Moodys LLP Tax Advisors

Some Short Answers / Rebuttals To Common Tax Myths

admin@moodystax.com (Kim G C Moody CA, TEP) — Wed, 08 Feb 2012 22:49:01 +0000

The study and practice of tax is tough. I have said it before and I'll say it again, I believe that tax is one of the most difficult areas of practice in existence.

In my many years of being a tax specialist, there have been no shortages of "tax myths" that I have run across and dealt with in practice. Here are my answers / rebuttals to some of the more popular ones:

Yes, the imposition of income tax in Canada IS legal in Canada and anyone who states otherwise is leading you down the wrong path.
No, the Canada Revenue Agency (the "CRA") has not accepted your filing positions simply because you received a notice of assessment. The CRA generally has three years, with many exceptions that can extend this time, from the date of the notice of assessment to review and make changes to your return. We talk generally about this topic in one of our recent blogs Filing On The Basis Of Proposed Tax Legislation.
No, the CRA does not "allow" say $10,000 of salaries to be paid to minor family members. The law provides that only reasonable salaries in the circumstances with a business purpose are deductible to the business.
No, you can't avoid tax on death by simply gifting property to the next generation. There are taxes that can arise, such as capital gains taxes, by virtue of such property being deemed to have disposed of at fair market value. If you're a US citizen, then US gift tax might apply.
So, someone is saying that if you buy a charitable tax shelter that you will be able to save more in taxes than the actual cost of the "investment" that will be "donated"? Dream on.....if it's too good to be true it likely is. The CRA has been successfully attacking charitable tax shelters for years. The CRA has written on this often.
So you're buying a vacation property and someone has told you that you can save a lot of tax by purchasing it through a corporation? Get some advice on this.....such a "plan" is usually ripe for disaster. Read what we've written on this.
So you're a US citizen resident in Canada and you're not compliant with your US tax filings? "How will they find me?" or "The US has bigger fish to fry than me!" are your mantras? Well, your mantras are about to become very challenged. The US is aggressively trying to find you and there's a good chance they will....especially when FATCA comes into force. The US recently released the FATCA proposed regulations and you can read what we have written about here.
So someone has told you that you don't pay Canadian tax on investment earnings on offshore bank accounts? Wrong...dead wrong. As a Canadian resident, you must pay income tax on your world-wide income. You may also have reporting obligations on your foreign assets as discussed below.
So you think the disclosure of foreign assets does not include US securities like Microsoft, Apple, Cisco, etc.....right? Wrong. It does. The definition of "specified foreign property" in subsection 233.3(1) of the Income Tax Act (the “Act”) (which is the section that requires foreign property disclosure by virtue of the requirement to file prescribed form T1135) specifically includes a share of the capital stock of a non-resident corporation. We have previously written about this.
So you've lived in a house that you just constructed or otherwise acquired for just one day since someone has told you that if you live it in for a day that it will be considered your principal residence and thus any gain realized on a sale will be tax free.....right? If it was only that simple. The definition of "principal residence" in section 54 of the Act is very lengthy and requires very detailed conditions to be met. One of the requirements is that the housing unit must have been "ordinarily inhabited" in the year by the taxpayer, the taxpayer's spouse or common law partner or by a child of the taxpayer. Will one day occupancy meet the test of being "ordinarily inhabited"? Each situation will need to be reviewed for the facts and circumstances but it would be highly unlikely that one day occupancy would meet the test of being ordinarily inhabited.

The CRA is also aware of tax myths and has recently published a good Tax Alert . The US Internal Revenue Service also has a tax myth publication.

The bottom line is this.....tax is tough. Be very wary of accepting tax advice from someone who does not practice in the area.

A Mild RRSP Season – Except for the Advantage Rules

admin@moodystax.com (Robert R. Worthington LL.B.) — Fri, 03 Feb 2012 21:09:17 +0000

RRSPs are an extremely popular investment vehicle for Canadians. With the mild weather, it may be easy to forget it is February and the RRSP deadline is February 29th. (The deadline is usually March 1, but with 2012 being a leap year it will be the last day of February.) This RRSP season, taxpayers and their advisors should be aware of a change in the RRSP rules enacted as a result of the 2011 Federal Budget. These new "advantage rules" target tax avoidance schemes and other structures that most taxpayers would not be involved in, but these rules also set a trap for the unwary. If the advantage rules apply, the Canada Revenue Agency ("CRA") may impose a penalty tax of 100%. In general terms, this 100% tax is on the amount of the "advantage", which may be the entire value of the investment.

The advantage rules are complex and their intended policy may be subject to debate. But in very broad strokes, these rules target schemes including economic benefits resulting from trading RRSP room between taxpayers, transactions that artificially inflate RRSP room, conversion of taxable employment income or business income into tax-sheltered RRSP investments, and a variety of other tax-avoidance concoctions yet to be conceived that take advantage of the RRSP rules in an inappropriate manner.

As mentioned, the advantage rules are unlikely to effect the transactions or investments of most taxpayers. However, the pitfall lies in "swap transactions", which are probably completed by a number of taxpayers fairly regularly.

It is well known that a withdrawal from an RRSP is generally included in a taxpayer's income, subject to certain exceptions.^[1] In certain cases, a deduction is available where an amount is withdrawn from an RRSP, but these exceptions are narrow. These exceptions are where a taxpayer recontributes or transfers an amount to a pension plan,^[2] a retirement compensation plan,^[3] or a retiring allowance.^[4] There is also an exception involving the death of an RRSP annuitant.^[5] That said, many advisors had believed it to be permissible to "swap" investments to or from an RRSP. For example, before the enactment of the advantage rules, taxpayers might withdraw cash from their RRSP but contribute other investments to the RRSP, and provided that the investments contributed were of at least the same value as the amount withdrawn, it was believed that the withdrawal would not be a taxable amount. Prior to the advantage rules, we understand the CRA generally took no issue with this practice.

The advantage rules, however, impose the penalty tax on a "swap transaction", which is defined as follows:

"swap transaction", in respect of a registered plan, means a transfer of property between the registered plan and its controlling individual or a person with whom the controlling individual does not deal at arm's length, but does not include

(a) a payment out of or under the registered plan in satisfaction of all or part of the controlling individual's interest in the registered plan;

(b) a payment into the registered plan that is a contribution, a premium, or an amount transferred in accordance with paragraph 146.3(2)(f);

(c) a transfer of a prohibited investment or a non-qualified investment from the registered plan, in circumstances where the controlling individual is entitled to a refund under subsection 207.04(4) on the transfer; or

(d) a transfer of property from one registered plan of a controlling individual to another registered plan of the controlling individual if

(i) both registered plans are RRIFs or RRSPs, or

(ii) both registered plans are TFSAs.

These broad provisions contemplate a variety of transfers in and out registered plans as well as transfers between "registered plans" (which is defined to include RRSPs, RRIFs, and TFSAs).[6] Indeed, the seemingly innocuous practice of replacing cash inside an RRSP with other investments of the same value held outside an RRSP, or vice versa, seems to be caught.

The CRA has confirmed this is the case in a recent technical interpretation.[7] The CRA noted that fair market value transactions are not excluded from the "swap transaction" definition. There are limited exceptions to the "swap transaction" definition set out in paragraphs (a) through (d) reproduced above. Otherwise, in the CRA's view, the advantage rules effectively create a wholesale prohibition on swap transactions.

As a result, taxpayers and investment advisors should avoid moving assets in and out of RRSPs unless they are prepared to suffer an income inclusion, as they would under most RRSP withdrawals – or, even more unfavourably, pay the 100% penalty tax.

[1] An "excluded withdrawal", defined in subsection 146.01(1) of the Income Tax Act is not taxable. As well, there are very limited exceptions set out in the case law where RRSP withdrawals are not taxable.

[2] Paragraph 60(j).

[3] Paragraph 60(j.1).

[4] Ibid. "Retirement compensation plan" and "retiring allowance" are defined in subsection 248(1).

[5] Subsection 60(l).

[6] It should be noted that the advantage rules apply to RRIFs and TFSAs as well as to RRSPs.

[7] CRA document no. 2011-0429561M4.

Filing On The Basis Of Proposed Tax Legislation

admin@moodystax.com (Kim G C Moody CA, TEP) — Wed, 01 Feb 2012 16:40:05 +0000

This is not a new topic. However, it is one that we deal with time and time again....especially in recent years.

Tax policy and the implementation of tax legislation in Canada is under the purview of The Department of Finance. Much of Canada's new tax legislation arises from the annual Federal Budget. However, there are also technical amendments released in draft form (often for public comment) throughout the year. Such draft or proposed legislation may be further amended to correct for errors, provide clarification and address public submissions before it is finally released into a Bill. The Bill is then put before Canada's House of Commons and the Senate for debate and eventually receives Royal Assent and becomes law (unless for some reason the Bill fails to pass). The proposed legislation will often contain detailed “coming into force” provisions that establish the date from which a specific proposed provision will have legal application. Often, but not always, the application of the proposed legislation will be effective from a date earlier (i.e. retroactive effect) than the date that the provision is actually passed into law. The process to convert draft legislation to law can often take a long time.

The Department of Finance may also release “comfort letters” in response to parties' concerns with the technical accuracy of certain existing provisions of the Income Tax Act (the “Act”). Such comfort letters often state that The Department of Finance is prepared to correct the perceived problem and further undertake to recommend to the Minister of Finance to release proposals that will achieve such objective. However, the comfort letters are appropriately hedged and state that there is no guarantee that such proposed amendments will become law.

