Every two weeks, 14 civil servants gather in a Canada Revenue Agency boardroom in Ottawa for ex parte deliberations that have huge consequences for corporate and individual taxpayers — and the tax lawyers who advise them. All but three of the officials are from CRA. (They're joined by two from Justice and one from Finance.)
The GAAR committee, as this mythic panel is known, spends half a day reviewing three or four contentious tax files forwarded up the CRA hierarchy by auditors. For each file, the committee recommends whether the General Anti-Avoidance Rule – s. 245 of the Income Tax Act – should be applied by CRA, and if so, how much the taxpayer should be reassessed. In advance of the meeting, CRA's tax-avoidance officials submit a “recommendation report” on each file. The committee members also receive a summary of the taxpayer's views.
At the meeting, the auditor assigned to a file makes a presentation. The taxpayers under scrutiny cannot attend (though they do get to speak with the committee's CRA members before the meeting — and again afterwards, if the recommendation goes against them). “It's frustrating for taxpayers,” says Gabrielle Richards, partner at McCarthy Tétrault LLP in Toronto. “They wish it were a full hearing with an opportunity to be heard orally. The decision is made without you actually knowing whether the GAAR committee members have the benefit of everything you as a taxpayer would like to put forward.”
The GAAR committee had 1,080 cases referred to it between 1988 and 2012, and decided in 76 per cent (822) of those cases that GAAR applied. Of the files reviewed, 21 per cent involved surplus “stripping” (pulling retained earnings and profit out of a corporation in a form other than dividends); 9 per cent involved “kiddie tax” (which was introduced many years ago to effectively tax at the highest rate certain kinds of income that is realized in the hands of minors; and 8 per cent involved loss creation by stock dividend. On the latter files, GAAR was invoked every time.
So, has the number of cases referred to the GAAR committee been increasing? Yes, suspect most tax lawyers interviewed for this article, but CRA says it does not track the data year by year. (CRA refused Lexpert's request for an interview with a GAAR committee member.) What seems beyond dispute is that there have been more tax disputes landing in the courts, and CRA officials have been encouraged by the outcomes to take a more aggressive approach in applying GAAR and in ramping up their audit programs.
The Courts
“They've been buoyed by their success at the Supreme Court level,” says Matthew Williams, partner at Thorsteinssons LLP in Toronto. “You see them using the GAAR more frequently. It's been used much more in the second half of its history than in the first half.” There were 19 GAAR cases that went to court prior to 2005 and 26 litigated since then. In the first period, the Crown won only seven, while in the latter period it won 14.
It's long been a fundamental principle of Canadian tax law that taxpayers are entitled to legally arrange their affairs as they see fit in order to reduce their tax exposure. However, since its adoption by Parliament in 1988, GAAR has complicated that task profoundly. The GAAR stipulates that, where a transaction or a series of transactions achieves an avoidance of tax, and those transactions have that as their primary purpose, then the tax benefit may be denied — if, pursuant to s. 245(4), the transaction constitutes a “misuse” or “abuse” of the tax-related provisions it utilized. This means that the tax benefits are found to be inconsistent with the object, purpose or spirit of the tax rule(s) used to generate the tax benefit.
A series of judgments since 2005 by the Supreme Court of Canada turning on GAAR has unleashed CRA to challenge corporate and individual tax-planning arrangements more vigorously. “The courts have tightened up GAAR and given it more teeth than most tax practitioners had anticipated,” says Cliff Rand, National Managing Partner, Deloitte Tax Law LLP.
GAAR has become a “very useful tool for the CRA,” he adds. “It's not invoking the rule just when it comes across avoidance transactions but also as a deterrent. CRA doesn't see how many transactions are not going ahead due to GARR. There is no hard and fast definition in the Income Tax Act of what would be viewed as ‘abusive,' so it has a far-reaching deterrent effect on tax planning.”
The issue in all GAAR litigation now always turns on whether there was an abusive transaction, because there almost always is a tax-avoidance aspect. “The Supreme Court and the Federal Court of Appeal have clarified that every step in a transaction has to have a non-tax purpose” to be accepted, says Rand. “It's not enough that the overall purpose of the transaction is not to avoid tax.”
Adds Gerald Grenon, a partner at KPMG Law in Calgary: “Once you say that any step [that is tax-driven] means you've got an avoidance transaction, you're in a much more uncertain world [for tax advisors and their clients]. You have to ask yourself, ‘Could someone say this is an abuse?'”
