TaxMatters@EY – July 2021

Gael Melville, Vancouver, and Maureen De Lisser, Toronto

Introduction

A recent Canada Revenue Agency (CRA) technical interpretation¹ deals with the interaction of the small business deduction rules with the rules under section 55 of the Income Tax Act (the Act) that may apply, in certain circumstances to recharacterize a tax-free intercorporate dividend as a capital gain or as additional proceeds of disposition.

The CRA’s responses provided clarification that deemed gains and deemed proceeds of disposition arising under subsection 55(2) could receive the same favourable treatment as other gains arising from the disposition of “active assets” when it comes to calculating a corporation’s small business deduction.

Small business deduction and the passive income grind

The small business deduction is a deduction from Part I tax available only to corporations that are Canadian-controlled private corporations (CCPCs) throughout the taxation year. As part of the calculation of a CCPC’s small business deduction, a corporation must calculate its business limit. A corporation — or an associated group — that earns more than $50,000 of passive investment income in the preceding taxation year will be subject to a business limit reduction, or grind.² The small business deduction is eliminated entirely when passive investment income exceeds $150,000 in the preceding taxation year.³

The passive income grind is itself calculated using the concept of “adjusted aggregate investment income.” Among the items carved out in calculating adjusted aggregate investment income are taxable capital gains from the disposition of “active assets” of the CCPC.

Active assets

Taxable capital gains from the disposition of a CCPC's property that is an active asset at the time of disposition are excluded from the CCPC's adjusted aggregate investment income. Therefore, these gains will not increase the amount of the passive income grind of the CCPC's business limit and so will not reduce the small business deduction that the CCPC can claim.

An active asset may be any of the following:

• An asset used in an active business
• Aa share of the capital stock of another corporation
• An interest in a partnership

Only the second of these is relevant to the CRA technical interpretation that is under discussion here.

A share of the capital stock of another corporation can be an active asset of a CCPC if the other corporation is connected with the CCPC for purposes of subsection 186(4) of the Act⁴ and the share meets the definition of qualified small business corporation share in subsection 110.6(1) of the Act (with certain modifications to apply the definition to shares held by a corporation rather than an individual).

The section 55 recharacterization rules

Subsection 55(2) of the Act is an anti-avoidance provision intended to prevent what is commonly referred to as capital gains stripping. Essentially, a capital gains strip is a transaction where a corporation converts what would otherwise be a taxable capital gain into tax-free intercorporate dividends.

When the subsection applies, the amount of the dividend received is deemed not to be a dividend, and is instead recharacterized as proceeds of disposition if the dividend is received on a redemption, acquisition or cancellation of a share to which certain income tax rules apply.⁵ In any other case, the dividend is recharacterized as a gain from the disposition of a capital property.

Intersection of the small business deduction and section 55 rules

The carve-out for active assets in the definition of adjusted aggregate investment income in subsection 125(7) of the Act refers to “taxable capital gains from the disposition of property, that is at the time of disposition, an active asset of the corporation….”

However, paragraph 55(2)(c) of the Act deems a dividend to be a gain of the dividend recipient from the disposition of a capital property, and doesn’t use the term “active asset.” This mismatch in wording prompted a question at the CRA roundtable at the 2020 APFF Conference effectively asking the CRA to clarify whether or not a deemed gain under subsection 55(2) could be eligible for the carve-out in computing a corporation’s passive investment income grind for purposes of the business limit.

CRA’s responses

The CRA was asked two questions in connection with the interaction of the small business deduction rules with the section 55 rules.

First, the CRA was essentially asked whether a deemed capital gain under paragraph 55(2)(c) could ever relate to an active asset on the basis it is deemed to arise from the disposition of a capital property rather than from the disposition of a share.

In its response, the CRA referred to the definition of the term capital property in section 54 of the Act and confirmed that the reference in paragraph 55(2)(c) to “capital property” includes a share. Further, if the conditions in paragraph (b) of the definition of “active asset” in subsection 125(7) of the Act are met in respect of the share on which the dividend is paid, then a deemed gain under paragraph 55(2)(c) could be a capital gain from the disposition of property that was an active asset at the time of payment of the dividend. This would in turn mean that it will not increase the passive income grind of the dividend recipient corporation’s business limit for purposes of computing that corporation’s small business deduction.

The second question the CRA was asked related to paragraph 55(2)(b), which deals with a dividend received on a redemption, acquisition or cancellation of a share by the issuing corporation. The CRA was asked to confirm that a deemed gain under paragraph 55(2)(b) could arise from an active asset.

The CRA responded that if the share that was redeemed, acquired or cancelled met all the conditions of paragraph (b) of the definition of “active asset” in subsection 125(7) of the Act, then the taxable capital gain from the disposition of the share could be eligible for the carve-out in computing the recipient corporation’s passive investment income grind.