In recent years, there has been a tremendous amount of draft legislation and comfort letters that have been released and have not yet been proclaimed as law. The Office of the Auditor General of Canada pointed out this problem in its 2009 Fall Report.

Two obvious examples of proposed legislation not yet being passed into law come to mind. The first is the non-resident trust and foreign investment entity proposals. These proposals were first introduced in the 1999 Federal Budget and the resulting draft legislation has been revised at least six times over the last 13 years and still remains “proposed” (i.e. not law). The most recent revision resulted in the virtual scrapping of the foreign investment entity proposals but retained the non-resident trust proposals. If passed, much of the effect of these proposals will have retroactive effect to 2007 (with the date of the proposed application being changed many times over the years). The second are the restrictive covenant proposals that were first announced by the Department of Finance on October 7, 2003. Such proposals are extremely complex and we have written extensively on this subject. The restrictive covenant proposals have been amended many times with the most recent being July 2010. Such proposals also have not been passed into law but if passed will generally have retroactive effect to October 7, 2003 (with some exceptions to this general date).

Canada's tax system provides, under section 152, that an individual's tax return for a particular taxation year is generally "statute-barred" from a reassessment on the 3rd anniversary date of the date that the particular taxation year was assessed. For example, if Mr. Apple's 2006 personal tax return was filed in April 2007 and was assessed by the Canada Revenue Agency ("CRA") say May 15, 2007, then Mr. Apple's 2006 tax return would be prevented from any amendment (either by the CRA or by Mr. Apple) on May 15, 2010.

There are some exceptions to the general rule. For example, if Mr. Apple or the person filing the return made any misrepresentation on the 2006 tax return that was attributable to neglect, carelessness, willful default or committed a fraud then the CRA may reassess beyond the May 15, 2010 date (see subsection 152(4) of the Act). Also, there are some circumstances where Mr. Apple may want to file a waiver, also provided for under subsection 152(4), to the CRA that keeps all or parts of the 2006 return open for reassessment. Mr. Apple may also be able to rely on the “taxpayer relief provisions” of subsection 152(4.2) to extend the statute-barred date if he makes an application no later than the day that is 10 calendar years after the end of the particular taxation year in question if he was entitled to a refund or a reduction of taxes payable for that particular year. Corporations or inter vivos trusts are not entitled to benefit from the “taxpayer relief provisions” unlike Mr. Apple as earlier described. Corporations, other than Canadian-controlled private corporations, have similar rules regarding statute-barred dates but generally the date is four years from the date of notice of assessment.

Accordingly, what is a taxpayer to do when they are dealing with a tax matter that might be the subject of proposed legislation? For example, if a taxpayer granted a restrictive covenant in 2011, should he file his tax return on the basis of existing law or under the basis of the proposed legislation (which will generally be very complicated to deal with and may not have favorable tax results in comparison to existing law)? Good question and quite a quandary. When analyzing the issue, one should consider statute barred issues as discussed above and also whether the proposed legislation contains specific provisions that might override the normal rules of subsection 152(4) if a person wanted to ignore the proposed legislation and file on the basis of existing law.

The CRA has a long standing policy that encourages taxpayers to file their tax returns on the basis of proposed legislation. In CRA Income Tax Technical News No. 44, the CRA had the following to say on the topic:

It is the CRA’s longstanding practice to ask taxpayers to file on the basis of proposed legislation. This practice eases both the compliance burden on taxpayers and the administrative burden on the CRA. However, where proposed legislation results in an increase in benefits (for example, Canada child tax benefit) to the taxpayer, or if a significant rebate or refund is at stake, the CRA’s past practice has generally been to wait until the measure has been enacted.

A comfort letter is not considered proposed legislation and usually only reflects the Department of Finance’s views on a particular issue affecting a specific taxpayer. Given that our tax system is on the basis of self-assessment, taxpayers may decide to file on the basis of a comfort letter. Generally, the CRA will not reassess taxpayers who filed on the basis of a comfort letter, provided that they did so in conformity with the comfort letter.

Generally speaking, the CRA will not reassess if the initial assessment was correct in law. As a result, a taxpayer’s request to amend their tax records to reflect proposed legislation will be denied. It is recommended that taxpayers file a waiver in respect of the normal reassessment period to protect their interests.

In the event that the government announces that it will not proceed with a particular amendment, any taxpayers who have filed on the basis of the proposed amendment are expected to take immediate steps to put their affairs in order and, if applicable, pay any taxes owing. Where taxpayers acted reasonably in the circumstances, took immediate steps to put their affairs in order, and paid any taxes owing, the CRA will waive penalties and/or interest as appropriate.

In my opinion, the CRA's guidance usually, but not always, makes sense. From a practical perspective it is also sound. However, everyone's facts are different and, of course, one would need to carefully consider what is appropriate in their circumstances. People should heed professional tax advice on this difficult area of tax law.

The Top 5 Tax Mistakes Made By Private Client Canadian Practitioners

admin@moodystax.com (Kim G C Moody CA, TEP) — Fri, 13 Jan 2012 21:26:59 +0000

Firstly, this is my list not yours. It is very subjective and is a reflection of my many years of experience of being a tax specialist and building a “tax only” advisory practice. Most of the practitioners that are clients and friends of our firm know their tax limitations. However, there are other practitioners whose work we often trip across that do not know their limitations. The simple fact is that tax is tough. I would venture to say that it is one of the most challenging professions in existence. Unfortunately, there is no tax specialist designation in Canada to help the public identify professionals who have credible knowledge and experience in tax. I'm hopeful that will change soon.

With the above in mind, here are the top five mistakes we often see.

1. Taxable Benefit Issues Not Considered

The Canadian Income Tax Act (the ”Act”) is littered with benefit provisions. For example, section 6 of the Act deals with employment benefits. The section is purposefully drafted broadly to capture many types of benefits into the employee's taxable income. Section 15 is another example and applies to many types of benefits received by a shareholder of a corporation. Again, section 15 is purposefully drafted very broadly but also has specific provisions so as to capture certain types of benefits into the shareholder's taxable income. We find in many cases that an inexperienced practitioner may not have considered taxable benefit exposure when reporting on a taxpayer's situation.

For example, consider the situation of Mr. Apple who is the shareholder of a Canadian - controlled private corporation, "Opco". Mr. Apple's acquaintances, and perhaps his advisor, have told him that he should purchase his personal use vacation property through Opco since he “will save a lot of tax”. Wrong. While the specific facts would need to be reviewed in order to give proper advice, it is highly likely that Opco has conferred a taxable benefit on Mr. Apple by virtue of section 15 of the Act as a result of the purchase and personal use of the vacation property. In some cases, such a taxable benefit can lead to ultimate double taxation. I've written and lectured about this many times. Accordingly, be very aware of situations that can cause taxable benefits to arise.

2. Taxation of Prepaid Amounts

One of the fundamental accounting principles that is taught to accounting students early on in their studies is the ”matching principle”. Overly simplified, it stands for the proposition that expenditures must be matched to the derivation of the related income. For example, if Opco pays $10,000 on January 1, 2012 for an insurance policy that will expire on December 31, 2013, the matching principle will generally cause accountants to not expense the full $10,000 in Opco's 2012 fiscal year (assuming a calendar year end for Opco) but will instead amortize the cost over the period of benefit being 24 months. Accordingly, the prepaid portion of the insurance contact will be capitalized and reflected as an asset on the balance sheet of Opco.

The same logic applies for amounts received by Opco. For example, let's assume that Opco provides consulting services and charges one of its customers a lump sum amount of $24,000 on January 1, 2012 for services that it will provide over the next 24 months. Let's further assume that Opco has received the $24,000 on January 1, 2012. Using the matching principle, most accountants would record the $24,000 as a deferred liability on the balance sheet of Opco as of January 1, 2012 and amortize such amount to revenue over the next 24 months.

For Canadian tax purposes, the receipt of the $24,000 on January 1, 2012 is likely immediately taxable under paragraph 12(1)(a) of the Act irrespective of the fact that it may not have yet been earned for accounting purposes. There are certain reserves under section 20 of the Act that may be available to defer such unearned amounts until the time that it is earned but the facts and circumstances would need to be reviewed as the eligibility for the section 20 reserves are very specific and narrow.

Bottom line.....review amounts received in advance and be aware that more than likely section 12 of the Act will apply to capture such amounts into taxable income irrespective of the accounting treatment.

3. Salaries Paid to Family Members

Canada's system of personal taxation is one which taxes income at progressive tax rates. Canada's system is also one where each taxpayer must report and pay tax on their own income separately. Unlike the US, there is no ability to jointly file returns and combine income in certain cases. Accordingly, Canada's system will often cause taxpayers and their advisors to look for clever ways to income split amongst family members so as to use multiple progressive tax rates and reduce the overall family tax burden.

One strategy that is used by certain practitioners when advising their entrepreneurial clients is to pay salaries to family members so the business can claim a deduction against its business income and the recipient family member can use their lower progressive tax rates. In some cases, we see significant salaries being paid to very young children. Simple.....but does it work? This particular strategy is one of the many tax myths that exist in practice. We often hear from people that they've heard that salaries of say $7,000 to $10,000 to kids are acceptable since the Canada Revenue Agency (“CRA”) has said so. Or that their buddy has been using such a strategy for years and the CRA has never challenged it so it must be fine.

