.

The CRA further states that the volunteer’s total annual compensation should also be considered in determining whether the amount is nominal.

What does it mean?

If your organization is considering the use of rewards programs or other non-monetary compensation as a way of encouraging volunteerism, you should be aware of the CRA’s position on volunteer compensation. If you don’t take this into consideration, it could result in the CRA asserting that the volunteer received taxable income.

Facts

Mr. McClarty was an employee of Clifton Associates Ltd. and resigned in June 2001. In August 2001, he and three former employees formed Projectline Solutions Inc. (PSI), and managed to win contracts in the same industry as Clifton. Each of the four shareholders held the shares personally.

Throughout the period 2001 to 2006, Clifton threatened legal action against Mr. McClarty, so he sought some creditor proofing and protection. His accountant advised him to undertake certain transactions.

In October 2002, McClarty Professional Services Inc. (MPSI), a holding company, was incorporated and the McClarty Family Trust (the Trust) was formed. Mr. and Mrs. McClarty were the trustees of the Trust and, along with their three minor children, the beneficiaries.

Mr. McClarty held 100% of the Class A voting shares of MPSI and the Trust held 100% of the Class B non-voting shares. MPSI then subscribed for 31 Class A shares of PSI. The other three business partners held the remaining classes of shares of PSI personally.

On 30 September 2003, MPSI declared a stock dividend on its Class B shares held by the Trust. The stock dividend consisted of 48,000 Class E non-voting preferred shares (Class E preference shares) of MPSI with a paid-up capital (PUC) and adjusted cost base (ACB) of $1 in total and a redemption price of $1 per share. The Trust sold these Class E preference shares to Mr. McClarty for a $48,000 promissory note, resulting in a capital gain of almost $48,000, which was distributed to the three minor beneficiaries by way of promissory notes of approximately $16,000 each. This capital gain was reported in each of the minors’ tax returns.

On the same day, Mr. McClarty paid $48,000 to MPSI in repayment of previous shareholder loans. MPSI used this money to make a shareholder loan of $48,000 to the Trust. The Trust then loaned the $48,000 to Mr. McClarty as a trustee loan. Mr. McClarty then paid another $48,000 to MPSI in repayment of other shareholder loans. This circular flow of funds had the effect of increasing Mr. McClarty’s debt with the Trust, providing for increased creditor proofing.

On 17 December 2003, Mr. McClarty incorporated 101051392 Saskatchewan Ltd. (101 SK). He was the sole director and shareholder. The purpose of 101 SK was to capture future investments and facilitate the creditor protection scheme.

On 31 December 2003, Mr. McClarty sold the Class E preference shares to 101 SK in return for a $48,000 promissory note. On the same day, MPSI redeemed the Class E preference shares for $48,000. While 101 SK received a deemed dividend, no tax was payable, as the deemed dividend was received from a taxable Canadian corporation.

On the same day, 101 SK paid $48,000 to Mr. McClarty, who then repaid part of his debt to the Trust. The Trust paid the $48,000 to MPSI in satisfaction of the shareholder loan it had received. MPSI then paid the $48,000 to Mr. McClarty as repayment of another shareholder loan. At the end of December 2003, Mr. McClarty owed $48,000 to the Trust, and the Trust owed $16,000 to each of the minor beneficiaries.

The transactions in 2004 proceeded in a similar way as the 2003 transactions, with some minor changes in the shareholder loan amounts. At the end of December 2004, Mr. McClarty owed $104,400 to the Trust and the Trust owed $32,000 to each of the minor beneficiaries.

The Minister applied the GAAR, recharacterizing the $48,000 of capital gains each year in the Trust as dividends. The Minister also recharacterized the distributions to the minor beneficiaries as dividends instead of capital gains. The Minister’s concern was that Mr. McClarty was able to split income with his children despite the kiddie tax rules in section 120.4. At the time, because the transactions were structured to provide the children with capital gains instead of dividends, the kiddie tax did not apply.

Tax Court of Canada decision

TCC Justice François Angers used the GAAR framework by the Supreme Court of Canada in Canada Trustco as follows:

• Is there a tax benefit resulting from a transaction or series of transactions?
• Is the transaction an avoidance transaction, in that it was not reasonably undertaken or arranged primarily for a bona fide purpose other than to obtain a tax benefit?
• Was there abusive tax avoidance, in that the tax benefit was not reasonably consistent with the object, spirit or purpose of the provisions of the Act?

Tax benefit

The taxpayers (i.e., the Trust and the three minor beneficiaries) conceded that there was a tax benefit resulting from the transactions.

