TaxMatters@EY – September 2011

What is subsection 14(1.01)?

Subsection 14(1.01) allows a taxpayer to treat a gain on the sale of certain eligible capital property as a capital gain rather than as ordinary business income. When the election is filed, the disposition of the eligible capital property is deemed to be a disposition of capital property at the time of the actual disposition. A taxpayer may choose to file this election to preserve a cumulative eligible capital (CEC) balance, utilize capital losses, claim a capital gains reserve on unpaid proceeds of disposition or claim a capital gains exemption.

The taxpayer has the option of filing the subsection 14(1.01) election with the tax return for the year, or with a capital dividend election that is filed on or before the taxpayer’s filing due date for the year.

Facts

The CRA rulings directorate was asked to consider a situation involving a corporate taxpayer that had disposed of eligible capital property with a gain. Soon after the sale, the taxpayer filed a capital dividend election. Because the corporation intended on filing a subsection 14(1.01) election, the corporation added 50% of the gain to its capital dividend account when the amount of the capital dividend was determined. However, the corporation did not file the subsection 14(1.01) election with the capital dividend election, but filed it after the taxation year end with the tax return for the year.

After the corporation filed the capital dividend election, the CRA issued a proposal letter indicating that the corporation paid an excessive capital dividend since the subsection 14(1.01) election was not filed on or before the time the capital dividend became payable. This treatment is consistent with the CRA’s view outlined in an earlier technical interpretation.

The CRA’s response

This technical interpretation confirms that the CRA’s position remains unchanged. Had the taxpayer filed the subsection 14(1.01) election with the capital dividend election, there would have been no excessive capital dividend.

But it is the CRA’s view that based on a textual, contextual and purposive analysis of subsection 14(1.01) and the capital dividend election provisions, when the subsection 14(1.01) election is filed after the particular point in time when the capital dividend became payable, there is no capital gain on the sale of the eligible capital property at that time and, therefore, no portion of the gain can be added to the capital dividend account at that time. In other words, the CRA considers it to be a subsequent event that cannot be taken into account retroactively to the time the capital dividend becomes payable.

Although the CRA’s position has not been confirmed or refuted by the courts, and contrary views may exist, taxpayers wishing to avoid having the CRA assess an excessive capital dividend should ensure a subsection 14(1.01) election is filed with the related capital dividend election, which should be filed on or before the date the capital dividend becomes payable.

In a news release issued on 19 August 2011, National Revenue Minister Gail Shea and Finance Minister Jim Flaherty confirmed that for the 2010 filing year, the second year of the TFSA program, they “will once again be as flexible as possible in cases where a genuine misunderstanding of the TFSA contribution rules occurred.”

Individuals who receive a letter indicating they may have over-contributed to their TFSA for 2010 may make a request to the CRA for a review of their file and a waiver of tax on the excess contributions.

The TFSA letter will generally be accompanied by a proposed TFSA return. A proposed TFSA return is issued in cases where the CRA requires additional information. It does not represent a notice of assessment. Individuals who receive a proposed TFSA return have 60 days to respond.

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

Potential areas for future OECD work highlighted in Mr. Gurría’s address included the following:

• Development of better analytical tools to measure and more precisely define the competiveness of tax systems.
• Creation of a common analytical framework to assess the cost of investment tax incentives, coupled with regular publication by governments of how much these incentives cost, and evaluation of whether they are achieving their stated goals.
• New joint efforts to reduce compliance costs.
• Better analysis of how globalization and economic integration impact tax systems, to avoid disincentives for cross-border trade and investment, but also to limit the scope for tax avoidance via multiple deductions, the creation of untaxed income and other unintended consequences of international tax arbitrage.
• Renewed international dialogue to ensure that existing international arrangements, including the OECD Model Tax Convention and Transfer Pricing Guidelines, meet future needs.

On fiscal consolidation

“Tax increases will almost certainly have to be part of the consolidation package in most countries. The question is how to raise them without jeopardizing the competitiveness of our economies and longer-term growth potential. Sustainable growth means delivering growth-friendly fiscal consolidation. How can we then raise additional revenues without harming entrepreneurship, innovation or savings? And how can we do it without damaging the prospects of a job-rich recovery and the attractiveness of a country as a location for investment, particularly in the knowledge-based sector?

“There is no simple recipe, but the slogan long associated with the OECD of following a broad-base–low-rate approach to taxation captures many of the essentials.”