The fact is salaries paid from a business to family members must be reasonable in the circumstances in order to be deductible and to comply with section 67 of the Act. Any non-reasonable amount will not be deductible to the business but is still taxable in the recipient's hands (which results in double taxation). The facts and circumstances will dictate what is reasonable but let's be serious. As a real example, I have 4 kids ranging from the age of 6 to 15. I love them to death but would it be reasonable to pay my 12 year old $10,000 from my business for ”administrative duties” or “licking stamps” (common examples that we often hear)? Not a chance. Or at the very minimum, highly debatable and not likely.

Further, the salaries must have been incurred to earn income from the business in order to comply with section 18 of the Act. Was the payment of the $10,000 to my 12 year old incurred to earn income from my business? Debatable but not likely. Accordingly, be wary of the many tax myths in this area and be mindful of the sections 67 and 18 risks.

4. Corporate Surplus Stripping

The use of a corporation to carry on a business is a traditional and often sound strategy. As most readers know, a corporation is a separate legal person. While the corporate vehicle can offer many tax advantages, it also has its downsides or challenges for the private business. One of the most challenging issues is how does a shareholder remove after tax corporate surplus (or what accountants often refer to as retained earnings) in a tax efficient manner? The most traditional way is by way of taxable dividends which are the subject to personal taxation in the individual shareholder's hands.

However, some practitioners want to be clever and find ways to remove corporate surplus to the individual shareholders in a more tax efficient manner. One strategy that we often see involves the use of the $750,000 capital gains deduction (”CGD”) applicable to qualified small business corporation shares. Let's consider the case of Mr. Apple again who owns shares of Opco. Let's assume that the shares of Opco have a fair market value of $500,000 and that all the detailed conditions which need to apply for Mr. Apple to use his available CGD apply. Mr. Apple wants to access Opco's surplus tax free. Accordingly, Mr. Apple's advisor develops the following plan:

Mr. Apple sells his shares of Opco to a new holding company (“Holdco”) that his wife wholly owns for $500,000.
As payment for the shares, Holdco will issue a promissory note to Mr. Apple in the amount of $500,000.
Given the above sale, Mr. Apple will realize a capital gain of $500,000 (assuming that his adjusted cost base of his Opco shares was nominal) but he will offset such gains with his available CGD.
Opco then pays dividends over time (whenever it has surplus cash) to Holdco. Since the shares of Opco are wholly owned by Holdco, Holdco will be “connected” with Opco and will generally receive such dividends on a tax free basis.
Holdco will then use the cash to repay the promissory note to Mr. Apple thus resulting in him receiving such cash tax free.

Sounds pretty good right? Well, if it were only that easy. Unfortunately, the above plan simply doesn't work. Section 84.1 of the Act will cause Mr. Apple's capital gain described in step c above to be recharacterized as a taxable dividend. This will result in Mr. Apple not being able to claim the CGD and cause him to pay tax at personal dividend rates. Not good. Section 84.1 is one of the most common reasons why advisors are sued in tax matters.

Similar to section 84.1, there are other anti-surplus stripping rules within the Act. Practitioners need to be aware of such anti-avoidance rules and ensure that their plans are not caught by them.

5. US Tax Issues Not Considered

The US is one of the only countries in the world that imposes taxation on a citizenship basis. Simply put, if you are a US citizen (or if you are substantially present in the US or are a green card holder) then the US will tax you on your worldwide income (unless you renounce your citizenship which is a separate topic that can come with significant tax complications). Identifying who is a US citizen is not always an easy exercise and is very much a matter that is reserved for US immigration lawyers.

We have written often on US tax matters but for brevity, US citizens resident in Canada often have significant reporting requirements, may have unanticipated US tax liabilities and have exposure to the US transfer tax regime (including the US estate tax depending on the size of the US citizen's estate upon death).

Know your client. Are you sure they are not US persons? Are you doubly sure? Have you or your client sought US legal advice to confirm? Be careful.

IRS Promises New Procedure for Taxpayers Who Haven't Filed But Owe No Tax And Indefinitely Extends Offshore Voluntary Disclosure (OVDI) Program

admin@moodystax.com (Roy A. Berg JD, LL.M. (US Tax)) — Mon, 09 Jan 2012 23:35:20 +0000

On January 9, 2012 the IRS issued IR 2012-5, which makes two very important announcements: First, it promises new procedures to bring unfiled returns current for taxpayers who have not filed, but owe no tax. Second, it indefinitely extends the basic terms of the 2011 Offshore Voluntary Disclosure Initiative (OVDI).

Promise of New Procedure to Bring Unfiled Returns Current if No Tax is Owed

Although cryptic, this statement is the most important element of the IRS's announcement and warrants setting it forth in full:

"The IRS recognizes that its success in offshore enforcement and in disclosure programs has raised awareness related to tax filing obligations. This includes awareness by dual citizens and others who may be delinquent in filing, but owe no US tax. The IRS is currently developing procedures by which these taxpayers may come into compliance with US tax law."

There is already a process in place, it just isn't very pleasant and does contain some risk.

While Canadian politicians and the US Ambassador have made similar promises, this is the first time the IRS has made such an announcement. It remains to be seen what these procedures will entail and whether they will be different than the IRS announced in FS 2011-13 issued on December 7, 2011. It is, however, a very promising development.

Indefinite Extension of the Basic Terms of 2012 OVDI

The announcement makes clear that basic terms of the 2011 OVDI will be extended indefinitely for those who wish to avail themselves of that procedure to bring unfiled returns current. Under the OVDI taxpayers were required to file eight years of returns (including income tax returns, FBARs, and other forms), and pay a penalty in exchange for relief from criminal prosecution. The penalty ranged from 25% of the taxpayer’s foreign assets and, in some cases, was reduced to 5% of the amount held in foreign accounts.

Under the procedure announced today, the maximum penalty is increased to 27.5% of the taxpayer's foreign assets, but the reduced 5% penalty remains unchanged. However, the IRS states that the rules of the procedure could change at any time:

"For example, the IRS may increase penalties in the program for all or some taxpayers or defined classes of taxpayers - or decide to end the program entirely at any point."

While this is welcome news for those who missed the deadlines imposed by the 2011 OVDI, it fails to address the many ambiguities and uncertainties that persist in the program. In particular:

Are registered accounts (Canadian RRSPs, RIFs, RESPs and the like) to be included in the penalty calculation?
Are Canadian spousal RRSPs included in the penalty calculation?
Are we able to reduce the penalty base for gains, withdrawal penalties, and taxes?
Will we be able to make a “reasonable cause” argument for a late election to defer tax in an RRSP?

Finally, while the OVDI made clear that the taxpayer could not argue “reasonable cause” for abatement of penalties within the program, it is unclear whether this preclusion will continue under the new initiative.

Possible IRS Motivation

It is possible that the IRS's decision to make the announcement is the result of three important developments:

First, the Taxpayer Advocate Service's Directive issued on August 16, 2011. The Directive acknowledged problems in the 2009 OVDP that resulted in inequitable treatment of similar taxpayers and directed the IRS to address these problems - see Shamik Trivedi's article on the issue.
Second, the IRS likely recognized that the publicity surrounding the OVDI and OVDP will make it increasingly difficult for the taxpayer to assert that failure to file FBARS was not willful.
Third, and similarly, the IRS likely recognized that such publicity will make it difficult for the taxpayer to assert ignorance as a basis of making a reasonable cause argument.
Fourth, objections raised by the US expatriate communities in Canada and India and sympathetic foreign officials like Minister Flaherty.

Considering the foregoing, we believe the new program is very beneficial to unwitting taxpayers who, otherwise, would have no mechanism to bring returns current without the possible application of draconian penalties.

Copthorne Holdings: A Nasty Holiday Gift for Taxpayers from the Supreme Court of Canada

admin@moodystax.com (Roberto Domagas CA and Robert Worthington LL.B.) — Tue, 20 Dec 2011 19:59:51 +0000

Copthorne Holdings Ltd. v. Canada, 2011 SCC 63 (CanLII) is a recent decision from the Supreme Court of Canada regarding the general anti-avoidance rule (“GAAR”)^[1]and provides the much-anticipated interpretation and confirmation of these rules. While the “main event” was whether the transactions undertaken by the taxpayer resulted in abusive tax avoidance to which the GAAR applies, this blog focuses on the Court’s analysis of the meaning of “series of transactions”. The “series of transactions” concept was critical to the outcome of this appeal. The Court provided guidance on how past, present and future transactions are “contemplated”, thereby confirming the framework by which a “series of transactions” would be identified for the application of the GAAR.

The case facts are exceedingly complex, but for purposes of this blog can be briefly summarized as follows: A Canadian corporation (“Holdco”) sold shares of its subsidiary (“Subco”) to its non-resident parent, thereby creating a sister company relationship between Holdco and Subco. This transaction created the opportunity for a horizontal amalgamation to occur between Holdco and Subco (“Amalco”), versus what would otherwise have been accomplished by way of a vertical amalgamation. What appears to have offended the Minister is that the taxpayer ultimately ended up with the same “structure”, i.e. non-resident parent owning an amalgamated corporation, however the horizontal amalgamation allowed the taxpayer to preserve $67 million of paid-up capital (“PUC”) of the issued shares of Subco, compared to a vertical amalgamation where the PUC would have otherwise disappeared.^[2] The significance of preserving (or, in the Crown's view, “duplicating”) the $67 million of PUC is that it was later returned to the parent on a tax-free basis on a share redemption, thereby escaping the application of Canadian withholding tax. The Supreme Court of Canada affirmed the lower Courts' decision, applying the GAAR to deny the tax benefits resulting from the series of transactions, which was found to include the sale of Subco, amalgamation of Holdco and Subco, and share repurchase by Amalco.

