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ADMS 4562 LECTURE 9 NOTES
Last updated on June 11, 2015
The Final Content Exam will be on Thursday, July 30 from 7 to 10pm.
The exam covers lectures 5 to 9.
The exam location is VH (Vari Hall) room A
The exam handout (provided with this lecture’s material) will be given
to you at the exam
Students who have a conflict should contact your course director at least 2 weeks
prior to the exam to be put on the list to write an alternate ADMS 4562 exam
Past final content exams will not be posted
The format of the exam is described on the course outline
Topics
1. Sale of Shares and Section 55(2)
– Problem Set Question 1 (in separate document)
Readings: S. 55(2), FIT Chapter 16 (16240)
Recommend: Ch 16, Exercise 10
2. Partnerships
- Problem Set Question 2 (in separate document)
Readings: ADMS 3520 Lecture 10 Notes (separate document), FIT Chapter 18 (18000)
Recommend: Ch. 18, Multiple Choice 1 and 2, Exercises 1 and 2
3. The General Anti-avoidance Rule (GAAR):
Readings: Chapter 13 (13500)
Recommend Ch. 13, Multiple Choice 4 and 5, Exercise 11; and Ch. 17 Review Question 6
4. Major Causes of Liability Insurance Claims in Tax Practice
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2
Subsection 55(2)- Arm’s length sale of shares by a corporation
Legislative intent:
s. 55(2) prevents the conversion of a capital gain (CG) on an arm's length sale of shares
by a corporation to a tax-free (s. 112) dividend if the dividend is greater than “income
realized and retained after 1971” (also called "post-1971 retained earnings" or "safe
income"). Subsection 55(2) only applies to limit dividends to safe income when the
dividend is paid in the course of an arm’s length sale.
S. 55(2) applies automatically if all of the following conditions are met:
1. Vendor of shares is a corporation
2. Purchaser and vendor deal at arm’s length (i.e., are not related). Siblings are deemed
to be at arm’s length for purposes of s. 55(2) only [ITA 55(5)(e)]
3. Vendor receives a tax-free inter-corporate dividend (s. 112) at any time prior to the
sale
4. One of the purposes or results of the dividend is to reduce the CG on the ultimate sale
of shares
Result  S. 55(2) limits the dividend to safe income. The remaining dividend is
deemed to be proceeds of disposition (POD) and this typically results in an
additional CG. [Discussed in more detail below, plus see 55(5)(f) election]
S. 55(2) actually limits the dividends to the greater of
1. the dividend subject to Part IV tax or
2. safe income portion
The courts have ruled that the two exemptions cannot be added together. In this course
we will be concentrating on the safe income rule.
1.1
S. 55(5)(f) Election- Dividends in excess of safe income
If the dividend exceeds safe income, the recipient can (and should) elect under s. 55(5)(f)
to split the dividend into two separate dividends in order for the “safe income” portion to
remain a dividend – otherwise the entire dividend will be deemed to be proceeds of
disposition. In other words, the s. 55(5)(f) designation allows part of the dividend to be
treated as a separate dividend paid out of safe income. The other part (i.e., the part of the
dividend in excess of safe income) will be deemed to be proceeds of disposition and this
typically results in an additional capital gain
Some taxpayers will be aware of s. 55(2) and will pay 2 separate dividends (one out of
safe income, one not) rather than relying on an election under s. 55(5)(f) either by
1. paying two cash dividends, or two stock dividends or
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2. having two deemed dividends (by increasing the PUC of shares twice to create two
dividends).
However, if they don’t know about s. 55(2) and/or if they pay one dividend that is in
excess of safe income the s. 55(5)(f) designation is a way of mitigating the problem
retroactively (by electing to split the dividend into two separate dividends)
The exact calculation of safe income is complex and beyond the scope of this course.
1.2
Test yourself on 55(2)
P Ltd. owns 100% of S Ltd. S Ltd.'s shares have a paid-up capital and an ACB of
$20,000 and a FMV of $85,000. S Ltd.'s post-1971 tax retained earnings amounts to
$55,000 and its pre-1972 CSOH account amounts to $40,000. P Ltd. is planning to sell S
Ltd. to an arm's length purchaser. Prior to the sale, S Ltd. borrows $85,000 from a bank
to pay P Ltd. two amounts: $20,000 in respect of a reduction in S Ltd's paid-up capital
and $65,000 in respect of a taxable dividend. After the payments, P Ltd. sells S Ltd.
shares for a nominal amount. Which of the following statements is true, assuming the
optimal election is made under s. 55(5)(f)?