The most recent of the Supreme Court rulings on GAAR came in December 2011 in Copthorne Holdings Ltd. v. Canada, a complex case involving companies controlled by Hong Kong billionaire Li Ka-Shing and his son Victor Li. Through a series of transactions, two Canadian corporations within Li's group that had previously been parent and subsidiary became “sister” corporations, or corporations owned directly by the same non-resident shareholder. This amalgamation was intended to take advantage of the favourable tax treatment of paid-up capital, the capital invested in a class of shares of a corporation by its shareholders.
The high court ruled that a series of transactions by Copthorne, a Li family holding company, violated the “spirit” of the tax-avoidance statute and was thus “abusive.” The case involved more than $140 million in withholding taxes on income repatriated from Canada. The ruling lowered the threshold for what is considered “abusive” under GAAR.
Copthorne clarified the SCC's three previous rulings on the applicability of GAAR. These were Canada Trustco Mortgage Co. v. Canada in 2005, Matthew (Kaulius) v. Canada in 2005 and Lipson v. Canada in 2009. (Of the four GAAR cases litigated all the way to the SCC, only in one was GAAR held not to apply.)
Risk-based Auditing
“GAAR is not the only reason why CRA is being more aggressive,” says Pamela Cross, partner at Borden Ladner Gervais LLP in Ottawa. “Tax authorities have for several years been implementing a risk-based audit approach. They wish to allocate up to 80 per cent of CRA resources on high-risk groups. So if you're categorized as low- or medium-risk, you won't see the CRA as much. But the risk-based audit approach is more much disciplined. There are more formal processes and a lot of written questions. It's much more comprehensive and intrusive than audits used to be.”
Williams agrees: “They've certainly become much more targeted and focused in using their audit powers. These audit initiatives are not just on the GAAR, and in some cases they're not the GAAR at all. They're specific provisions in the Act or specific legal doctrines that are being used to attack certain tax-planning initiatives.”
Take the case of “PowerSellers” – high-volume vendors on the eBay auction website. CRA fretted in the mid-2000s that these vendors were under-reporting or not reporting their online income. So it obtained a Federal Court order in September 2007 requiring eBay Canada to provide tax officials with full account information – names, contact information and sales records – on over 9,000 Canadian PowerSellers. The CRA eventually audited over 300 of them.
Since autumn of 2011, CRA has risk-assessed, and rated, 1,170 large corporations. By March 31, 2013, the agency will likely have had face-to-face meetings with the CEO, CFO or tax director of 140 of these corporations to explain its new risk-based approach and the implications of this approach for the corporations.
The initial risk assessment weighs such factors as audit history, industry sector issues, major acquisitions or divestitures, unusual or complex transactions, international transactions and participation in aggressive tax planning.
The CRA uses a list of a dozen generic questions to elicit details on corporate governance as it relates to tax matters. The questions ask about the corporation's formal framework for identifying and assessing the major tax risks linked to normal ongoing operations; the extent and frequency of tax risk reviews; and how the company monitors the risk of non-compliance and what steps are taken when a particular issue is identified.
Joel Nitikman, partner at Fraser Milner Casgrain LLP in Vancouver, tells his corporate clients: “They may not get around to you for another two years. Maybe you've got some time to change your risk profile within CRA by filing all the right documents and not missing deadlines. But if you're in a certain industry that ranks very high on their list of audit targets, then there's nothing you can do about that.”
“Frankly, the jury is still out on the process,” says Pierre Barsalou, a founding partner of tax litigators Barsalou Lawson Rheault in Montreal. “Our recommendation to clients is to be co-operative, but there's a legitimate question as to how much will change as a result of the initiative. Once you have a risk profile, then what? As far as seeing a variation on the subsequent audit work, it's not clear to some of the clients what will change in their lives. If they're ranked low-risk, they probably weren't being audited in an intensive manner previously anyway.”
In principle, “our clients welcome this approach,” says Richards at McCarthys. “It allows energy and resources to be focused on what's relevant. But it hasn't worked out yet in practice. Some auditors who've been trained to turn over every pebble on the beach find it difficult to give that up.”
