Rectification in Tax and Estate Matters Part I – Tax

Confucius said “A man who has committed a mistake and doesn’t correct it is committing another mistake.”

When we are dealing with tax and estate matters, even a simple mistake may have disastrous consequences. One way such a mistake may be corrected is by way of a rectification order.  Indeed, rectification is an important remedy that allows for the correction of errors or mistakes in legal instruments that have resulted in an unintended result.  This newsletter will review the doctrine of rectification as it applies to tax matters.  Our next newsletter will focus on rectification in estate matters.

What is Rectification?

A rectification order is an equitable remedy to correct errors in legal instruments that do not reflect the true intention of the parties resulting in unintended and, likely, unfortunate results.  A rectification order allows the affected parties to rectify the terms of a transaction as was initially intended by the parties. The effect of the rectification is retroactive.

The remedy of rectification is available only under certain defined circumstances; essentially to correct a mistake. However, rectification is not permitted if the intention of the parties is simply to alter the terms of an instrument nor can it be invoked in an attempt to correct every mistake in order to alter unwanted results.

In order for a rectification order to be granted, one must file an Application to the Superior Court of Ontario; only a court may grant such remedy.  Interestingly, the Tax Court of Canada cannot grant equitable remedies, and, as a result, rectification of a tax matter can only be heard by the appropriate forum, the Superior Court of Ontario.  The duty of the Court is to examine the evidence and assess the facts in order to determine whether the application is truly one to correct a mistake which result in an unintended legal effect or an undesirable legal consequence.  The Court must ensure that the parties are not just changing their minds “in the middle of a transaction.” The evidence is the key to the determination.

To be successful in obtaining a rectification order, one must establish:

1. the existence and nature of the common intention of the parties prior to preparation of the instrument alleged to be deficient;
2. that the common intention remained unchanged at the time the document was made; and
3. that the instrument, by mistake, does not reflect that initial common intention.

If one can prove the above, the Court may grant a rectification order thus restoring the party(ies) to their initial common intention.  Applicants should be aware that rectification orders are a discretionary remedy granted at the discretion of the Court and one should not anticipate the granting of an order.

Rectification in Tax Matters

In tax matters where unintended tax consequences arise as a result of a mistake, rectification may be a valuable tool, if not a “life saver,” for taxpayers who find themselves in a situation where their tax planning went awry.

Although the equitable doctrine of rectification is not new, it only truly emerged as a valuable tool in tax matters in the last decade or so.  The leading case, Canada v. Juliar, has been a key decision in establishing such remedy to taxpayers. Indeed, in Juliar, the Court granted a rectification order in a tax matter which ultimately fixed a mistake in a document intended for tax planning purposes. The granting of the rectification order enabled the taxpayer to avoid having to face a tax liability from an unanticipated outcome. Interestingly, the Court had no issue with the fact that the taxpayers’ intention throughout the transaction was to avoid immediate tax consequences.

Since the Juliar decision, the law and the doctrine of rectification in tax matters has expanded considerably.  Taxpayers appear to show a willingness to consider an application for rectification to correct/rectify transactions that achieved unintended tax consequences. Notably, the jurisprudence has acknowledged that the avoidance of tax is a legitimate intention in rectification matters involving a tax issue.  As a result, rectification may be available where transactions that resulted in unintended tax consequences might be altered in order to achieve the initial tax intention; that is the avoidance or minimization of tax.

A more recent decision from the Supreme Court of British Columbia, McPeake v. Canada, is also instructive as to how and when granting a rectification order may be appropriate in tax matters.  The McPeake decision is consistent with prior cases where the taxpayers demonstrate an intention to avoid tax but the documents or transactions failed to reflect their true intentions.

The McPeake decision stands out also on the basis that in tax matters, the taxpayers must convince the Court that their initial intention was to avoid tax.  Another interesting point of that decision is the fact that the Court accepted that it ought to consider the unfairness or harm the taxpayer may suffer should the rectification order not be granted (thus allowing a tax liability to arise although the avoidance of such liability is what gave rise to the transaction in the first place).