(a) P Ltd. should include a $85,000 dividend in its Division B net income.
(b) P Ltd. would include a $65,000 dividend in its Division B net income.
(c) P Ltd. would include a $55,000 dividend and a $5,000 taxable capital gain in its
Division B net income.
(d) P Ltd. would include a $50,000 dividend in its Division B net income.
The correct answer is (c).
S. 55(2) applies since all of the following conditions are met:
1. Vendor of shares (P Ltd.) is a corporation
2. Purchaser and vendor deal at arm’s length (i.e., are not related)
3. Vendor receives a tax-free inter-corporate dividend (s. 112) at any time prior to the
sale (P Ltd. receives a $65,000 dividend).
4. One of the purposes or results of the dividend is to reduce the CG on the ultimate sale
of shares
Since safe income is $55,000 and since the 55(5)(f) election is filed $55,000 can stay as a (taxfree) dividend and the excess amount $10,000 will be deemed to be a separate dividend and
additional proceeds of disposition (P of D)
P of D = $0 (nominal) plus $10,000 = $10,000
less ACB
$0
Capital gain
$10,000
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Taxable capital gain (1/2)
$5,000
ACB was $20,000 but it is reduced to $0 (as is PUC) after the $20,000 PUC reduction payment.
The $20,000 is received tax-free since it equals the PUC prior to the PUC reduction payment.
2
PARTNERSHIPS [section 96]
The basic partnership rules were introduced in ADMS 3520 Lecture 10 (refer to separate
document). The problem set question reviews the concepts in a comprehensive problem
which is more difficult than those covered in ADMS 3520.
A partnership is a relationship defined and governed by provincial law. Ontario’s
Partnerships Act defines a partnership as a relationship “…between persons carrying on a
business in common with a view to profit…”
An incorporated company and a sole proprietorship are not partnerships.
Partnerships typically have to file an information return [reg. 229(1)]. A partnership must
file a partnership information return if any of the following are met:
1) the partnership has a corporation or a trust as a partner;
2) the partnership has in its year-end an absolute value of revenues plus expenses of more
than $2M;
3) the partnership has at year-end more than $5M of assets (valued at cost without
subtracting any amortization).
If the ACB of a partner’s partnership interest is negative at any point, there is no
immediate CG [s. 40(3)(a) and 53(2)(c)] unless
(a) the interest has been disposed of
(b) it is a residual interest in a partnership (e.g. the interest of a retired partner) or
(c) the partner is limited or passive (limited partnerships are discussed below)
How could the ACB of a partnership interest be negative?
Answer: If the partner’s share of losses and/or draws exceeds contributions and/or
income.
Is Interest expense incurred to purchase a partnership interest deductible?
Answer: Yes- as long as the partnership is earning income from business or property, all
other conditions in s. 20(1)(c) are met and no other provision of the Act applies to stop
the deduction.
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2.1
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SPECIFIC ANTI-AVOIDANCE RULES FOR PARTNERSHIPS
1. The CRA has the power to reallocate partnership income or loss if:
- the allocation of income or loss was made to defer or reduce income tax payable [s.
103(1)]
or
- the allocation of income or loss between non-arm’s length partners is not reasonable [s.
103(1.1)]
2. Business income can be deemed to be property income for attribution rules:
partnership income earned by a partner who is a spouse or non-arm’s length minor or
niece or nephew is deemed to be property income subject to the attribution rules in 74.1 if
the partner is a limited partner or not actively engaged in the business [s. 96(1.8)]
2.2
ROLLOVERS (for Partnerships)
Rollover to Form a Partnership
Let’s say two sole proprietor’s want to form a partnership. Each has business assets
worth substantially more than cost (e.g. goodwill, real estate, etc.). How can they transfer
their assets to the partnership without any adverse tax consequences?
Answer: The rules are very similar to s. 85(1). An election can be filed on the transfer of
property by a partner to a Canadian partnership to have it occur on a rollover under s.
97(2). Otherwise s. 97(1) will apply and the transfer will be made at FMV which means
the seller will have a disposition at FMV and the partnership will acquire the asset at a
cost equal to FMV. The new partner’s ACB of his/her partnership interest will equal the
FMV transferred in to the partnership.