International transactions in general, and transfer-pricing activity in particular, have become a major preoccupation for CRA in light of Canada's growing globalization. In 1998, Ottawa introduced much more detailed rules on transfer pricing and tougher penalties if CRA requires adjustments to the pricing of non-arm's-length transactions. “The federal government for a while was devoting $30 million a year to transfer pricing alone,” says Wilfrid Lefebvre, senior partner at Norton Rose Canada LLP in Montreal. “That buys an awful lot of auditors. CRA has hired economists, too. They're very well equipped to look at transfer pricing,”
Lefebvre cites CRA's aggressive tactics with GlaxoSmithKline Canada Inc. The agency challenged the purchase price that GSK Canada paid its Swiss affiliate in the early 1990s for ranitidine, the active ingredient of Zantac. CRA argued that Glaxo paid much more for the ingredient than generic drug manufacturers would have had to pay on the open market.
The SCC, in a ruling last October, held that CRA's comparison was simplistic, and passed the case back to the Tax Court, which had ruled in CRA's favour. “At the audit level, there's a strong incentive for CRA to reassess,” says Lefebvre. “It's a problem with the system. There's no accountability for a [flawed] reassessment. If they assess a million dollars, and three years later, the courts find the assessment was wrong, nothing will happen to the assessor.”
The volume of tax disputes has grown dramatically. The Notices of Appeal to the Tax Court of Canada have climbed steadily from 3,862 in 2008 to 4,521 in 2012. “The disputes are more substantial, the rules more complicated,” says Grenon. “Yes, the oil patch has grown,” he says of the tax-litigation climate in Alberta, “but the number of disputes has grown disproportionately.
“In 1994, it was rare in Calgary for two lawyers to devote all their practice to tax dispute resolution. Firms handling tax disputes would use a tax planner and a litigator with some tax knowledge. Then Bennett Jones, the largest firm in Calgary, hired its first tax litigator. Now, Bennett Jones, Oslers, Deloitte and Fraser Milner all have one or more lawyers whose practices are predominantly tax dispute resolution.”
High Net Worth Individuals
High net worth individuals (HNWI) have always been subject to CRA's compliance programs, but since 2004, the tax authorities have run the Related Party Initiative (RPI), first as a pilot project, then as a full-blown CRA program, managed within the International and Large Business Directorate.
The CRA focuses on about 550 HNWIs because of the complexity of their affairs. These are individuals who create intricate business structures, which include domestic and offshore limited partnerships, trusts, corporations and private charitable foundations. Each HNWI and related group has a net asset value of at least $50 million, with the group comprising 30 entities or more.
“Our approach to HNWIs has been to reinforce our risk assessment by conducting a comprehensive review of the entities in the related group,” says a CRA conference paper from the 2011 STEP Conference. Groups that are assessed and deemed “high-risk” are referred for audit to CRA's Large Files program. Depending on the nature of the business and how the entities are structured, small or mid-size businesses may become part of the audit.
At the outset of an audit under the RPI, the HNWI is contacted and asked to complete a 20-page questionnaire about their links, if any, to various types of corporations, trusts, and other entities, and investments, both in Canada and offshore. “It's quite difficult to complete a form like that,” says Cross, “and almost impossible without getting advice on how to do it, because it's really full of landmines.”
The type of information CRA is seeking “is quite complicated and broad,” agrees Barbara Novek, a founding
partner of tax boutique Sweibel Novek LLP in Montreal. “It is intrusive. They're asking for information on the entities in which the individual may have an interest but not necessarily a controlling interest.
“In cases where the individual is a beneficiary of a trust, for example, or a minority shareholder in a non-resident entity, the information provided to them might be quite limited. It may pertain only to their particular investment or the return that they themselves realized. But they may not be entitled to full financial information on the entity in question.”
CRA says in a position paper that, based on feedback from taxpayers and their advisors, the CRA has revised the questionnaire to better target the data it seeks and to avoid duplicate requests of the HNWI and their advisors. But Novek isn't impressed. “Where additional financial and accounting is obtained from other advisors, it's true to say that duplicate information is not being requested. If they have it from one source, they're not asking another. … But it doesn't make things hugely easier for the parties concerned.”
In recent years, CRA has focused intensively on domestic trusts. It is concerned that some of them may be used for improper income splitting with minors or improper capital gains sharing with minors. Trusts can be legitimately used for those purposes, but they need to be structured properly. CRA checks on whether the requirements have been met.
It is also looking at domestic trusts that attempt to take advantage of lower tax rates in certain provinces. When CRA's trust initiative started, they largely focused on Alberta trusts. CRA sent questionnaires to trusts having Alberta trustees, trying to determine whether the management was actually taking place in Alberta. In a properly structured trust, the trustees would be the effective managers of the trust and would manage it from the province where they reside.