Avoidance transaction

Based on the evidence that indicated that Mr. McClarty was under threat of legal action by Clifton up to 2006, even though no legal action was ever commenced, Justice Angers found that the transactions at issue were undertaken primarily for creditor proofing. The stock dividend resulted in a shift of the value of the assets from MPSI to the Trust, which was consistent with creditor proofing.

Justice Angers found that while some creditor protection could have been achieved had a dividend been paid to the Trust and funds loaned to Mr. McClarty, it would have been less effective because of the higher tax rate on the dividend to the minor beneficiaries and would have resulted in fewer funds available.

The TCC determined that the entire series of transactions was triggered by the desire to protect the assets of MPSI in anticipation of the legal threat. The sale of shares by the Trust to Mr. McClarty and subsequent sales to 101 SK were found to have been done to lessen the tax consequences of the creditor-proofing plan and would never have been undertaken in the absence of the need to protect MPSI’s assets.

Justice Angers concluded that every single transaction constituting the series was made with a bona fide purpose other than to obtain the tax benefit, since the primary motivating element behind each transaction was protection of the assets.

Abusive tax avoidance

Since the judge found that there was no avoidance transaction, there was no need to determine whether there was abusive tax avoidance.

However, Justice Angers did indicate that there was definitely a gap left in section 120.4 of the Act that should be filled by Parliament and not by using the GAAR. Subsection 120.4(3) of the Act was added for transactions after 22 March 2011, to deem a capital gain to be a dividend obtained through a disposition of shares to a non-arm’s-length person.

Conclusion

The TCC looked at the issue of whether the transactions were undertaken for a bona fide purpose and found that the testimony and evidence supported the primary non-tax purpose: creditor proofing.

Instead of examining the purpose of each transaction individually, Justice Angers concluded that all the transactions had a bona fide purpose because of the primary motivating factor behind each. Further, there was no tax avoidance transaction despite the fact that an alternative transaction could have been undertaken that would have resulted in higher taxes.

The most interesting aspect of this case is that the amounts at issue are relatively small ($48,000 of capital gains per year). This may signal that the Minister is invoking the GAAR more frequently irrespective of how much is at stake.

Tax Alerts – Canada

• 2012 Issue No. 18 - Changes coming to transfer pricing provisions
  The 2012 federal budget contained several amendments to the administration of the transfer pricing provisions in the Income Tax Act. The proposed amendments are designed to clarify that adjustments arising under those provisions will always result in a deemed dividend that will be subject to withholding tax — a practice known as “secondary adjustments.”
• 2012 Issue No. 19 - Supreme Court decides landmark trust residence case
  The important Supreme Court of Canada decision in Fundy Settlement v Canada addresses the issue of determining the residence of a trust. While many additional issues had been considered by the lower courts, the Supreme Court addressed only the issue of determining the residence of a trust as a matter of general principles.
• 2012 Issue No. 20 - Manitoba budget 2012–13
  Manitoba Finance Minister Stan Struthers tabled the province’s budget on 17 April 2012. The budget contains several tax measures affecting individuals and corporations.
• 2012 Issue No. 21 - Prince Edward Island budget 2012–13
  PEI Finance, Energy and Municipal Affairs Minister and Treasury Board Chair Wesley J. Sheridan tabled the province’s budget on 18 April 2012. The minister announced plans to adopt a harmonized sales tax . The budget contains no changes to corporate income tax or personal income tax rates.
• 2012 Issue No. 22 - Changes to SR&ED could impact innovation in Canada
  In its 2012 budget, the federal government made recommendations that significantly reduce the value of the Scientific Research and Experimental Development (SR&ED) tax credit program, especially for large corporations. We dive deeper into the proposals and comment on their potential impact on Canada’s key industries.
• 2012 Issue No. 23 - Newfoundland and Labrador budget 2012–13
  Newfoundland and Labrador Finance Minister Tom Marshall tabled the province’s budget on 24 April 2012. The budget contains no new taxes and no tax increases.

Publications and articles

• Tax policy and controversy outlook: Americas 2012
  This report, part of a suite of three regional reports, provides a 2012 outlook for tax policy and enforcement in 17 of the largest countries in the Americas. It discusses each country’s political landscape, current tax policy and administration leaders, recent tax policy changes, pending tax proposals and key tax enforcement focus areas.
• Successful sale
  In the April 2012 issue of CAmagazine, Ernst & Young’s Doron Barkai and Beau Young note that achieving a successful business divestiture is among the most significant challenges many business owners in Canada face. The process and decisions are complex. In addition to the tax considerations that taxpayers and their advisers must assess, numerous other factors, such as commercial, financial, regulatory and family matters, must be considered.
• 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.