A Canadian partnership is one where all the partners are resident in Canada (for tax
purposes), [ITA 102(1)].
The election is similar to s. 85(1) with two major exceptions:
(1) real estate inventory can be transferred using a s. 97(2) rollover (but not under an s.
85(1) rollover)
(2) consideration = boot and the partnership interest (rather than boot and shares)
There are also stop-loss rules similar to those in section 85.
Admitting a New Partner
With an existing partnership, a new partner can be admitted, subject to the terms of the
partnership agreement, by contributing assets into the partnership directly or by buying
out the partnership interest of an existing partner. The FMV of assets paid to acquire a
partnership interest adds to the new partner’s ACB of his/her partnership interest.
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If a former partner has sold some (or all) of his/her partnership interest then he/she will
have a capital gain or capital loss on the sale (equal to proceeds received less ACB of
his/her partnership interest).
Withdrawal or Death of a Partner
A retired partner who has not yet received a full payout for his/her partnership interest
has a residual interest in the partnership.
When a partner retires, he/she will receive: (1) his/her allocation of any income/loss in
the year of retirement; and (2) assets in return for giving up his/her partnership (or
residual) interest.
The former partner will have a capital gain or capital loss on the sale of his/her
partnership (or residual) interest. Income allocated will add to the ACB of his/her
partnership interest (and loss allocated will decrease ACB).
If a partner dies, the deceased will have: (1) an allocation of any income/loss in the year
to the date of death; and (2) a deemed disposition of his/her partnership interest at FMV
immediately before death (triggering a capital gain or capital loss on death). Income
allocated will add to the deceased’s ACB of partnership interest (and loss allocated will
decrease ACB).
Rollovers on the Breakup of a Partnership
How can a partnership break up without any immediate adverse tax consequences?
Answer: For the purposes of this course, you only need know that s. 98 provides tax-free
rollovers in certain circumstances when the business continues to be carried on by one or
more of the partners.
2.3
INCORPORATION OF A PARTNERSHIP
Step 1 – Transfer the Partnership’s Assets to Newco
A s. 85(2) rollover is available on the transfer of property from a partnership to a taxable
Canadian corporation (Newco). At this point, the partners continue to own their interests
in the partnership and the partnership owns all the shares of Newco.
Step 2 – Transfer the Newco Shares to Partners and Terminate the Partnership
within 60 days
A s. 85(3) rollover is available if Newco shares are transferred from the partnership to
the partners and the partnership is terminated within 60 days of this transfer. (The
partnership’s lawyer must wind up the partnership within 60 days of the transfer of
shares)
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Why incorporate? The usual reasons:
- Limited liability
- Small business deduction on Canadian active business income
- Shares are eligible for the $800,000 capital gains exemption if the shares qualify as
QSBC shares. [In 2015 and thereafter the $800,000 will be indexed to inflation]
An alternative is for each partner to transfer his/her partnership interest to a holding
company
Benefits:
- More flexible (each partner is still separate)
- Limited liability at the Holdco level
- Small business deduction in Holdco restricted by specified partnership income rules.
2.4
LIMITED PARTNERSHIPS (LPs)
Usually set up under provincial limited partnership legislation - must have one general
partner, usually the general partner is a company with no assets.
A limited partner has limited liability (i.e., limited to the partner’s capital account and
any debts guaranteed by the partner) unless he/she takes an active role in the partnership
in which case he/she will cease to be a limited partner
Used a lot for tax shelters because losses flow through to investors but the investors’
liability is limited
Because of abuse in this area, four special rules have been enacted:
1.The Act now limits investment tax credits and losses to a limited partner's at-risk
amount [section 96(2.1),(2.2)], which conceptually is =
The ACB of the limited partner’s partnership interest
plus the limited partner’s share of current year's income
minus amounts payable by the limited partner to the partnership (or persons not
dealing at arm’s length with the partnership)
2. If the ACB of a partnership interest is negative at any point, there is an immediate
capital gain (CG) [s. 40(3)(a)]
3. Tax shelters must be registered
4. Third party penalty rules for promoters and sellers of tax shelters. Because of all these
restrictions, limited partnerships are not as popular for tax purposes as they have been in
the past. However, limited partnerships do serve a useful purpose: they limit the liability
of limited partners.