The residency issue was at the heart of the Garron family trust case, a.k.a. the St. Michael Trust Corp. case (Fundy Settlement v. Canada, 2012 SCC 14). Two family trusts (whose beneficiaries are resident in Canada) claimed to be resident in Barbados, and not in Canada, and therefore not liable to Canadian capital gains tax when they sold shares they had held in two Ontario corporations.
The Supreme Court held that the residency of trusts is the place of management rather than where the trustee resides. The ruling clarified the test of residency, says Catherine Watson, partner at McInnes Cooper LLP in Halifax. “It's a central management and control test now that will govern where the residency of the trust is.”
When Watson plans for clients, “say we want an Alberta-resident trust for tax reasons, we would definitely need an Alberta-resident trustee who is actually calling the shots. It's best, if there's a protector, that they're also in Alberta. All of this could play into CRA's assessment of the central management and control.” Another question is whether to use a lay individual as trustee or hire a professional trustee. “One of the lessons of Garron is that a professional trustee in the jurisdiction you want your trust to be recognized in is important.”
Reportable Transactions
Following the lead of jurisdictions such as the UK, the US and Quebec, Canadian Finance Minister Jim Flaherty announced new reporting requirements for certain tax-avoidance transactions, as part of the March 2010 federal budget. The legislation, Bill C-48, is still before Parliament, but the measures will apply retroactively to transactions concluded after 2010.
Quebec had introduced new rules in October 2009 to combat “aggressive tax planning” (ATP) — defined as a tax-avoidance transaction that complies with the letter of the law while abusing its spirit. The “Quebec Truffle,” uncovered in 2006, relied on a separate election under federal and provincial legislation as to the residence of trusts. This strategy reportedly resulted in $500 million in tax avoidance in all provinces by fewer than 200 taxpayers — until it was shut down by retroactive legislation.
A major purpose of Ottawa's transaction reporting requirements is not only to identify which aggressive tax planners might be worth auditing but also to deter moves by tax advisors to develop standardized tax products for their clients. The requirement is also intended to give tax authorities early notice of planning schemes that are introduced on the market, so that, if necessary, prompt legislative action can be taken.
In Ottawa's proposed reporting requirements, a reportable transaction is defined for the purposes of GAAR as an “avoidance transaction” that features two of the following three “hallmarks”: (1) the promoter or tax advisor is paid a fee contingent on successfully obtaining a tax benefit; (2) the promoter or tax advisor requires confidential protection on the transaction; or (3) contractual protection was provided to the taxpayer (i.e., indemnity or compensation if the transaction fails).
There is a Catch-22 element that surrounds reportable transactions. The Finance Department has said that reporting a transaction will not be considered an admission that GAAR applies to it. However, a reportable transaction must first be an “avoidance transaction,” and that satisfies the first criterion of the GAAR. This suggests that that the underlying transaction is more likely to be challenged by CRA under GAAR. “It's like holding up a red flag saying, ‘Come in and audit us,'” says Nitikman.
The rules go further than intended, he says. “Small, everyday business deals are potentially caught by those rules.” Consider the hallmark of contractual protection. “CRA says nobody does that in a real business deal. They say the fact that you're doing it means this is an aggressive kind of tax shelter where you're only able to get people to buy into the deal because you're guaranteeing the tax saving.”
However, in many bona fide commercial deals, the buyer company requires from the seller assurances that it has accurately disclosed its financial situation, including its tax loss position. That seemingly innocent guarantee could be construed under the ATP rules as a “hallmark.” “This is a problem,” says Nitikman. “The legislation is too broad.”
Not only the taxpayer seeking the tax benefit but also the promoters or tax advisors who are entitled to fees, as described in the “hallmarks,” are required to file an information return. So where does this leave the lawyer who is an advisor in a reportable transaction?
According to the proposed legislation, lawyers are not required to disclose information that they believe “on reasonable grounds” would be covered by solicitor client privilege. But not every conversation or piece of paper that passes between a lawyer and a client is privileged, so the lawyer has to determine which information is covered by privilege.
Also, a tax practitioner who charges their client a contingency fee for arranging a tax-saving structure helps make it a reportable transaction. “I think the reporting obligation will impact on the use of contingency fees in tax planning,” says Cross.
“Some firms may decide that they will simply have a number of transactions that will have to be reported. Other firms may say, ‘if we charge [on an hourly basis], we don't fall within the rules of having to report.' It may be that you will see more simple fee arrangements. I don't want all my clients having to fill out those [aggressive tax planning] forms.”