The definition of “series of transactions”^[3] includes transactions “completed in contemplation of the series”. The contentious question answered by the Court is whether an offending transaction has to be contemplated prospectively, i.e. the offending transaction is known at the time of a particular transaction, or is it possible to contemplate the offending transaction retrospectively, i.e. whether it is sufficient to connect an offending transaction to a transaction that occurred in the past. In Copthorne, did the taxpayer have to know at the time of the share sale that they were going to undergo a future share repurchase, or is it sufficient to create “a series of transactions” where the offending transaction was executed because the prior sale was contemplated?

In its analysis, the Court noted in the CRA’s 1988 Roundtable it was said that a “series of transactions” is to be applied prospectively, not retrospectively. The Court also cited academic commentary^[4] suggesting the “series of transactions” test should be applied prospectively, and even agreed that the more common sense use of the term “contemplation” is prospective.

Nevertheless, in upholding both lower Courts’ analyses, the Court decided that contemplation of a series may include retrospective contemplation. The main rationale seemed to be a reference to the Court's earlier GAAR decision in Canada Trustco, in which the Court commented that the definition of “series of transactions” in subsection 248(10) included both prospective and retrospective contemplation. The Court was loathe to reverse its relatively recent decision in Canada Trustco. Interestingly, however, nothing in the Canada Trustco case turned on whether a series of transactions could include retrospective contemplation. Further, in its analysis, the Supreme Court stated that the text and context of subsection 248(10) leave open when the contemplation of the series must take place, i.e. the provision allows for either prospective or retrospective connection of a related transaction to a common law series.

Before the Court’s decision in Copthorne, some commentators expressed that if a retrospective contemplation is permitted, it is all too easy to find that when a later transaction is completed, earlier transactions were known and taken into account.^[5] Indeed, hindsight is 20/20. Irrespective of whether the result in Copthorne is equitable, it seems unfair to taxpayers to allow the Crown to argue with 20/20 hindsight that an earlier transaction was contemplated when the later transaction was completed, and therefore the later transaction was an avoidance transaction as being part of the same series.

The only common law saving “test” from a transaction being considered part of a “series of transactions” is that the transaction requires more than a “mere possibility” or connection with “an extreme degree of remoteness” with the other transactions. However as the Court demonstrated, these hurdles were easily met by the Minister in this case notwithstanding that two years had passed between transactions, and that the rationale for the sale transaction was because proposed changes to the foreign accrual property income rules were imminent. The Court clarified that a “strong nexus” is not required to connect transactions into a series as proposed by the Tax Court, and by the result of this case, establishing a nexus was not onerous.

The potential ramifications of this “reverse contemplation” principle extend well beyond the GAAR, because several other provisions of the Act contain a series of transactions test. One common example is in subsection 55(2). We sometimes recommend clients complete a “butterfly” reorganization to “purify” a corporation by transferring assets from an operating corporation (an “Opco”) to another corporation on a tax-deferred basis. The reasons for completing a butterfly/purification reorganization may include putting shareholders in a position to claim the $750,000 capital gains deduction in the event Opco shares are sold in the future. However, a butterfly reorganization is only tax-deferred if it is not part of a series of transactions that includes a sale of shares. As such, if clients are contemplating a specific sale, we would typically advise that a butterfly should not be completed because the sale could be part of the same series of transactions as the butterfly, and consequently, the anti-avoidance rule in subsection 55(2) would apply to trigger a taxable capital gain.

If a specific sale is not contemplated, or if the owners were not marketing Opco (and assuming a number of other conditions are satisfied) a butterfly reorganization may be completed - or so we had thought, prior to Copthorne. The problem is that now the CRA could arguably apply the “retrospective contemplation” analysis and take the position that the subsequent sale was completed in contemplation of the earlier butterfly transaction!

This result would be unfortunate, and we believe would not be consistent with the tax policy in the Act. We hope the CRA may administratively clarify that it would not apply the series of transactions test retrospectively other than in the GAAR context. In any event, taxpayers should be cautious when undertaking transactions that involve provisions of the Act that contain the “series” test, particularly where anti-avoidance rules are concerned.

[1]Section 245 of the Income Tax Act RSC 1985, c.1 (5th Supp.), as amended and proposed to be amended, and including the regulations promulgated thereunder (the “Act”). Unless otherwise stated, statutory references in this blog are to the Act. No assurance can be given that proposed amendments to the Act will be enacted in the form proposed or at all.

[2]See subsection 87(3) of the Act.

[3]See subsection 248(10) of the Act.

[4]D.G. Duff, “The Supreme Court of Canada and the General Anti-Avoidance Rule: Canada Trustco and Mathew” in David D. Duff and Harry Erlichmann, eds., “Tax Avoidance in Canada after Canada Trustco and Mathew, (Toronto: Irwin Law, 2007,1).

[5]Michael Kandev et al, “The Meaning of Series of Transactions" as Disclosed by a Unified Textual, Contextual, and Purposive Analysis” (2010) vol. no. 58, no. 2, Canadian Tax Journal 277.

IRS Says No New Relief Planned For Canadians

admin@moodystax.com (Roy A. Berg JD., LL.M. (US Tax)) — Fri, 16 Dec 2011 19:37:44 +0000

On December 15^th and 16^th I attended the International Taxation conference sponsored by the IRS and held in Washington DC. There were more than 700 people in attendance and the lunchtime speaker on the first day was Douglas Shulman, the Commissioner of the IRS. At the end of his prepared remarks he answered only three questions posed by the audience. The first question he answered was mine, which was the following:

“On December 2 the US Ambassador to Canada announced that, before the end of the year, the IRS would issue guidance on tax compliance and penalty relief for Canadian residents [Click here for my prior blog on that topic] and then on December 7 the IRS Issued Fact Sheet 2011-13, which doesn’t really address the relief the Ambassador alluded to, though it does provide some guidance. [Click here for my prior blog on the IRS announcement]. Is the Fact Sheet the guidance the Ambassador was alluding to, or should we expect further guidance from the IRS?

Mr. Shulman said that the Fact Sheet was the guidance the Ambassador was alluding to. Further, he said “there is a lot of misinformation out there, and we wanted to clarify [the current state of the law].”

Both my question and Mr. Shulman’s response were quoted in Tax Notes Today on December 16, 2011, which you can read by clicking here.

After he answered my question he introduced me to Rosemary Sereti, who is Director of International Individual Compliance for the IRS. Ms. Sereti is the chief architect and is in charge of the Offshore Voluntary Disclosure Initiative (OVDI). I spoke with Ms. Sereti at length at the conclusion of the lunch. Ms. Sereti was very generous with her time and provided the following insight:

She confirmed Mr. Shulman’s comment that the Fact Sheet was the guidance the Ambassador had alluded to.

Penalty abatement for Canadian residents participating in the OVDI is available only if the taxpayer “opts out” of the program and successfully argues that he had “reasonable cause” for failing to file the returns.

The IRS is aware of the problems caused by including registered retirement savings plans (RRSPs) in the OVDI penalty computation.

The IRS is on the lookout for taxpayers who attempt to bring their unfiled returns current by using “quiet disclosure” and those who attempt to resolve their filing obligations in this way will face harsh penalties.

What we can conclude from my interaction with Mr. Shulman and Ms. Sereti is the following:

First, it is unlikely that there will be a made-in-Canada-solution for those Canadian residents who are not current on their US filing obligations.

Second, there is the possibility of penalty abatement for participants in the OVDI provided the participant “opts out” of the program and can prove they had reasonable cause for failing to file returns.

Third, since the IRS is aware of the problems caused by including RRSPs in the OVDI penalty computation and has not issued guidance on the matter it is reasonable to conclude that, for now, the treatment of these accounts is an open issue.

Fourth, those who attempt to bring their filing obligations current by using “quiet disclosure” may find themselves in much more trouble than if they had used “voluntary disclosure.

US Citizens Resident in Canada – Common Circumstances Where US Tax May Be Payable

admin@moodystax.com (Faizal Valli CA & Brian Dennehy CPA, JD, LL.M (US TAX)) — Wed, 14 Dec 2011 00:07:17 +0000

Now that the OVDI Program is over and the IRS has released its Fact Sheet on US citizens or dual citizens residing outside of the US, this is a good time to reflect on some common circumstances when US citizens resident in Canada may have additional US tax to pay.

One of the common rebuttals that we hear from US citizens residing in Canada who are not compliant with their US tax affairs is “we haven’t filed our US tax returns because the Canadian tax liability is higher than the US tax liability and therefore there is no need to file”. In many cases, it may be true that the Canadian tax liability is higher than the US tax liability but one may never know until a thorough review of all of the facts and income sources has been completed. In addition, such individuals may also need to file other US reporting forms (even when there is no income tax payable) like Form 5471, FBAR, Form 3520/3520A, 8891, etc., but such filing requirements are beyond the scope of this blog. Some common circumstances where US tax may be payable are as follows:

1. Deferral of Income Accruing in an RRSP

The RRSP rules in Canada are conceptually straight forward...a Canadian resident individual obtains a deduction when computing taxable income for contributions to a RRSP (subject to certain limits) and any earnings accumulated inside the RRSP are automatically tax deferred. Canada does not require a taxpayer to file additional forms or schedules to obtain a deferral of income accruing in an RRSP.