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LIMITED LIABILITY PARTNERSHIPS
In Ontario, certain professions (e.g. public accounting and law) are allowed to practice in
limited liability partnerships (LLPs), a concept borrowed from U.S. law. In a LLP, a
partner's liability with respect to matters of professional negligence is limited to the assets
invested in the firm unless he/she is personally at fault in the legal claim. If he or she is
personally at fault, all the partner's assets are exposed (e.g., personal assets such as real
estate, investments, etc.). A LLP is therefore better than a general partnership, which has
joint and several liability (i.e., every partner's assets are exposed even when he/she is not
at fault). A LLP is different from a limited partnership. Other differences (in addition to
different legal liability protection) include:
- the "at risk" rules which limit losses and ITCs do not apply to LLPs [s. 96(2.4)]
- there is no immediate CG when a partner of a LLP has a partnership interest with a
negative ACB [s. 40(3)(a)]
Note: there have been changes to Ontario’s Partnership Act. You are not responsible for
these changes for purposes of this course. Changes affecting LLPs (effective August 1,
2007 and thereafter) are as follows:
 Existing LLPs will now become “full shield” LLPs (as opposed to “partial shield”
LLPs). This means that a partner of a LLP will no longer be liable for the general
debts of the partnership (though he/she will still be liable for professional
negligence if he/she is personally at fault)
 The income tax consequence of this change is that full shield LLPs will now be
considered limited partnerships (LPs) for purposes of the Act. Hence the “at risk”
rules (discussed above) will now apply to full shield LLPs and if a partner in a full
shield LLP has a partnership interest with a negative ACB there will be an
immediate capital gain (discussed above)
In Ontario, the accounting and legal professions (and doctors, dentists…) are allowed to
practice through “professional corporations”. Professional corporations do not provide
as much limited liability protection as regular corporations. For matters of professional
negligence, the professional/shareholder is still legally liable. To date, the use of
professional corporations for big accounting and law firms has been limited - only sole
proprietorships and very small partnerships are interested in incorporating. Why? Two
reasons:
1. There is only integration for the amount eligible for the small business deduction,
$500,000; and $500,000 split among many partners does not help much and
2. There is better liability protection with a LLP.
2.6
What is the difference between a Partnership and a Joint Venture?
This a question of fact and law. In law, a joint venture is limited to a single undertaking,
whereas a partnership is not. Some real estate ventures are joint ventures (single
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undertaking) whereas others are partnerships. Accounting and law firms are partnerships.
For tax, the major significance is that:
- a partnership is a separate entity (CCA is deducted at the partnership level)
- in a joint venture, the venturers own a % of all the assets directly and CCA is therefore
taken at the venturer level
- there are tax-free roll-out provisions if a partnership breaks up and each partner takes
his/her/its % of each partnership asset - there is no such rollout if a joint venture breaks
up.
- there is no specified partnership restriction on the amount eligible for the small business
deduction for a joint venture
2.7
Special rules for corporate partners (SBD)
A corporate partner's entitlement to the small business deduction on partnership active
business income is determined by its specified partnership income under subparagraph
125(1)(a)(ii) and 125(7). Specified partnership income = partner's % of the < of (1)
partnership’s Canadian ABI or (2) $500,000
Rationale: The result is the same whether a group of people
1. become shareholders in one company carrying on the active business or
2. each person has a 100% owned corporation and all the corporations form a partnership
which carries on the business.
In both cases, the maximum small business deduction available will be $500,000 (in
aggregate)
Corporate Partners s. 34.2
Many corporate partners will no longer be able to defer income earned through a partnership.
If: 1) a corporation is a partner at the end of its taxation year; 2) the partnership’s year-end
differs from the corporation’s year-end; and 3) the corporation (together with any affiliated and
related parties) is entitled to more than 10% of the partnership’s income, then:
For taxation years ending after March 22, 2011, corporate partners (meeting 1 to 3 above) will
need to accrue “stub period” income in addition to the actual partnership income for the year.
Any accrued stub period income included in a particular taxation year can be deducted in the
following taxation year.