Sheldon Gordon is a business and legal-affairs writer based in Toronto.
The GAAR committee, as this mythic panel is known, spends half a day reviewing three or four contentious tax files forwarded up the CRA hierarchy by auditors. For each file, the committee recommends whether the General Anti-Avoidance Rule – s. 245 of the Income Tax Act – should be applied by CRA, and if so, how much the taxpayer should be reassessed. In advance of the meeting, CRA's tax-avoidance officials submit a “recommendation report” on each file. The committee members also receive a summary of the taxpayer's views.
At the meeting, the auditor assigned to a file makes a presentation. The taxpayers under scrutiny cannot attend (though they do get to speak with the committee's CRA members before the meeting — and again afterwards, if the recommendation goes against them). “It's frustrating for taxpayers,” says Gabrielle Richards, partner at McCarthy Tétrault LLP in Toronto. “They wish it were a full hearing with an opportunity to be heard orally. The decision is made without you actually knowing whether the GAAR committee members have the benefit of everything you as a taxpayer would like to put forward.”
The GAAR committee had 1,080 cases referred to it between 1988 and 2012, and decided in 76 per cent (822) of those cases that GAAR applied. Of the files reviewed, 21 per cent involved surplus “stripping” (pulling retained earnings and profit out of a corporation in a form other than dividends); 9 per cent involved “kiddie tax” (which was introduced many years ago to effectively tax at the highest rate certain kinds of income that is realized in the hands of minors; and 8 per cent involved loss creation by stock dividend. On the latter files, GAAR was invoked every time.
So, has the number of cases referred to the GAAR committee been increasing? Yes, suspect most tax lawyers interviewed for this article, but CRA says it does not track the data year by year. (CRA refused Lexpert's request for an interview with a GAAR committee member.) What seems beyond dispute is that there have been more tax disputes landing in the courts, and CRA officials have been encouraged by the outcomes to take a more aggressive approach in applying GAAR and in ramping up their audit programs.
The Courts
“They've been buoyed by their success at the Supreme Court level,” says Matthew Williams, partner at Thorsteinssons LLP in Toronto. “You see them using the GAAR more frequently. It's been used much more in the second half of its history than in the first half.” There were 19 GAAR cases that went to court prior to 2005 and 26 litigated since then. In the first period, the Crown won only seven, while in the latter period it won 14.
It's long been a fundamental principle of Canadian tax law that taxpayers are entitled to legally arrange their affairs as they see fit in order to reduce their tax exposure. However, since its adoption by Parliament in 1988, GAAR has complicated that task profoundly. The GAAR stipulates that, where a transaction or a series of transactions achieves an avoidance of tax, and those transactions have that as their primary purpose, then the tax benefit may be denied — if, pursuant to s. 245(4), the transaction constitutes a “misuse” or “abuse” of the tax-related provisions it utilized. This means that the tax benefits are found to be inconsistent with the object, purpose or spirit of the tax rule(s) used to generate the tax benefit.
A series of judgments since 2005 by the Supreme Court of Canada turning on GAAR has unleashed CRA to challenge corporate and individual tax-planning arrangements more vigorously. “The courts have tightened up GAAR and given it more teeth than most tax practitioners had anticipated,” says Cliff Rand, National Managing Partner, Deloitte Tax Law LLP.
GAAR has become a “very useful tool for the CRA,” he adds. “It's not invoking the rule just when it comes across avoidance transactions but also as a deterrent. CRA doesn't see how many transactions are not going ahead due to GARR. There is no hard and fast definition in the Income Tax Act of what would be viewed as ‘abusive,' so it has a far-reaching deterrent effect on tax planning.”
The issue in all GAAR litigation now always turns on whether there was an abusive transaction, because there almost always is a tax-avoidance aspect. “The Supreme Court and the Federal Court of Appeal have clarified that every step in a transaction has to have a non-tax purpose” to be accepted, says Rand. “It's not enough that the overall purpose of the transaction is not to avoid tax.”
Adds Gerald Grenon, a partner at KPMG Law in Calgary: “Once you say that any step [that is tax-driven] means you've got an avoidance transaction, you're in a much more uncertain world [for tax advisors and their clients]. You have to ask yourself, ‘Could someone say this is an abuse?'”