The technical interpretation provides welcome clarification on the interaction of the subsection 55(2) recharacterization rules with the passive investment income grind relevant to the computation of a CCPC’s small business deduction. The ability to treat a deemed gain under subsection 55(2) as a gain from the disposition of an active asset in circumstances where the recharacterized dividend was paid on a share meeting the conditions of an “active asset” is good news, since it means the deemed gain does not adversely affect the computation of a CCPC’s small business deduction.

Lucie Champagne, Alan Roth, Andrew Rosner and Candra Anttila, Toronto

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Winnie Szeto, Toronto, and Gael Melville, Vancouver

In this case, the taxpayer took the unusual step of commencing an action against the CRA seeking damages for “unjust enrichment.”

CRA records indicated that certain refund cheques were issued to the taxpayer and that the cheques had been negotiated, but the taxpayer denied ever receiving or depositing the cheques. In response, the CRA asked the Federal Court (FC) for summary judgment in its favour.

In granting the CRA’s motion and dismissing the taxpayer’s action, the FC concluded that the taxpayer was too late in making his claim and the CRA was not unjustly enriched.

Facts

The taxpayer claimed charitable donation tax credits that resulted in tax refunds of approximately $17,000 in the 2005 taxation year and approximately $16,000 in the 2006 taxation year. CRA records indicated that Notices of Assessment and refund cheques were issued in June 2006 and April 2007 for the 2005 and 2006 taxation years, respectively.

The taxpayer claimed he did not receive or deposit the refund cheques. He also claimed that in 2006 he had called the CRA’s general inquiries line asking about the whereabouts of the 2005 refund cheque, and the CRA representative said that it was probably withheld due to an audit of his charitable donations.

The CRA later reassessed the taxpayer’s 2005 and 2006 taxation years and denied both his claims for charitable donation tax credits. The CRA issued Notices of Reassessment to the taxpayer in March 2008 and March 2010, notifying him that he had outstanding balances of approximately $20,000 each for the 2005 and 2006 taxation years, on the assumption that the taxpayer had cashed the refund cheques.

In June 2015, the taxpayer’s solicitors received a letter from the CRA indicating that the refund cheques were issued and the dates they were issued, but the taxpayer claimed he was not made aware of the contents of the letter.

The taxpayer filed objections to the initial reassessments, but in May 2017 the CRA issued further Notices of Reassessment, again under the assumption that the taxpayer had cashed the refund cheques.

In February 2018, the taxpayer filed a service complaint with the CRA, claiming that he had not received the refund cheques. The CRA responded that its records showed that the refund cheques for the relevant taxation years were issued and paid.

Due to the passage of time, the taxpayer was unable to access his bank records to support his claim that he did not deposit the refund cheques, and similarly the CRA no longer had copies of them.

As a result, in November 2018 the taxpayer launched an action against the CRA seeking damages for unjust enrichment. In response, the CRA brought a motion with the Federal Court for summary judgment in its favour.

The Court had to consider two main issues:

• Whether the taxpayer’s claim against the CRA was statute barred because the relevant two-year limitation period for the claim had expired before the taxpayer commenced his action in 2018
• Whether the Crown had been enriched because the taxpayer claimed he had not received or cashed the refund cheques

Motion for summary judgment

The purpose of a summary judgment is to allow the court to dispose of cases promptly without going to a full trial. Rule 215(1) of the Federal Courts Rules provides that if the court is satisfied that there is no genuine issue for trial with respect to a claim or defence, the court shall grant summary judgment.¹

The test on a motion for summary judgment is whether the case is so doubtful that it does not deserve consideration by the trier of fact at a future trial.² The party seeking summary judgment, in this case the Crown, has the evidentiary burden to establish that there is no genuine issue for trial. However, Rule 214 provides that the opposing party, in this case the taxpayer, is required to provide specific facts and evidence showing that there is indeed a genuine issue for trial.³

Statute of limitations

The parties agreed that the applicable limitation period for this case was two years after the claim was “discoverable” as set forth in section 4 of the Ontario Limitations Act, 2002.⁴ However, they disagreed on when the taxpayer’s claim was discoverable.

The CRA argued that the taxpayer should have known about his loss or damage as early as 2006, when he realized he did not receive his 2005 refund cheque, and if not at that time, then he should have been aware in 2010, when he received the second of the initial reassessments. In any event, the taxpayer should have known by July 2015, when his solicitors received the CRA letter. The CRA further argued that the taxpayer should not be able to rely on the verbal advice from the representative he received in 2006 to justify waiting until 2018 to commence his claim for unjust enrichment.

The taxpayer argued that to fairly determine when his claim was discoverable, the court needed to hear directly from him to assess his credibility regarding the 2006 advice, his continued reliance on the 2006 advice even after receipt of the initial reassessments, and his belief that objections were the appropriate mechanism by which the issue with the refund cheques would be resolved. He also argued that he was unaware of the contents of the CRA letter and that his solicitors were not retained in respect of the 2005 and 2006 taxation year disputes, and so did not have an obligation to notify him of the CRA letter.