Stub period income is calculated as follows:
Corporate partner’s share of income
for the fiscal period of the partnership
(other than dividends)
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# days in the stub period / # days in the
partnership’s fiscal period
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As a transitional measure, income from the first stub period can be brought into income over the
5 taxation years that follow that first year. Hence if a corporation has a December 31, 2011 yearend, they would need to include any stub period income for 2011 starting in 2012 and continuing
until 2016 as follows: 2012 (15% included); 2013 (20% included); 2014 (20% included); 2015
(20% included); and 2016 (25% included).
Stub period income cannot be negative.
Partnerships that meet certain criteria can elect to take advantage of a one-time only election to
change their year-end (so that it coincides with the corporate partner’s year-end).
2.8
TEST YOURSELF (Corporation vs. partnership)
Your client has asked you to provide her with the reasons why corporations are the major
form of business organization and why partnerships are sometimes used. Use a schedule
to compare and contrast partnerships and corporations. Consider some of the following
criteria: Raising Equity Capital, Liability, Flow through of losses, Taxation of Profits,
Taxation of Withdrawals, Methods of Tax Deferral, Methods of Income Splitting with
Family Members, Retirement Planning, Windup, Other. [Comparing, contrasting and
classifying info. using schedules like this helps you learn and understand the advantages
and disadvantages of different business structures]
3. GENERAL ANTI-AVOIDANCE RULE (GAAR) s. 245(2)
GAAR is designed to apply to transactions that specific anti-avoidance rules to not apply
to. GAAR applies to deny the tax benefit of a transaction if the primary purpose of the
transaction is tax avoidance and it results in an “abuse” of the provisions of the Act (or
other related enactments).
GAAR was introduced after the Government lost in the Stubart case in 1984 because
there was no purpose test in the Act. The cases it applies to are usually complicated –
many involve offshore transactions.
GAAR became effective September 1988 (date of Royal Assent)
Since 1993, GAAR has been administered by a central GAAR committee in Ottawa
because the cases are so complicated. Quarterly statistics are published as to the number
of cases referred to the committee and their disposition.
The 2004 Federal Budget amended GAAR retroactively to
(a) apply also to tax treaties, regulations and other related enactments
(b) to change the wording of S. 245(4) to simplify the wording [to eliminate a double
negative in the purpose test and a previous reference to misuse (as well as abuse) of the
Act].
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Your Act contains a list of GAAR cases complete to the time of publication and the types
of issues that have been tested in the Courts. Taxpayers have won most of the GAAR
cases in the courts: only a handful of cases have been won by the government. There
have been only a few Supreme Court cases.
For a discussion of the difference between tax planning (which is legal) and tax evasion
(which is not legal) see CPA Canada’s White Paper “Corporate tax evasion, avoidance
and competition” available at:
https://www.cpacanada.ca/connecting-and-news/news/professional-news/2014/02/cpacanada-white-paper-clarifies-tax-evation-and-avoidance-issues-feb-2014
As a professional you are bound by the rules of professional conduct and you cannot
be associated with false or misleading information.
INFORMATION CIRCULAR IC-88-2 CONTAINS EXAMPLES OF CRA'S
POSITION ON GAAR
The CRA’s position on GAAR is set out in Information Circular IC 88-2 & its
supplement. Additional examples can be found in articles, the proceedings of Canadian
Tax Foundation conferences and in CRA technical interpretations & internal memoranda
(obtained under Access to Information Act & published by various electronic tax
services, e.g. CCH, Carswell, CICA, PWC).
Here are some examples of planning techniques discussed in this course which the CRA
discusses in IC 88-2:
GAAR does not apply because there is no abuse of the Act to:
1. Most estate freezes (par. 10)
2. Incorporation of a proprietorship, i.e., using subsection 85(1) (par. 11)
3. Sale or gift of shares to a non-arm's length person (e.g., a child) to create a capital gain eligible
for the capital gains exemption (par. 3 of supplement)
4. A reasonable salary or bonus paid to reduce corporate taxable income to the amount eligible
for the small business deduction, i.e., $500,000 (par. 18)
GAAR applies because there is an abuse of the Act to:
1. An amalgamation done in order to change a company’s year-end (par. 21). If you amalgamate
(merge) corporations the two predecessor companies have a deemed year end immediately
before the merger (s. 87). The CRA believes the use of an amalgamation to change a year end is
a misuse or abuse of the Act because this is not the purpose of s. 87. Most practitioners agree.