However, a US citizen must properly and timely file a Form 8891 to obtain such a deferral from his/her US taxable income. Otherwise, RRSP income is included in the US citizen’s taxable income for the current year. In addition, a Form 8833 must be filed to claim the benefits of the Canada-US Tax Treaty to deduct the current year RRSP contribution from the calculation of US taxable income. If a return was not filed or if it was filed late, the taxpayer must follow certain procedures to defer the income generated by the account. Simply filing the forms is not sufficient. If these procedures are not followed the taxpayer will likely owe US tax.

2. Capital Dividends Received By a US Citizen

Capital dividends, overly simplified, are tax free dividends paid from Canadian private corporations to the extent that the corporation has a “capital dividend account”. Very generally, the capital dividend account of a Canadian private corporation is a surplus account that accumulates tax free amounts (such as the tax free portion of a realized capital gain or life insurance proceeds) that can ultimately be paid out to the shareholders of the corporation tax free.

The US does not recognize the concept of a “capital dividend.” Corporate distributions to its shareholders are subject to ordering rules which prescribe the characterization of such income. A “dividend” is generally defined to mean any distribution of property made by a corporation to its shareholders out of its earnings and profits.^{^[1]} If a corporation does not have earnings and profits, a corporate distribution to its shareholders is treated as (1) a return of capital and (2) capital gain to the extent the distribution exceeds earnings and profits and the shareholder’s basis. Accordingly, capital dividends are usually fully taxable as dividends for US purposes.

3. Canadian “Estate Freeze” Transactions

A common strategy used by shareholders of Canadian private corporations is to “freeze” their interest in the corporation and transfer the future growth to some other party. To accomplish an estate freeze one must usually exchange their existing shares for new shares on a tax-deferred basis in Canada.

An in depth discussion of the complexities of an estate freeze that involves a US person is well beyond the scope of this blog. Simply stated, an estate freeze may result in both US gift and income tax consequences from the transfer and issuance of shares. Additional complexities and potentially harsh tax results may flow by the use of a Canadian trust in the freeze.

4. Stock Options

Canada generally has a preferential system to deal with the taxation of stock option benefits. In many cases, the resulting benefit is only half taxable pursuant to section 7 and paragraph 110(1)(d) of the Income Tax Act. In some cases, there may be (or may have been) opportunities available to defer recognition of the resulting stock option benefit to the year of disposition of the stock.

For US citizens, stock options may trigger taxable compensation as well as a gain on the sale of the acquired shares. Depending on whether the options are publicly traded and other factors, the US will determine compensation as arising on either the date of grant, vest, or exercise. Subsequent tax will arise on the date of sale. Both the timing and characterization of income may result in a disparity in the foreign tax credits available to offset the US income inclusion.

5. Use of the $750,000 Capital Gains Deduction

Astute readers of our blogs will know that Canadian residents who hold shares of a qualified small business corporation may be able to benefit (to the extent that very detailed tests are met) from the $750,000 capital gains deduction upon the disposition of such shares.

Generally, gain from the sale of stock is treated as capital gain in the US. The US does not recognize the capital gains deduction claimed by a Canadian resident US citizen. Accordingly, any such gain would be fully taxable in the US in the year of sale. The capital gains deduction claim and reduced tax in Canada may result in insufficient Canadian tax available to offset US tax payable.

6. Flow-through Share Deductions

A common tax deduction for high income earning Canadian residents is flow-through share deductions. Overly simplified, a flow-through share deduction is available as a result of an investment in an oil and gas corporation (or partnership) which will renounce their ability to claim deductions on Canadian Exploration Expenses or Canadian Development Expenses in favour of the investor. This can often times reduce Canadian income tax (subject to possible alternative minimum tax).

From a US tax perspective, deductions and credits available to a corporation cannot be shifted to its shareholders. These deductions/credits comprise a portion of the tax attributes of the corporation. If flow-through share deductions are used by a US citizen to offset his/her Canadian taxable income, he/she may lack sufficient Canadian tax payable to offset US tax payable.

7. Principal Residence Exemption

As many people know, Canadian residents are generally exempt from capital gains taxation on realized gains from their “principal residence”. The discussion of a principal residence is beyond the scope of this blog but generally includes a property where a person ordinarily and habitually lives.

The US allows an individual to exclude up to US$250,000 from the sale or exchange of his/her principal residence from gross income.^{^[2]} To qualify for the exemption, the property for which such exclusion is being claimed must have been used by the person 2 of the previous 5 years. In order to calculate the gain, a US citizen must convert the purchase and sale price into US dollars using the exchange rate in effect on the respective dates. With the rise in the value of the loonie against the US dollar, a US citizen selling his home in Canada may experience an unexpectedly large US taxable gain.

8. Charitable Donations

Canada has a preferential tax system for donations of “listed securities” directly to charity. To the extent that certain conditions are met, the capital gains inclusion rate on a direct donation of listed securities to charity will be zero thereby avoiding any capital gains tax that would otherwise apply. In addition, when calculating allowable charitable donations as a tax credit, Canada limits the amount of charitable donations (that are subject to the credit) in the taxation year to 75% of the taxpayer’s net income plus 25% of taxable capital gains realized on the disposition of property donated to charity and other amounts beyond the scope of this blog. Also, Canada and it provinces provide a generous tax credit equal to the highest marginal tax rate for donations over $200, which can further reduce Canadian tax paid for large donation amounts claimed.

The calculation of the tax benefit for charitable donations generally yields more favourable results in Canada than the US. In general, the deduction for charitable donations is limited to 20%, 30%, or 50% of a taxpayer’s gross income depending on the property contributed and the classification of the charity.^[3] A US tax filer must report charitable donations as an itemized deduction^[4] on Schedule A of the Form 1040. Itemized deductions are restricted in two important ways (1) they are subject to a reduction for high income earning taxpayers and (2) if claimed, must be used in lieu of the standard deduction to which the taxpayer is otherwise entitled. In 2011, the standard deduction available to a US taxpayer is $5,700. In other words, a taxpayer only realizes benefits from itemized deductions to the extent he/she can claim an amount in excess of $5,700. Thus in certain circumstances, a US taxpayer may receive little or no tax benefit for charitable contributions.

9. Pension Income Splitting

In 2007, the Canadian Government introduced pension income splitting legislation which enables optional pension income splitting with a spouse. In some cases, this can result in significant tax savings amongst spouses.

However, pension income earned by a US citizen is attributable and taxable to the person who earned it for US purposes. Although US citizens filing a joint return may realize a similar result, splitting pension income is simply not allowed in the US. As a result, the entire amount of pension income will be recognized by the recipient with only a portion of the tax that would otherwise have been creditable to offset the US taxable income to the extent that Canadian pension splitting is utilized.

10. Allowable Business Investment Losses (ABILs)

ABILs are a special type of capital loss that, if certain conditions are met, will result in the allowable loss (which is one half of the realized loss) to be utilized to reduce all other sources of Canadian taxable income. This can be beneficial given that capital losses are only deductible against capital gains.

Unfortunately, ABILs do not have similar treatment in the US. In general, a loss from the sale of stock is treated as a capital loss. A US citizen may utilize up to $1,500 a year in capital losses to offset other types of income. However, any remaining capital loss can only be used to offset capital gains or be carried forward to another tax year.

11. Medical Expenses

Canada has a comprehensive medical expense tax credit regime whereby only certain medical expenses are creditable.

When calculating US taxable income, medical expenses are deductible as an itemized deduction (as described above in discussing the deduction available for charitable donations). However, the ability to use such expenses to offset US taxable income is even more limited. Medical expenses are only available as an itemized deduction to the extent they exceed 7.5% of an individual’s adjusted gross income. Again, many US citizens may receive little or no tax benefit from incurring medical expenses.

12. Canadian Lottery/Gambling Winnings

In Canada, lottery/gambling winnings are generally tax free.

In the hands of a US citizen, lottery winnings are fully taxable as ordinary income. A taxpayer’s winnings can be offset by substantiated lottery losses. However, the taxpayer must claim these losses as an itemized deduction subject to the overall limit on itemized deductions and the loss of the standard deduction.

While the above list is not exhaustive, it should give you a flavour that the two taxation systems - Canada’s and the US’ - are not entirely consistent. Although the Canada-US Income Tax Treaty does a very good job of trying to eliminate double taxation, the treaty does not resolve the two countries’ differing tax treatment on certain sources of income and availability of deductions/credits thereby causing different taxes payable. US citizens resident in Canada need to exercise great caution in assuming that their ultimate US income tax liability may not be nil notwithstanding the fact that their Canadian tax affairs are up-to-date. Seek professional help!

[1] In general, earnings and profits is taxable income with certain adjustments.

[2] A married couple filing jointly can elect to exclude up to $500,000.

[3] If the contribution is capital gain property, the available deduction is limited to 30% of his/her adjusted gross income if the taxpayer elects to claim the fair market value as the deductible amount, or up to 50% if he/she claims the adjusted basis as the deductible amount.

[4] Itemized deductions include home mortgage interest, tax preparation fees, medical expenses and sales taxes.