On the shift to consumption taxes

“Today, it is rare to find a country with a top personal income tax rate over 50% or a corporate income tax of more than 35%. These cuts have not led — or at least not yet — to lower revenues from these taxes.

“At the same time, countries have begun the process of shifting towards higher reliance on VAT, primarily by increasing the standard rate of VAT and closing loopholes.”

A race to the bottom?

“But these are not the only ways in which governments have responded to these competitive pressures. Recently we have seen an increasing number of countries put in place preferential tax regimes for intangibles and for highly mobile individuals.

“We continue to see a proliferation of investment tax incentives, especially in non-OECD countries, despite the ambiguous evidence on the effectiveness of such incentives for both domestic and foreign investment. In this context, it is worth asking where this race to become more competitive will lead us to. How many of you have recently stated publicly that you want your tax system to be the most competitive in the EU and the G20?

“Will this lead to a race to the bottom? Will we see the tax burden shift from mobile to immobile factors of production?”

On the growing influence of the emerging markets

“We need to put in place adequate rules to ensure that double or multiple taxation will not result from operating in different countries and that opportunities are seized to harmonize compliance requirements rather than each country imposing its own requirements. We must have a firm commitment to the goal of ensuring that internationally agreed principles are actually being applied, and are capable of being applied.

“It is also critical that we put in place effective international dispute-resolution mechanisms to handle the inevitable frictions that will arise from the interaction of national tax systems. Along these lines, we must continue to adapt the OECD Model Tax Convention and Transfer Pricing Guidelines to new developments and speed up the process of updating these instruments so that collective action is not pre-empted by individual countries.

“In a nutshell: we need to move away from bilateral to multilateral instruments. And in order to meet these challenges we must put in place a process that is inclusive and takes into account the views of all key players, not just OECD countries.”

Major economic downturns in the past have triggered self-defeating protectionist policies by governments — witness the Great Depression. The self-defeating reaction Secretary-General Gurría fears this time is overly aggressive tax competition — “a race to the bottom.”

His rhetorical question, “How many of you have recently stated publicly that you want your tax system to be the most competitive in the EU and the G20?” no doubt reminded Canadians attending the conference of Finance Minister Flaherty’s frequent statements that “Canada will have an overall tax rate on new business investment that is the lowest in the G7 this year and the lowest statutory corporate income tax rate in the G7 by 2012.”

Consistent with Gurría’s fears, UK Chancellor George Osborne, in his March 2011 budget, countered with, “Other countries are attracting multinationals away from the UK. I want this to be a place that international companies go to, not leave.” Osborne claimed that a corporate tax reduction contained in his budget would ensure the UK has the lowest rate of corporation tax in the G7.

These examples may serve to illustrate his thesis, but Secretary-General Gurría’s concern is not with the actions of countries like Canada or the UK, but with non-OECD countries that have much lower tax rates that would put in place additional preferential and harmful tax incentives and practices.

Whether “a race to the bottom” is, in fact, materializing, the potential areas for future work highlighted in Gurría’s address provide a good roadmap for improved international cooperation.

Fred O’Riordan
National Advisor – Tax Services
Ernst & Young LLP

• The CRA recently confirmed this right in a GST/HST interpretation letter, which laid out the facts as follows: A taxpayer operates a store and pays GST on the goods purchased.
• The goods were purchased for resale in keeping with the taxpayer’s commercial activities.
• The goods are stolen and the theft is reported to the local police and the taxpayer’s insurance company.
• The insurance company tells the taxpayer it will not cover the taxes paid on the purchased goods that were subsequently stolen.

The CRA was asked whether the taxpayer could claim an ITC with respect to the GST paid on the purchased goods that were later stolen.
The CRA noted that, under the Excise Tax Act, a taxpayer may claim an ITC for GST paid, where all the following conditions to claim the ITC are met:

• The property is acquired, imported or brought into a participating province by the taxpayer for consumption, use or supply in the course of its commercial activities.
• The taxpayer is a registrant in the reporting period in which the GST on the good or service was paid for or became payable.
• The taxpayer has sufficient regulatory documentation to justify its ITC application.
• The GST in respect of the supply of the good or service is payable or has been paid by the taxpayer.
• The ITC is claimed in a return filed during the prescribed period.