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2. If a partner transfers property using a s. 97(2) rollover and ends up with a partnership interest
with an ACB lower than its FMV and the partner subsequent withdraws more than the ACB, the
rollover will be ignored (par. 12). The CRA believes the use of s. 97(2) to accommodate a de
facto sale is a misuse or abuse of the Act because this is not the purpose of s. 97(2). Most
practitioners agree.
EXHIBIT 13-12 of FIT IS A GOOD SUMMARY OF THE RULES IN S. 245(1) TO (4)
THE FOUR TESTS of GAAR
GAAR APPLIES IF THE
FOUR ANSWERS ARE
1. OTHER PROVISION:
DOES ANY OTHER PROVISION OF THE ACT APPLY to stop the
tax benefit (or to stop the transaction)?
* Note: In a Supreme Court of Canada (SCC) case [Lipson et al. v.
the Queen 2009], the court found that GAAR can be used even if
another provision of the Act can apply to stop the tax benefit.
However, if another provision of the Act can apply to stop the tax
benefit then, generally speaking, the tax plan is probably not very
good
2. TAX BENEFIT: S. 245(1):
NO (see *)
DOES THE TRANSACTION (OR SERIES) RESULT IN A
TAX BENEFIT?
A tax benefit is a reduction in tax. Deferring tax is also a tax benefit.
This determination is usually clear.
YES
3. AVOIDANCE TRANSACTION: S. 245(3):
IS THE TRANSACTION (OR SERIES of transactions) AN
AVOIDANCE TRANSACTION?
An avoidance transaction is one that has a primarily tax purpose
(examples of a non-tax purpose are business or family reasons). This
determination is usually clear, although sometimes it is difficult. The
government occasionally loses some GAAR cases on this point (e.g. in
Canadian Pacific, the primary purpose of the borrowing was considered
to be for business purposes although it had some tax advantages)
4. MISUSE OR ABUSE OF THE ACT RULE:S. 245(4)
CAN IT REASONABLY BE CONSIDERED THAT THE
TRANSACTION (or series of transactions) RESULTS IN A
MISUSE OR ABUSE OF THE PROVISIONS OF THE ACT
READ AS A WHOLE?
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YES
YES (see **)
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This is the most difficult test because it is often difficult to determine the
policy or purpose of the Act. The policy must be clear and unambiguous.
Extrinsic aids (e.g. Dept. of Finance technical notes accompanying draft
legislation) may be used by the court in making this determination. The
government loses most GAAR cases on this point.
**Note: In a Supreme Court of Canada (SCC) case [Lipson et al. v.
the Queen 2009], the court stated that when determining if the
transaction(s) result(s) in a misuse or abuse of the Act you look at the
provisions of the Act that were applicable to the transaction(s) that
gave rise to the tax benefit and not to the overall purpose of the entire
Act
3.01 Information Reporting of Tax Avoidance Transactions
The 2010 federal budget introduced a new information reporting change applicable in
2011 and thereafter. Both taxpayers and their advisors are required to report to the CRA
by filing form RC312 Reportable Transaction Information Return. This reporting is
required for tax avoidance transactions (defined above) that meet at least 2 of 3
conditions/“hallmarks” (see below).
Significant penalties will apply if the required information reporting is not filed on time.
Also any tax benefit, obtained from the avoidance transaction, is denied until this
information reporting form is filed.
While both the taxpayer and the advisor must report these “reportable transactions”, as
long as one party files the properly completed report on time no penalties will be owing
(by either party). This information report is due on June 30th of the year following the
calendar year when the reportable transaction occurred.
Conditions (“hallmarks”)
1) the tax advisor is being paid based, at least in part, on the tax benefit/contingent
consideration;
2) the tax advisor requires that the transaction(s) remain confidential; and
3) the taxpayer or the advisor obtains “contractual protection”. Contractual protection
exists if: (a) there is any insurance (other than professional liability insurance) or other
protection that will apply if the tax plan does not work; or (b) the advisor agrees to
provide additional assistance to the taxpayer if there is a dispute with the tax authorities
(relating to the tax plan).
Note: these conditions/ “hallmarks” are quite common with many complex tax planning
engagements. However, filing this information reporting form does not in any way mean
that GAAR will apply.
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3.02 Tax Written Communications
Important communications between the tax advisor and the client should typically be put
in writing. Such communications may be in the form of an email, a memo or a letter
depending upon the circumstances. Written communications are a better record of tax
advice given and such communications can be relied upon months or years in the future
when memories may have faded. The starting point for a written communication is often
a summary of the relevant facts and assumptions upon which the tax advice flows from.