The most recent of the Supreme Court rulings on GAAR came in December 2011 in Copthorne Holdings Ltd. v. Canada, a complex case involving companies controlled by Hong Kong billionaire Li Ka-Shing and his son Victor Li. Through a series of transactions, two Canadian corporations within Li's group that had previously been parent and subsidiary became “sister” corporations, or corporations owned directly by the same non-resident shareholder. This amalgamation was intended to take advantage of the favourable tax treatment of paid-up capital, the capital invested in a class of shares of a corporation by its shareholders.
The high court ruled that a series of transactions by Copthorne, a Li family holding company, violated the “spirit” of the tax-avoidance statute and was thus “abusive.” The case involved more than $140 million in withholding taxes on income repatriated from Canada. The ruling lowered the threshold for what is considered “abusive” under GAAR.
Copthorne clarified the SCC's three previous rulings on the applicability of GAAR. These were Canada Trustco Mortgage Co. v. Canada in 2005, Matthew (Kaulius) v. Canada in 2005 and Lipson v. Canada in 2009. (Of the four GAAR cases litigated all the way to the SCC, only in one was GAAR held not to apply.)
Risk-based Auditing
“GAAR is not the only reason why CRA is being more aggressive,” says Pamela Cross, partner at Borden Ladner Gervais LLP in Ottawa. “Tax authorities have for several years been implementing a risk-based audit approach. They wish to allocate up to 80 per cent of CRA resources on high-risk groups. So if you're categorized as low- or medium-risk, you won't see the CRA as much. But the risk-based audit approach is more much disciplined. There are more formal processes and a lot of written questions. It's much more comprehensive and intrusive than audits used to be.”
Williams agrees: “They've certainly become much more targeted and focused in using their audit powers. These audit initiatives are not just on the GAAR, and in some cases they're not the GAAR at all. They're specific provisions in the Act or specific legal doctrines that are being used to attack certain tax-planning initiatives.”
Take the case of “PowerSellers” – high-volume vendors on the eBay auction website. CRA fretted in the mid-2000s that these vendors were under-reporting or not reporting their online income. So it obtained a Federal Court order in September 2007 requiring eBay Canada to provide tax officials with full account information – names, contact information and sales records – on over 9,000 Canadian PowerSellers. The CRA eventually audited over 300 of them.
Since autumn of 2011, CRA has risk-assessed, and rated, 1,170 large corporations. By March 31, 2013, the agency will likely have had face-to-face meetings with the CEO, CFO or tax director of 140 of these corporations to explain its new risk-based approach and the implications of this approach for the corporations.
The initial risk assessment weighs such factors as audit history, industry sector issues, major acquisitions or divestitures, unusual or complex transactions, international transactions and participation in aggressive tax planning.
The CRA uses a list of a dozen generic questions to elicit details on corporate governance as it relates to tax matters. The questions ask about the corporation's formal framework for identifying and assessing the major tax risks linked to normal ongoing operations; the extent and frequency of tax risk reviews; and how the company monitors the risk of non-compliance and what steps are taken when a particular issue is identified.
Joel Nitikman, partner at Fraser Milner Casgrain LLP in Vancouver, tells his corporate clients: “They may not get around to you for another two years. Maybe you've got some time to change your risk profile within CRA by filing all the right documents and not missing deadlines. But if you're in a certain industry that ranks very high on their list of audit targets, then there's nothing you can do about that.”
“Frankly, the jury is still out on the process,” says Pierre Barsalou, a founding partner of tax litigators Barsalou Lawson Rheault in Montreal. “Our recommendation to clients is to be co-operative, but there's a legitimate question as to how much will change as a result of the initiative. Once you have a risk profile, then what? As far as seeing a variation on the subsequent audit work, it's not clear to some of the clients what will change in their lives. If they're ranked low-risk, they probably weren't being audited in an intensive manner previously anyway.”
In principle, “our clients welcome this approach,” says Richards at McCarthys. “It allows energy and resources to be focused on what's relevant. But it hasn't worked out yet in practice. Some auditors who've been trained to turn over every pebble on the beach find it difficult to give that up.”
International transactions in general, and transfer-pricing activity in particular, have become a major preoccupation for CRA in light of Canada's growing globalization. In 1998, Ottawa introduced much more detailed rules on transfer pricing and tougher penalties if CRA requires adjustments to the pricing of non-arm's-length transactions. “The federal government for a while was devoting $30 million a year to transfer pricing alone,” says Wilfrid Lefebvre, senior partner at Norton Rose Canada LLP in Montreal. “That buys an awful lot of auditors. CRA has hired economists, too. They're very well equipped to look at transfer pricing,”
Lefebvre cites CRA's aggressive tactics with GlaxoSmithKline Canada Inc. The agency challenged the purchase price that GSK Canada paid its Swiss affiliate in the early 1990s for ranitidine, the active ingredient of Zantac. CRA argued that Glaxo paid much more for the ingredient than generic drug manufacturers would have had to pay on the open market.