Official IRS Guidance For Taxpayers Who Have Not Filed U.S. Tax Forms

admin@moodystax.com (Roy A. Berg JD, LL.M. (US Tax)) — Fri, 09 Dec 2011 16:13:09 +0000

Late on December 7, 2011 the IRS issued Fact Sheet 2011-13 ("Information for U.S. Citizens or Dual Citizens Residing Outside the U.S."), which provides important guidance on two matters for taxpayers residing outside of the U.S.: first it gives insight into the type of facts that would support a "reasonable cause" argument for the abatement of penalties. Second, it clarifies the procedure to bring current unfiled returns, thereby confirming the IRS’s disdain for “quiet disclosures.” The guidance provided by the Fact Sheet makes clear the importance of engaging a professional who is experienced in these matters.

Facts likely to support a “reasonable cause” argument for the abatement of penalties

Many of the penalties faced by individuals who haven’t filed their U.S. returns may be reduced to zero provided the taxpayer can prove reasonable cause for not filing. Reasonable cause is a legal doctrine, the application of which is determined by all of the facts and circumstances surrounding the taxpayer’s failure to file. Particular facts that support its application are found in case law, administrative interpretations, the statutes, and the treasury regulations.^[1]

The taxpayer was unaware of his U.S. filing obligations

Depending on the particular facts, one of the theories that may support a finding of reasonable cause is that the taxpayer was unaware of his filing obligations. The Fact Sheet lists several facts that the IRS will, apparently, weigh more heavily than others in determining whether being unaware is sufficient to support the “reasonable cause” argument, including:

The taxpayer’s education;

Whether the taxpayer has previously been subject to the tax for which the return has not been filed;

Whether the taxpayer has been penalized before;

Whether there were recent changes in the tax forms or law the taxpayer could not reasonably be expected to know; and

The level of complexity of a tax or compliance issue.

The Fact Sheet then gives several examples, the facts of which support a finding of reasonable cause, the most telling of which is Example 4. Under Example 4 the IRS concludes that reasonable cause is shown based on the following facts:

The taxpayer complied with tax filing and payment obligations in his country of residence;

He was previously unaware of his U.S. filing obligations;

After discovering his U.S. filing obligations he filed his previously unfiled returns;

He attached a statement to his returns setting forth his reasonable cause argument;

He had a legitimate reason for maintaining non-U.S. accounts;

There was no indication that he had taken efforts to intentionally conceal the reporting of income or assets; and

There was no additional U.S. tax due.

In making the reasonable cause argument, it is critically important to analyze the facts, support the facts with affidavits or other evidence, and to make sure that the facts are supported by existing law. A U.S. lawyer who is experienced with the foregoing is an essential component to prevailing on reasonable cause argument.

Procedure to bring current unfiled returns: DO NOT ATTEMPT “QUIET DISCLOSURE”

The Fact Sheet states that if a taxpayer has not filed returns or foreign bank account reports (FBARs) he should immediately file the delinquent returns (6 years for the FBAR) and attach a statement with the filings that sets forth the reasonable cause argument. This guidance makes clear the IRS’s distain for “quiet disclosures.”

In the past many taxpayers have attempted to bring current their unfiled returns by simply filing the returns without notifying the IRS, this is what is referred to as a “quiet disclosure.” The IRS has publicly stated that it will not tolerate quiet disclosures and that those who attempt to bring their filing obligations current via quiet disclosure risk criminal prosecution. For example, in FAQ 15 of the Offshore Voluntary Disclosure Initiative (OVDI)^[2]the IRS stated:

Those taxpayers making “quiet” disclosures should be aware of the risk of being examined and potentially criminally prosecuted for all applicable years.

The Fact Sheet makes clear that unfiled returns must be brought current and the IRS must be informed of the taxpayer’s actions, including his reasonable cause argument. By following these rules, the taxpayer will maximize the possibility of proving reasonable cause and thereby reducing his penalties to zero.

Other penalties may apply.

The Fact Sheet addresses only the penalties that apply for failure to file FBARs and U.S. income tax returns. However, section 3 makes clear that other failure-to-file penalties may apply for other forms that have not been filed. These other forms include:

Forms 3520 and 3520A, which are required for certain interests in non-U.S. trusts or estates and gifts or inheritances from non-U.S. persons;

Forms 5471 and 8865, which are required for certain interests in non-U.S. corporations and partnerships;

Forms 926 and 8865, which are required for certain transfers to non-U.S. corporations and partnerships; and

Form 8938, which is a new form that is required to be filed beginning in 2012. The form must be filed by certain individuals who own non-U.S. accounts (much like the FBAR). There is a $10,000 penalty for failure to file this form.

The publication of the Fact Sheet is great news for individuals living outside the U.S. who are not current on their U.S. tax filing obligations because it gives some degree of certainty as to the facts that will support a reasonable cause argument for the abatement of penalties, and it also gives guidance as to the procedure to bring delinquent filings current.

[1] e.g., United States v. Boyle, 469 U.S. 241, 250-251 (1985); Internal Revenue Code Section 6664(c); IRM 20.1.1; IRM 4.26.16; Treasury Regulation 1.6664-4.

[2]See also, 2009 Offshore Voluntary Disclosure Program FAQ 10.

Tax Penalty Relief for American Citizens Residing in Canada? One New Concession However Other Relief is Already Available

admin@moodystax.com (Roy A. Berg JD, LL.M. (US Tax)) — Fri, 02 Dec 2011 16:55:40 +0000

On December 2, 2011 Canada’s Globe and Mail reported, after an interview with US Ambassador to Canada Jacobsen, that US citizens living in Canada will be able to avoid the punitive penalties that result from the failure to file US income tax returns and other forms. The Globe article states that the IRS will issue written guidance by the end of December 2011 that makes clear the following three points:

Individuals who took part in the 2009 IRS amnesty program (the Offshore Voluntary Disclosure Program or OVDP) or the 2011 IRS amnesty program (the Offshore Voluntary Disclosure Initiative or OVDI) can get a refund of the penalties paid.
If a US citizen files late tax returns and owes no taxes, there will be no penalties for failure to file.
US citizens who were unaware of their obligation to file the foreign bank account report (form TD F 90-22.1 or FBAR) there will be no penalty provided they can prove “reasonable cause” for failure to file this form.|

If there proves to be substance behind the article, this is promising news. It shows that the Obama administration is sympathetic to the millions of US citizens residing in Canada that have been unaware of the filing obligations appurtenant to their citizenship.

A close reading of the three points mentioned in the article, however, indicates that very little relief is actually being offered that is not already available.

Refund of penalties paid under previous IRS amnesty programs. This is the only point that actually offers new relief and is welcome mitigation to the thousands of individuals who have suffered through the indignities of this laborious, expensive, program.
No penalties for late returns provided there are no taxes owed. This point is not new and is simply a restatement of existing law. Section 6651(a)(1) of the Internal Revenue Code provides that the penalty for failure to file an income tax return is 5% of the taxes owed on the return for each month the return is late. The penalty is capped at 25%. Therefore, if no taxes are owed, there is no statutory basis to impose penalties.^[1]
Relief from FBAR penalties. Likewise, this point is not new and is simply a restatement of existing law. The draconian penalties imposed for failure to file the FBAR simply do not apply if the taxpayer’s failure to file is due to “reasonable cause.” Click here to see the actual statute (31 U.S.C. 5321(a)(5))

When the guidance is issued it will presumably address the multitude of additional questions that arise such as: what is the procedure for coming forward with unfiled returns? How many delinquent returns need to be filed? What certainty will the taxpayer have that penalties will not be applied? Will there be relief of the criminal sanctions imposed by the willful failure to file FBARs?

What the article does not address is relief, if any, for penalties imposed for the failure to file a multitude of other forms. Each of the failure to file penalties for the following may be reduced to $0.00 provided the taxpayer proves “reasonable cause.”

New individual income tax returns. As mentioned above, beginning in 2012 there is a new schedule (form 8938) required to be included in the individual income tax returns for individuals who own non-us accounts. There is a $10,000 penalty for failure to file this form.
Ownership of Registered Retirement Savings Plans. US citizens who own an RRSP are required to file the form 8891 with their income tax return in order to defer the appreciation on these accounts. The Treasury Regulations set forth the procedure for filing this form late. Will the there be a new protocol for making a late filing?
Certain ownership interests in non-US trusts or estates. If an individual is a trustee, settlor, or beneficiary of a non-US trust that person is required to file a form 3520 or 3520-A. The penalties for failure to file these forms can be $10,000 and higher. Tax Free Savings Accounts (TFSAs) are considered foreign trusts and require the filing of these forms.
Ownership in non-US corporations and partnerships. If an individual owns certain interests in non-US corporations or partnerships the individual is required to file form 5471 or 8865. The penalty for failure to file is $10,000.
Transfer of property to a non-US corporation or partnership. If an individual transfers property to a non-US corporation or partnership the individual may be required to file form 926 or 8865. The penalty for failure to file can be 10% of the value of the property transferred.
Receipt of a gift from a non-US person. If an individual receives a gift from a non-US person the individual is obligated to file a form 3520. The penalty for failure to file is 5% of the value of the gift for each month the form is not filed. The penalty is capped at 25%.

Since the only new relief mentioned in the article involves penalties paid by participants in the 2009 and 2011 amnesty programs, it is unlikely that the guidance, when released, will address the foregoing issues.