This allows the client to review the facts and assumptions and let the tax advisor know if
any facts or assumptions are incorrect. The written communication must be carefully
written to be understandable to the client and technically accurate. Appropriate
references should be used so that you can easily find the reference sources used to
support your opinions/conclusions. Also it is important that the written communication
be carefully worded to explain the tax consequences of a tax plan in an accurate way but
not in a way that implies the tax plan is an avoidance transaction (see point #3 re: “the
Four Tests of GAAR” above)
3.1
Example re: GAAR
Stock dividend/capital loss
The following situation was heard by the Tax Court of Canada:
Scenario
Mr. X sells some capital property and has a $50 million capital gain. He receives 100% of his
proceeds in cash. He goes to his tax advisor to find out how he can reduce or defer his tax on
this capital gain. His tax advisor suggests the following
Plan
1. Mr. X uses the $50 million received to subscribe for common shares of Newco
2. Newco declares a stock dividend on the common shares. The stock dividend is preference
shares which have a redemption and retraction amount of $50 million and a PUC of $100.
(a) The “amount” of the stock dividend for tax purposes is $100 because it is based on the PUC:
s. 248(1).
(b) The ACB of the preference shares is the “amount” of the stock dividend (i.e., $100)
(c) The FMV of the preference shares is $50 million because of the redemption and retraction
price. Now that the entire value of Newco (which holds $50 million of cash) is attributable to the
preferred shares (which have a redemption and retraction amount of $50 million), the common
shares are only worth a nominal amount (let’s say $1).
3. Mr. X sells the common shares to a family trust for their nominal FMV and has a $50 million
capital loss ($1 Proceeds minus $50 million ACB) to offset his $50 million capital gain.
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Tax consequence (ignoring GAAR)
- Dividend of $100 (grossed up and eligible for a dividend tax credit)
- No tax to Mr. X on $25 million TCG because of $25 million ACL
- Deferred CG or dividend of $50 million on preferred shares which have an ACB and PUC of
$100 and a FMV of $50 million. (CG, if shares are sold; deemed dividend if shares are
redeemed.)
Why do you think that the CRA believes that GAAR will apply in this situation? What is the tax
benefit? Is it an avoidance transaction? Is there an abuse of the Act?
4. MAJOR CAUSES OF LIABILITY INSURANCE CLAIMS
(From "Defensive Tax Practice", a paper presented by Brian Wilson at 1997 Canadian
Tax Foundation Annual Conference)
- when a tax accountant or lawyer makes a mistake, he or she can be sued
- all partners of CA and law firms in public practice in Ontario have liability insurance
- claims are usually settled out of court
What things go wrong in practice? Here are some examples of balance sheet
information which is relied upon (and never checked by the accountant) and ends
up being wrong:
(a) shares were never issued, authorized or paid for
(b) dividends are never legally declared
(c) real estate was never owned (revenue and expense recorded in the wrong entity)
(d) investment account on balance sheet is really a shareholder loan account and there is a
s. 15(2) problem
MAJOR CAUSES OF LIABILITY INSURANCE CLAIMS
1. DIVIDENDS & S. 15
Dividends are not legally declared and paid….resulting in s. 15 problems.
2. S. 85(1)
(a) election forms not filed on time because the accountant forgets or thinks the lawyer is
doing it
(b) excess boot because assumed debt ignored
(c) $1 not elected for goodwill
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3. S. 55(2)
(a) the concept of safe income is forgotten about or safe income is miscalculated
(b) no designation under s. 55(5)(f) to mitigate problems (because too late- although the
judge in the Nassau Walnut case allowed a late exemption)
4. CAPITAL DIVIDENDS
Excessive capital dividend elections (because capital gains reassessed as income) and
don't elect to treat as a taxable dividend to avoid penalty tax (procrastinate, too late, etc.)
5. S. 84.1
S. 84.1 situation not identified as such and too much boot taken, PUC grind not
identified, etc. This potential cause of insurance claims was also highlighted in the
December 2011 Practice Advisory issued by the Institute of Chartered Accountants of
Ontario (ICAO)
It is clear that some of the ITA sections that cause students difficulty also cause tax
practitioners difficulty.
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