The SCC, in a ruling last October, held that CRA's comparison was simplistic, and passed the case back to the Tax Court, which had ruled in CRA's favour. “At the audit level, there's a strong incentive for CRA to reassess,” says Lefebvre. “It's a problem with the system. There's no accountability for a [flawed] reassessment. If they assess a million dollars, and three years later, the courts find the assessment was wrong, nothing will happen to the assessor.”
The volume of tax disputes has grown dramatically. The Notices of Appeal to the Tax Court of Canada have climbed steadily from 3,862 in 2008 to 4,521 in 2012. “The disputes are more substantial, the rules more complicated,” says Grenon. “Yes, the oil patch has grown,” he says of the tax-litigation climate in Alberta, “but the number of disputes has grown disproportionately.
“In 1994, it was rare in Calgary for two lawyers to devote all their practice to tax dispute resolution. Firms handling tax disputes would use a tax planner and a litigator with some tax knowledge. Then Bennett Jones, the largest firm in Calgary, hired its first tax litigator. Now, Bennett Jones, Oslers, Deloitte and Fraser Milner all have one or more lawyers whose practices are predominantly tax dispute resolution.”
High Net Worth Individuals
High net worth individuals (HNWI) have always been subject to CRA's compliance programs, but since 2004, the tax authorities have run the Related Party Initiative (RPI), first as a pilot project, then as a full-blown CRA program, managed within the International and Large Business Directorate.
The CRA focuses on about 550 HNWIs because of the complexity of their affairs. These are individuals who create intricate business structures, which include domestic and offshore limited partnerships, trusts, corporations and private charitable foundations. Each HNWI and related group has a net asset value of at least $50 million, with the group comprising 30 entities or more.
“Our approach to HNWIs has been to reinforce our risk assessment by conducting a comprehensive review of the entities in the related group,” says a CRA conference paper from the 2011 STEP Conference. Groups that are assessed and deemed “high-risk” are referred for audit to CRA's Large Files program. Depending on the nature of the business and how the entities are structured, small or mid-size businesses may become part of the audit.
At the outset of an audit under the RPI, the HNWI is contacted and asked to complete a 20-page questionnaire about their links, if any, to various types of corporations, trusts, and other entities, and investments, both in Canada and offshore. “It's quite difficult to complete a form like that,” says Cross, “and almost impossible without getting advice on how to do it, because it's really full of landmines.”
The type of information CRA is seeking “is quite complicated and broad,” agrees Barbara Novek, a founding
partner of tax boutique Sweibel Novek LLP in Montreal. “It is intrusive. They're asking for information on the entities in which the individual may have an interest but not necessarily a controlling interest.
“In cases where the individual is a beneficiary of a trust, for example, or a minority shareholder in a non-resident entity, the information provided to them might be quite limited. It may pertain only to their particular investment or the return that they themselves realized. But they may not be entitled to full financial information on the entity in question.”
CRA says in a position paper that, based on feedback from taxpayers and their advisors, the CRA has revised the questionnaire to better target the data it seeks and to avoid duplicate requests of the HNWI and their advisors. But Novek isn't impressed. “Where additional financial and accounting is obtained from other advisors, it's true to say that duplicate information is not being requested. If they have it from one source, they're not asking another. … But it doesn't make things hugely easier for the parties concerned.”
In recent years, CRA has focused intensively on domestic trusts. It is concerned that some of them may be used for improper income splitting with minors or improper capital gains sharing with minors. Trusts can be legitimately used for those purposes, but they need to be structured properly. CRA checks on whether the requirements have been met.
It is also looking at domestic trusts that attempt to take advantage of lower tax rates in certain provinces. When CRA's trust initiative started, they largely focused on Alberta trusts. CRA sent questionnaires to trusts having Alberta trustees, trying to determine whether the management was actually taking place in Alberta. In a properly structured trust, the trustees would be the effective managers of the trust and would manage it from the province where they reside.