[1] It is important to note that beginning in 2012 the individual income tax return (form 1040) will include a new schedule (form 8939) that requires the disclosure of foreign bank accounts much like the FBAR. There is a $10,000 penalty for the simple failure to file this schedule.

Should Tax Preparers be Registered in Canada?

admin@moodystax.com (Kim G C Moody CA, TEP) — Mon, 21 Nov 2011 18:39:23 +0000

In the tax profession, there are a number of issues that bug me. For example, the absence of a tax specialist designation in Canada to help the public distinguish between non-tax specialists and tax specialists bugs me. I first wrote about this issue in our July 11, 2011 blog. The fact is that I've held this view for well over a decade ... it's important to ensure that the public is better served.

Another issue bugs me. Why is it that many professions are regulated, like cosmetology, but tax return preparation is not? Notwithstanding that Moodys' professional services do not really include Canadian tax compliance (we prefer to work with the client's existing tax preparers), the tax preparation industry is a large one and is unregulated. Anyone who wants to prepare tax returns for a fee in Canada is free to do so. Over the years, I've seen some very poorly prepared tax returns that were ticking time bombs for the client / taxpayer. In other cases, the professional preparer simply made errors. In many cases, I believe, the tax laws have simply become too complex for the average tax preparer to understand unless they are a tax specialist. Thank goodness for good tax software. Unfortunately, though, tax software is not fool-proof and requires the astuteness of the operator to ensure that there are no errors.

One would argue, however, that a shrewd consumer will always be able to determine a tax preparer's qualifications to handle their needs, and therefore, regulation is not needed. I don't buy that logic. In many cases, I've seen sophisticated people simply select the cheapest service provider thinking that the tax preparer is on equal footing with other more qualified but more expensive providers.

I can only guess, since I don't have the statistics at my fingertips, that untrained tax preparers cost the Canadian government tremendous amounts of inefficiencies. This is in addition to the cost to the consumer in the form of missed tax deduction and credits, not to mention the cost of errors and the time and money subsequently expended to resolve, including the potential assessment of penalties and arrears interest by the Canada Revenue Agency (“CRA”). Further, I believe that the non-regulation of the tax preparation industry in Canada makes it easier for inappropriate aggressive tax avoidance to occur (like certain charitable tax shelters).

In the US, the government obviously believes that regulation of the tax preparation industry is important. Today, a paid preparer of US tax returns must register for a "PTIN.” Similar registration requirements exist in Australia. The UK also appears interested in exploring an enrollment or certification system for tax preparers.

At the 2010 STEP National Conference, The Department of Finance was asked whether or not a US style tax preparer registration system was looming for Canada. The answer provided made it seem like the Government of Canada was not interested. However, at a recent tax conference that I was a speaker at, I participated in a Roundtable Q&A session with the CRA. One of the questions dealt with "tax intermediaries." Based upon the answer provided, it is obvious that the CRA is watching the US, Australia and UK experience closely and might be interested in a similar registration system for Canada.

Stay tuned.....I don't think we've seen the end of this story. Hopefully we see a positive result soon.

Halloween Trick or Treat? - The Department of Finance Releases Income Tax Technical Amendments and New GAAR Decision.

admin@moodystax.com (Kim G C Moody CA, TEP) — Tue, 01 Nov 2011 22:16:08 +0000

On October 31, 2011 (on the fifth anniversary of the income trust amendments) the Department of Finance released a package of income tax and sales and excise tax technical amendments. While most practitioners, including our firm, are still working through the package there are two proposed amendments that are worthy of an early comment.

1. Subsection 15(2)

It is proposed that subsection 15(2) be amended to clarify that a partnership can be connected with the shareholder of a particular corporation if that partnership does not deal at arm’s length with, or is affiliated with, the shareholder. The proposed amendment applies in respect of loans made and indebtedness arising after October 31, 2011. This amendment is important and noteworthy given the fact that it was questionable from a read of the existing law as to whether or not partnerships could be connected with the shareholder of a particular corporation. Accordingly, taxpayers and their advisors will need to take a fresh look, in light of this proposed amendment, as to whether or not partnerships will be connected with a corporation thereby causing subsection 15(2) to apply to such loans or indebtedness. To the extent that subsection 15(2) will apply, such loaned amounts may be included in the connected shareholder’s income.

2. Personal Services Business Corporations

The Department of Finance is proposing a significant change for a personal services business carried on by a corporation. Prior to the announcement of these technical amendments, it may have been advantageous for a person, who would otherwise be considered to be an employee, to incorporate their employment services. Such a corporation is commonly known as a Personal Services Business corporation. Prior to the introduction of the eligible dividend regime, it was not advantageous to have a Personal Services Business corporation since such a corporation would automatically be taxed at the highest corporate tax rate and all expenses (with certain limited exceptions such as salaries to the shareholder) would not be deductible. With the introduction of the eligible divided regime in 2006 and declining corporate tax rates, having a personal services business corporation’s income being taxed at the highest corporate rate and later distributing such surplus as an eligible dividend could provide, in some cases, a significant tax deferral.

The proposed amendment introduced in yesterday’s technical amendments will eliminate any such deferral opportunities by causing any income earned by a corporation from a personal services business to be taxed at a combined Federal-Alberta rate of 38% (as compared to the normal highest corporate rate for 2011 of 26.5%; 25% for 2012). The proposed amendment applies to taxation years that begin after October 31, 2011. Such an amendment should discourage any taxpayer from entering into a personal services business corporation relationship.

New GAAR Decision

On October 28, 2011 the Tax Court of Canada released a decision – Global Equity Fund Ltd. v. Her Majesty the Queen. This decision is the latest decision in which the General Anti-Avoidance Rule (“GAAR”) was at issue. The firm that defended the taxpayer has written a good summary blog on the decision and you will find it here. Readers are encouraged to read this interesting decision. Moodys LLP were the tax advisors for the taxpayer in the structuring of the transactions at issue. The taxpayer’s victory was the only “win” of the three similar cases decided by the Tax Court in 2011.

Offshore Voluntary Disclosure Initiative (“OVDI”) Update

admin@moodystax.com (Roy Berg JD LLM (US Tax)) — Tue, 01 Nov 2011 22:06:52 +0000

As many regular readers of our blog or our Twitter feeds (@RoyBerg1, @Moodystax) already know, applications for the 2011 US OVDI ended on September 9, 2011. However, there has been no shortage of activity regarding non-compliant US citizens. Yesterday, our firm received some news from a highly-placed source regarding some further activity. Apparently, a very influential US body has drafted a letter that should be made public later this week. The letter advocates lenient tax treatment for US Citizens residing in Canada who are not current with their filing obligations.

Here is what we believe to be the case:

The letter is addressed to President Obama, Secretary of State Clinton and Ambassador Jacobson.

Notably absent on the distribution list are Secretary of Treasury Geithner and IRS Commissioner Shulman.
We believe the omission of Geithner and Schulman indicate that the issue is being framed as a diplomatic matter and not as a tax matter.

The letter purports to advocate the following relief for US Citizens residing in Canada for X years provided they are compliant with Canadian tax filing and reporting obligations:

Full abatement of the penalty regime under the IRS Amnesty Program;
Penalty relief for those who missed participation in the Amnesty Program; and
Ability to renounce US Citizenship without the imposition of the Exit Tax.

What we do not know is the effect, if any, the letter will have.

If the letter does manage to effectuate change to the current protocol then that would be great news. The work that practitioners have undertaken so far for their non-compliant US clients may place them in an expedient position to be compliant with their tax affairs. However, it is puzzling to think how the lobbied for changes could be implemented without causing significant other fallout. For example, if the letter effectuates change, would non-compliant US citizens be rewarded for waiting out the previous voluntary disclosure programs? Tricky issues.

We continue to monitor this space closely and will communicate any changes as they become available.

Sale of Insurance Brokerage Client List – Tax Consequences

admin@moodystax.com (Kim G C Moody CA, TEP) — Thu, 20 Oct 2011 15:43:32 +0000

Have you or your clients ever sold an intangible property like a client list? A recent Tax Court of Canada case, George Smith v. Her Majesty the Queen, highlights the tax implications that can arise on the sale of such a property.

In this case, the property was an insurance brokerage client list. Overly simplified, the facts were as follows:

1. Mr. Smith practiced as a licensed insurance broker in Quebec for a number of years.

2. Mr. Smith and another insurance brokerage company ("BFL") entered into an agreement of referral in November, 1995 whereby BFL provided Mr. Smith with the use of BFL's office facilities and services in consideration of splitting the commission/fee income earned and paid on any premiums paid the insurer's policyholder during the term of the agreement.

3. The agreement of referral also provided BFL with the option to purchase Mr. Smith's client list.

4. Mr. Smith and BFL entered into a sale agreement effective January 1, 2002 whereby Mr. Smith agreed to sell his client list to BFL.

5. On January 1, 2002 Mr. Smith's client list generated annual base commission revenue of $156,000. Accordingly, BFL and Mr. Smith agreed on a purchase price of 2.25 times the annual commissions which equated to a purchase price of $351,000.

6. Subject to certain adjustments, the purchase price was payable as follows:

a. January 1, 2002 - $142,000 (40.7%)
b. January 1, 2003 - $69,500 (19.77%)
c. January 1, 2004 - $69,500 (19.77%)
d. January 1, 2005 - $69,500 (19.76%)

7. It was understood that the purchase price was based on represented annual revenue of $156,000 and that the subsequent payments in 2003, 2004 and 2005 would be calculated by applying the percentage of the scheduled payments (as referred to above), to the actual year's revenue from the appellant's clientele received in the subject year multiplied by the acquisition factor of 2.25.