The CRA stated that, in this case, the amount of the eligible ITC can be calculated based on the supplier’s invoice and proof of insurance claim.

Thus, to the extent that all the conditions to claim an ITC have been met, the taxpayer may, in its GST/HST return, file an application for an ITC with respect to the GST paid on goods purchased for resale that were subsequently stolen.

Note that the same principle applies to the HST and to Quebec Sales Tax.

As stated in the technical interpretation:

• It is now the CRA’s position that, to the extent that the other conditions in the capital dividend account (CDA) definition are met, a corporation may increase its CDA balance by the life insurance component if it is able to demonstrate that the proceeds of a life insurance policy were paid directly to a financial institution and the institution reduced the debt of the corporation under contract between the corporation and the institution.
• The application of this position is effective as of 27 October 2010 (the date of the FCA’s decision) and is limited to fact situations that are similar or identical to the Innovative Installations decision.
• The CRA will not retroactively adjust the CDA of a corporation for a prior year, nor reverse a taxable dividend that was previously assessed. Rather, the CDA balance will be adjusted so that the prior-year insurance amount would increase the balance in the CDA on or after 27 October 2010.

For additional information, see our analysis of the Innovative Installations case in the May 2011 edition of TaxMatters@EY.

As is often the case, generous tax treatment attracts increased scrutiny from the Canada Revenue Agency (CRA), and often results in numerous court cases. In the MacCallum case, the taxpayer was successful in convincing the Tax Court of Canada (TCC) that a portion of the $162,852.27 amount paid by him to honour a guarantee of a debt owing by his son’s company qualified as an ABIL.

This case may be of assistance to other taxpayers in similar circumstances.

Background

Mitchco Construction Inc. was a small-business corporation wholly owned by the taxpayer’s son. D&N Truck Lines Ltd. (D&N) was primarily a trucking company but also carried on a broker/shipper business for owners–operators of trucks. D&N was 100% owned by SeaReach Holdings Ltd., which in turn was owned by the taxpayer (51%) and his spouse (49%).

Beginning in February 1996 and continuing through June 1996, D&N provided equipment and materials to Mitchco in the amount of $394,805 to enable it to fulfil a large construction contract with the City of Miramichi. A contract dispute arose, putting Mitchco into financial difficulty.

On 29 July 1996, the taxpayer provided a guarantee on a line of credit for Mitchco in favour of the bank. Mitchco’s financial difficulties continued and it eventually went out of business. The taxpayer was required to honour his guarantee and paid the amount of $162,852.27 to the bank in June 2003.

The taxpayer and his son testified that there was a verbal agreement that the taxpayer was to be paid a fee for providing the guarantee, but gave conflicting evidence as to the terms of the agreement, and there was no evidence of a fee having been paid. The son paid the taxpayer $50,819.15, but the evidence suggested that this was not a guarantee fee, but rather was paid to reimburse the taxpayer, in part, for the cost to him of honouring the guarantee.

Issue

The taxpayer deducted the $50,819.15 reimbursement from the $162,852.27 he had to pay the bank under the guarantee. He then claimed the difference ($112,033.12) as a Business Investment Loss (BIL) and treated half that amount as an ABIL. The Minister reassessed to deny the ABIL deduction on the basis that the taxpayer incurred the debt to help his son in a business venture and there was no business purpose for the debt. The taxpayer appealed to the TCC.

The statutory scheme for ABILs is as follows. Section 3 of the Income Tax Act permits the deduction of an ABIL against income from any source. Section 38 defines an ABIL as one-half of a BIL. Generally, a BIL arises from the arm’s-length disposition (or deemed disposition) of shares of a small-business corporation or certain debts owed by a small-business corporation, as set out in paragraph 39(1)(c) of the Act. An ABIL cannot arise on non-arm’s-length intercorporate debt.

The Crown did not challenge the deduction on the basis that it failed to meet any of the above conditions required to meet the ABIL definition. Instead, it argued that the taxpayer did not incur the debt “for the purpose of gaining or producing income from a business or property,” as required by subparagraph 40(2)(g)(ii), such that the loss was not a capital loss, and therefore could not be an ABIL. In this case, no tax relief would be available to Mr. MacCallum for this loss.