The judge agreed with the taxpayer that a trial judge would be in a better position to assess his credibility with respect to the 2006 advice and his continued reliance on it after receipt of the initial reassessments. However, the judge concluded that there was no issue of credibility with respect to the receipt by his solicitors of the CRA letter in July 2015. The judge was of the view that the lawyers were an agent of the taxpayer, and as such the taxpayer knew or ought to have known by July 2015 of the loss or damage caused by his failure to receive the refund cheques. As a result, the taxpayer commenced his action for unjust enrichment beyond the expiry of the prescribed two-year limitation period.

Unjust enrichment

The parties agreed that for a claim of unjust enrichment to succeed, three elements must be present:

• The defendant must be enriched
• The plaintiff must be correspondingly deprived
• There is no legal reason for the enrichment⁵

The CRA argued that it was not enriched because according to its records, it issued and mailed the refund cheques and they were negotiated, although the CRA did not know whether the taxpayer or a third party negotiated the cheques.

The CRA submitted four affidavits into evidence, two affidavits from a CRA employee and two from employees of the CRA’s processing agent, Public Services and Procurement Canada (PSPC). The affidavits detailed the CRA’s records as they pertained to the taxpayer’s accounts for the 2005 and 2006 taxation years. The information in the CRA’s database indicated that PSPC issued the Notices of Assessment and refund cheques, which were mailed to the taxpayer’s address on file.

The affidavits also described PSPC’s general process for issuing CRA refund cheques, how the PSPC’s database maintained data regarding negotiated and cancelled cheques for six years, and how unnegotiated or cancelled cheques remained indefinitely on their database as “outstanding.”

The affidavits also confirmed that PSPC’s records showed that the refund cheques did not appear on the “outstanding” list.

The taxpayer argued that the CRA did not sufficiently establish that the refund cheques were issued and mailed. He submitted that the CRA must have been enriched because the refund cheques were never actually issued, and therefore could not have been negotiated.

The taxpayer challenged the affidavit evidence provided by the PSPC employees. He argued that one of the employees did not work for PSPC in 2005, when the refund cheques should have been issued and, therefore, had no personal knowledge of the facts and her evidence should be given little or no weight. In addition, neither of the PSPC employees stated that the refund cheques were actually mailed to the taxpayer. Finally, the taxpayer argued that the other PSPC employee could not state with certainty that the refund cheques were not cancelled.

However, the judge disagreed with the taxpayer. She was satisfied that the CRA’s affidavit evidence, when read together, was internally consistent in its description of the taxpayer’s interaction with the CRA, his tax accounts and tax filings for the taxation years in dispute, the CRA’s requisitions to PSPC for preparation of the refund cheques, PSPC’s usual printing practices, issuance and mailing of the cheques, PSPC’s quality control measures, PSPC’s records regarding the CRA’s requisitions for the refund cheques and, most important, the status of the refund cheques.

The judge found that the CRA’s detailed affidavit evidence was reliable and sufficiently established that the 2005 and 2006 Notices of Assessment and refund cheques were printed and mailed to the taxpayer. Under section 248(7) of the Income Tax Act⁶, the taxpayer was deemed to have received the Notices of Assessment and refund cheques. The taxpayer did not present any evidence that contradicted the CRA’s evidence, and therefore did not meet his burden of showing that the CRA was unjustly enriched and that there was a genuine issue for trial.

Based on the above, the judge granted the CRA’s motion for summary judgment and dismissed the taxpayer’s claim for unjust enrichment.

Lessons learned

This case serves to remind taxpayers of several lessons.

First, taxpayers must be proactive and diligent in managing their tax affairs, especially when dealing with refund cheques of significant amounts.

Second, taxpayers should not rely solely on one-time verbal advice provided by a CRA representative regarding their tax account status. It is prudent to check and double-check.

Third, taxpayers should not assume that bank records or CRA records are kept indefinitely. Important tax and financial records should be kept or saved in a secure place.

Finally, the evidence from the CRA and PSPC in this case showed that there was a fairly robust process in place for the printing, issuing, mailing and status-keeping of Notices of Assessment and refund cheques. Unless a taxpayer can adduce sufficient evidence to prove otherwise, it is unlikely that a court will find an error with their process.

Tax Alerts – Canada

Tax Alert 2021 No. 23 – CRA releases revised Information Circular on Mutual Agreement Procedures
On 1 June 2021, the Canada Revenue Agency (CRA) released Information Circular IC71-17R6 Competent Authority Assistance under Canada’s Tax Conventions, replacing and cancelling Information Circular IC71-17R5, issued 1 January 2005.

Tax Alert 2021 No. 24 – 2021 Budget implementation bill receives Royal Assent
Bill C-30 implements certain tax measures announced in the 2021 federal budget, the 30 November 2020 federal fall economic statement, and the 2019 federal budget, as well as other previously announced tax measures.