8. The balance of payment due to be paid was also subject to an agreed to interest rate payment.

9. Given the above, the actual payments received were as follows:

Date	Actual Year's Revenue	2.25 Factor	Percentage	Down Payment	Interest Income
April 18, 2002	$156,000	$351,000	40.70%	$142,500	-
Date	Previous Year’s Revenue	2.25 Factor	Percentage	Subsequent Down Payment	Interest Income
January 15, 2003	$166,160	$373,860	19.77%	$73,912	$9,383
February 26, 2004	$208,098	$468,221	19.77%	$92,568	$3,125
January 10, 2005	$192,370	$432,833	19.76%	$85,571	$4,429

10. Mr. Smith appears to have included the received amounts in his income yearly pursuant to subsection 14(1) of the Income Tax Act (the "Act"), including the interest amounts received as will be further explained below.

Dispositions of property are usually subject to the "capital gains" rules under subdivision (c) of Part I of Division B of the Act. The result of applying the capital gains rules is that any profit from the disposition of a property is treated as a capital gain with only 50% of such amount being included in taxable income. A further advantage to the capital gains rules is that if all of the proceeds have not yet been received in the year of disposition, then deferral opportunities may exist to tax a portion of the resulting capital gains at the earlier of when the proceeds are received or over a five year period from the disposition date.

However, the capital gains rules do not apply to certain types of property. One of these exceptions is for "eligible capital property". Eligible capital property receipts, which will generally include client list disposition receipts, are taxed under subsection 14(1) of the Act which falls in subdivision (b) of Part I of Division B of the Act. The good news about being taxed under subsection 14(1) is that any net receipts are also subject to a taxable inclusion rate of 50% (like capital gains). However, a negative aspect of being taxed under this provision is that no tax deferral opportunities are possible (unlike those that might exist for capital gains as described above) for proceeds that are not yet due.

Accordingly, given the 50% taxable treatment laid out in subsection 14(1), Mr. Smith took the position that the subsequent payments he received in 2003 – 2005 were taxed pursuant to such beneficial treatment.

The Canada Revenue Agency ("CRA") disputed Mr. Smith's treatment of the received amounts subsequent to the date of disposition of his client list as being subject to subsection 14(1) of the Act. Instead, the CRA reassessed Mr. Smith to include the received amounts (exclusive of the interest payments) in 2003, 2004 and 2005 to be captured under paragraph 12(1)(g) of the Act which includes the following amounts in a taxpayer's income:

12(1)(g) payments based on production or use -- any amount received by the taxpayer in the year that was dependent on the use of or production from property whether or not that amount was an instalment of the sale price of the property, except that an instalment of the sale price of agricultural land is not included by virtue of this paragraph;

As you can see, paragraph 12(1)(g) is a very broad provision. The downside to being taxed under paragraph 12(1)(g) is that such amounts are fully taxable as opposed to being only 50% taxable to the extent that such amounts were caught under subsection 14(1).

In addition, the interest amounts received by Mr. Smith were reassessed by the CRA to be fully taxed under paragraph 12(1)(c) of the Act as interest income as opposed to being only 50% taxed under subsection 14(1).

Ultimately, the Tax Court of Canada found in favour of the CRA whereby such amounts received by Mr. Smith in 2003, 2004 and 2005 were taxed either as interest income (as appropriate) and amounts taxable under paragraph 12(1)(g) since the "Purchase Price" and the adjustments to the Purchase Price were all computed and determined by the annual commissions received from the appellant's client list and nothing else. Accordingly, Mr. Smith had an additional 50% income inclusion that he appears to not otherwise have included in his income for his 2003 – 2005 taxation years.

This case is an important lesson for taxpayers to ensure that dispositions of property and the resulting tax consequences are carefully thought through. Given the broad language of paragraph 12(1)(g), taxpayers and their advisors need to be careful of this trap.

Do You Own US Securities?

admin@moodystax.com (Kim G C Moody CA, TEP) — Thu, 13 Oct 2011 15:08:34 +0000

Do you own US securities (or other foreign stocks) in your personal portfolio? Does your corporation own US securities (or other foreign stocks)? If so, then pay careful attention to the information below.

1. Filing of Prescribed Form T1135

If you own US securities (or other foreign securities) in your investment portfolio you may be required, pursuant to section 233.3 of the Income Tax Act (the “Act”), to file prescribed Form T1135 with the Canada Revenue Agency (“CRA”) on a timely basis. This requirement catches a lot of people by surprise given the somewhat mundaneness of investing in US stock. However, subsection 233.3(3) of the Act reads as follows:

Returns respecting foreign property -- A reporting entity for a taxation year or fiscal period shall file with the Minister for the year or period a return in prescribed form on or before the day that is

(a) where the entity is a partnership, the day on or before which a return is required by section 229 of the Income Tax Regulations to be filed in respect of the fiscal period of the partnership or would be required to be so filed if that section applied to the partnership; and

(b) where the entity is not a partnership, the entity's filing-due date for the year.

As you can see, it is a “reporting entity” that is required to file such a form. A reporting entity is defined in subsection 233.3(1) of the Act as follows:

"reporting entity" for a taxation year or fiscal period means a specified Canadian entity for the year or period where, at any time (other than a time when the entity is non-resident) in the year or period, the total of all amounts each of which is the cost amount to the entity of a specified foreign property of the entity exceeds $100,000.

A “specified Canadian entity” includes an individual resident in Canada and also a Canadian corporation. In addition, the definition of “specified foreign property” includes a share of the capital stock of a non-resident corporation (which would include a US publicly traded stock).

Accordingly, to the extent that an individual (who owns such stock outside of their registered portfolio) or a corporation owns any foreign stock (including US stock) with a cost in excess of $100,000 at any time in the year then prescribed Form T1135 will need to be timely filed.

There appears to be a myth in the market place that there is an exemption for ownership of US stocks from the filing requirements for a T1135. However, no such exemption exists.

To the extent that prescribed Form T1135 is not timely filed, a person can be subject to a number of penalties. The least onerous penalty is a $25 per day penalty to a maximum of $2,500 for failure to file pursuant to subsection 162(7) of the Act. If the person knowingly or under circumstances amounting to gross negligence fails to file Form T1135, then an additional penalty becomes applicable under subsection 162(10) which will be $500 (or in some cases $1,000) per month that the T1135 is late filed to a maximum of 24 months.

In addition, a person can also be subject to an additional penalty under subsection 162(10.1) if the months that the T1135 is late filed exceeds 24 equal to five percent of the greatest of all amounts each of which is the total of the cost amounts to the person of the specified foreign property.

While these reporting rules have been in existence within the Act since the late 1990's, the CRA was usually very lenient and did not usually charge such penalties if prescribed Form T1135 was late filed. However, such administrative leniency ended without notice in the mid-2000's and there have been a number of reported cases where taxpayers have challenged the CRA's application of such penalties. One interesting case is currently before the Federal Court of Appeal. Click here for a copy of the lower court's ruling.

Accordingly, taxpayers and their advisors need to be very aware of the possible need to file prescribed Form T1135 when investing in foreign stocks, including US stocks.

2. Possible Exposure to US Estate Tax

An additional implication, for individuals, of investing in US stocks in your portfolio is that you could be subject to US estate tax even though you are not a US citizen. This is true because US estate tax is applicable to anyone in the world to the extent that they own US-situs property. US-situs property includes shares of US corporations. As an example, consider the following example facts:

Mr. Apple’s worldwide net worth is $10 million USD.
Mr. Apple is a Canadian resident and Canadian citizen, and is not a US citizen.
Mr. Apple’s investment portfolio includes $1 million USD of publicly traded stocks.
Mr. Apple dies.
The US estate tax rate for 2011 and 2012 is 35 percent with a $5 million USD exemption for US citizens. However, non-US citizens are only entitled to a pro-rated amount of the $5 million exemption which is calculated as the percentage of their US-situs assets ("A") to their worldwide assets ("B") multiplied by the $5M exemption ("C"). In other words, a non-US citizen is generally entitled to an exemption of US estate tax calculated as (A/B) x C.

Given that Mr. Apple owns US-situs property, the legal representatives administering his estate must consider the need to file a US estate tax return and to pay any US estate tax. As a very rough calculation, Mr. Apple’s US estate tax exposure would be as follows:

US-situs property - $1 million USD
Mr. Apple's worldwide net worth - $10 million USD
Mr. Apple's US estate tax exemption entitlement – $1 million USD/$10 million USD x $5 million USD = $500,000 USD
Therefore, Mr Apple’s estate tax would be computed as follows:

	Value of US-situs property	$1M USD
	Less: exemption entitlement	-$500K USD
	Amount subject to US estate tax	$500K USD
	US estate tax rate	35%
	US estate tax payable	$175,000 USD

While the Canada-US Tax Treaty may provide some relief from possible double taxation, the treaty will often not provide full relief. Accordingly, Mr. Apple’s legal representatives will need to look for ways, if possible, to reduce the overall Canadian tax and US estate tax exposure.

Conclusion

Be aware of Canadian foreign reporting requirements and US estate tax exposure when investing in US stocks.