Decision based on satisfying three tests

The TCC judge, Justice Valerie Miller, allowed the taxpayer’s appeal. In reaching her conclusion, she summarized the jurisprudence related to the application of paragraph 40(2)(g) as follows:

• Gaining or producing income need not be the exclusive or even the primary purpose of the loan, as long as it was one of its purposes (see Ludmer v the Queen, [2001] 2 S.C.R. 1082 (S.C.C.)).
• There does not have to be a direct link between the debt incurred by a taxpayer and the income he intends to earn (see the Queen v Byram, [1999] 2 C.T.C. 149 (FCA)).
• The anticipation of income cannot be too remote: “...[A] deduction cannot be so far removed from its corresponding income stream as to render its connection to the anticipated income tenuous at best. This does not preclude a deduction for a capital loss incurred by a taxpayer on an interest-free loan given to a related corporation where it had a legitimate expectation of receiving income through increased dividends resulting from the infusion of capital.” (Byram, paragraph 21)

The TCC was not satisfied on the evidence that the parties had agreed to the payment of a guarantee fee, so the taxpayer was unable to point to such a fee as his income-earning motive. However, the TCC was satisfied that the taxpayer had shown that one of his purposes for signing the guarantee in July 1996 was to support the continued existence of Mitchco, and thereby protect and collect a significant source of earnings for D&N and for himself, as reflected in the $394,805 debt Mitchco owed to D&N.
This purpose was not too remote to satisfy the requirements of subparagraph 40(2)(g)(ii) of the Income Tax Act. Therefore, the taxpayer was entitled to deduct the ABIL.

Observations

In the business world, guarantees of debt between related parties are fairly common. For example, corporations under common control often guarantee debts of other companies in the corporate group. Spouses often guarantee one another’s debts, and parents frequently guarantee debts of a child.
Ensuring an income-earning purpose exists, and is supported by appropriate documentation, is crucial to ensuring at least some tax relief is available to the guarantor in the event the guarantee is called. Payment of a guarantee fee should be considered in cases where a clear link between the loan guarantee and a source of income to the guarantor does not exist.
Even where a link can be supported, such as in the case discussed above, a guarantee fee would provide a clearer link, which could have saved Mr. MacCallum the costs incurred in supporting his claim before the Tax Court.

EY Insights can be accessed on mobile devices operating on the iOS (iPhone/iPad) and Android platforms, and is available through iTunes and the Android Market. After a free, one-time user registration, you can set up alerts to learn when new content is published, and set guidelines for the type of material that’s most applicable for your needs.

The EY Insights app is designed with simplicity in mind, and contains a bookshelf for downloading content, as well as the ability to annotate and bookmark.

The materials may be viewed online or offline once downloaded into your mobile device’s library. Our app offers fast and easy access to hundreds of our latest publications, studies, articles, surveys and global reports. New material is added as it’s published.

You can learn more about the application at EY Insights.

Tax Alerts

• 2011 Issue No. 29 - MAP program report reflects increased CRA transfer pricing audit activity
  The Canada Revenue Agency recently released its Mutual Agreement Procedure (MAP) Program Report for the fiscal year ending 31 March 2011. The report provides an overview of the operations of the MAP program, including statistical analyses of MAP cases completed and in progress.
• 2011 Issue No. 30.2 (webcast edition) - Foreign affiliates: 19 August legislative proposals
  The Department of Finance released the long-anticipated package of legislative proposals in respect of the “foreign affiliate” rules. The proposals replace a number of outstanding proposals those first released in 2004 to address various aspects of the treatment of foreign affiliate distributions and reorganizations, and so-called “internal dispositions.”
• 2011 Issue No. 31 - Elimination of partnership tax deferrals
  The BC government announced on Friday, 26 August 2011 that it will exit the federally administered harmonized sales tax (HST) system and restore the old provincial sales and use tax (PST). The target date is currently set for 1 April 2013.

Global Tax Policy and Controversy Briefing, August 2011
Our clients are telling us that tax policy and controversy issues are becoming a top priority, not just in the tax department, but increasingly at the C-suite and board level. Our quarterly publication is designed to help companies understand the biggest tax policy and enforcement trends in the regions of the world where they do business.

Guide to advance pricing agreements (APAs)
Transfer pricing continues to claim the attention of tax authorities around the world. International disputes — and the need for resolutions — have risen as a result of the heightened level of examination activity. Our Guide to advance pricing agreements outlines the dynamic transfer pricing landscape worldwide and how to proactively navigate it with APAs.

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.