The residency issue was at the heart of the Garron family trust case, a.k.a. the St. Michael Trust Corp. case (Fundy Settlement v. Canada, 2012 SCC 14). Two family trusts (whose beneficiaries are resident in Canada) claimed to be resident in Barbados, and not in Canada, and therefore not liable to Canadian capital gains tax when they sold shares they had held in two Ontario corporations.
The Supreme Court held that the residency of trusts is the place of management rather than where the trustee resides. The ruling clarified the test of residency, says Catherine Watson, partner at McInnes Cooper LLP in Halifax. “It's a central management and control test now that will govern where the residency of the trust is.”
When Watson plans for clients, “say we want an Alberta-resident trust for tax reasons, we would definitely need an Alberta-resident trustee who is actually calling the shots. It's best, if there's a protector, that they're also in Alberta. All of this could play into CRA's assessment of the central management and control.” Another question is whether to use a lay individual as trustee or hire a professional trustee. “One of the lessons of Garron is that a professional trustee in the jurisdiction you want your trust to be recognized in is important.”
Reportable Transactions
Following the lead of jurisdictions such as the UK, the US and Quebec, Canadian Finance Minister Jim Flaherty announced new reporting requirements for certain tax-avoidance transactions, as part of the March 2010 federal budget. The legislation, Bill C-48, is still before Parliament, but the measures will apply retroactively to transactions concluded after 2010.
Quebec had introduced new rules in October 2009 to combat “aggressive tax planning” (ATP) — defined as a tax-avoidance transaction that complies with the letter of the law while abusing its spirit. The “Quebec Truffle,” uncovered in 2006, relied on a separate election under federal and provincial legislation as to the residence of trusts. This strategy reportedly resulted in $500 million in tax avoidance in all provinces by fewer than 200 taxpayers — until it was shut down by retroactive legislation.
A major purpose of Ottawa's transaction reporting requirements is not only to identify which aggressive tax planners might be worth auditing but also to deter moves by tax advisors to develop standardized tax products for their clients. The requirement is also intended to give tax authorities early notice of planning schemes that are introduced on the market, so that, if necessary, prompt legislative action can be taken.
In Ottawa's proposed reporting requirements, a reportable transaction is defined for the purposes of GAAR as an “avoidance transaction” that features two of the following three “hallmarks”: (1) the promoter or tax advisor is paid a fee contingent on successfully obtaining a tax benefit; (2) the promoter or tax advisor requires confidential protection on the transaction; or (3) contractual protection was provided to the taxpayer (i.e., indemnity or compensation if the transaction fails).
There is a Catch-22 element that surrounds reportable transactions. The Finance Department has said that reporting a transaction will not be considered an admission that GAAR applies to it. However, a reportable transaction must first be an “avoidance transaction,” and that satisfies the first criterion of the GAAR. This suggests that that the underlying transaction is more likely to be challenged by CRA under GAAR. “It's like holding up a red flag saying, ‘Come in and audit us,'” says Nitikman.
The rules go further than intended, he says. “Small, everyday business deals are potentially caught by those rules.” Consider the hallmark of contractual protection. “CRA says nobody does that in a real business deal. They say the fact that you're doing it means this is an aggressive kind of tax shelter where you're only able to get people to buy into the deal because you're guaranteeing the tax saving.”
However, in many bona fide commercial deals, the buyer company requires from the seller assurances that it has accurately disclosed its financial situation, including its tax loss position. That seemingly innocent guarantee could be construed under the ATP rules as a “hallmark.” “This is a problem,” says Nitikman. “The legislation is too broad.”
Not only the taxpayer seeking the tax benefit but also the promoters or tax advisors who are entitled to fees, as described in the “hallmarks,” are required to file an information return. So where does this leave the lawyer who is an advisor in a reportable transaction?
According to the proposed legislation, lawyers are not required to disclose information that they believe “on reasonable grounds” would be covered by solicitor client privilege. But not every conversation or piece of paper that passes between a lawyer and a client is privileged, so the lawyer has to determine which information is covered by privilege.
Also, a tax practitioner who charges their client a contingency fee for arranging a tax-saving structure helps make it a reportable transaction. “I think the reporting obligation will impact on the use of contingency fees in tax planning,” says Cross.
“Some firms may decide that they will simply have a number of transactions that will have to be reported. Other firms may say, ‘if we charge [on an hourly basis], we don't fall within the rules of having to report.' It may be that you will see more simple fee arrangements. I don't want all my clients having to fill out those [aggressive tax planning] forms.”
Sheldon Gordon is a business and legal-affairs writer based in Toronto.