Rectification Application and the Crown

The Crown also distinguishes between an error in implementation and an error in tax planning and the Agency will vigorously oppose rectification orders disguised as an attempt to implement a form of retroactive tax planning.

The Crown’s position is that a taxpayer requesting a rectification order should provide the Agency with notice of the application; especially in instances where the rectification application is being made on the basis that the taxpayer is alleging unintended tax consequences.

However, whether or not the Crown should be notified of any particular application for rectification is a dilemma for the taxpayer and his lawyer to resolve.  There is a valid argument to be made that since the Crown may not be a party to the original instrument and the original transaction, it has no interest in the application to rectify the written instrument and the transactions. There is jurisprudence where the Court has said that notice to the Crown was “appropriate” or a matter of courtesy; however, the Court has never said it is mandatory.

In reality, the decision of whether to serve notice to the Crown or not is essentially a matter of assessing the basis of the application and ultimately, it is a strategic decision. Further, should one serve notice to the Crown, they risk having the Crown oppose the application.  However, opting not to serve notice may result in the judge requesting notice be served prior to rendering his or her decision.  Having to serve the Crown after the initial application is likely to raise suspicion from the Crown.

It is important to know that the Department of Justice has a rectification committee which discusses and decides whether to oppose an application.  The CRA and the Department of Justice have established a procedure to be followed when applying to the Court for a rectification order; notably, that a letter be sent to the Director of the Tax Services Office advising rectification will be sough, that the CRA should be named as a party in the Motion and that the Department of Justice be served with the Notice of Motion.

Once served, the rectification committee will review and discuss the merit of the application and inform the party(ies) whether it intends to oppose the application.

Conclusion

In tax matters, an application for a rectification order remains a valuable tool for taxpayers and should be considered when adverse tax consequences are erroneously triggered by an error or errors in implementing a transaction.

An application for a rectification should be considered by tax advisors, including accountants, lawyers and any other tax advisors.  Indeed, rectification may be the key to correct an oversight in their tax planning memorandum or an error in the drafting of an instrument.  Rectification may translate into a lifeline for their mistake, thus avoiding a liability; something well worth considering.

Ultimately, the original intent is the key determining factor in the decision whether to grant a rectification order.

In our next newsletter, we will address rectification in estate matters.

Tierney Stauffer LLP would be glad to assist and advise you.  If you have any questions, please do not hesitate to contact us.

Sébastien Desmarais
LL.B., LL.L., J.D.
Lawyer, Tierney Stauffer LLP
This article is provided  as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter  referenced in this document before making decisions. Any use of this document does not constitute a lawyer-client relationship.

Voluntary Disclosure Program – It’s worth considering under the right circumstances

The Voluntary Disclosure Program (VDP) is an initiative from the Canada Revenue Agency (CRA)  designed to encourage  taxpayers to be more compliant with their income tax filings and to correct omissions or errors which may be considered “negligent” from previous income tax returns.  
The VDP offers taxpayers an opportunity to correct inaccurate or incomplete information or to correct previous erroneous information without penalties or prosecution.
One of the major incentives of proceeding by way of a voluntary disclosure is the assurance of knowing that IF his/her disclosure is accepted by the CRA, the taxpayer is assured of not facing tax evasion charges.

Criteria for a VD to be Valid

For a voluntary disclosure to be valid, it must meet certain specific criteria.  If the taxpayer fails to meet any of these criteria, the voluntary disclosure will be considered potentially invalid resulting in penalties and prosecution.
The CRA is unequivocal that a valid voluntary disclosure must be

(1) voluntary,
(2) complete,
(3) involve a monetary penalty, and
(4) involve information that is one year or more overdue.

Timing

Timing is crucial when filing a voluntary disclosure.  The CRA and the jurisprudence are clear: a disclosure may not qualify as a voluntary disclosure if it is found to have been made with the knowledge of an audit, investigation or other enforcement action that has been initiated by the CRA or other authorities or an administration with which the CRA has information exchange agreements.
It is crucial that the taxpayer be unaware of any audit, investigation or enforcement procedure when filing a voluntary disclosure. This means that if there is any direct contact by the CRA (such as a telephone call from a CRA agent or receiving a letter or a requirement to file from the Agency), the voluntary disclosure will be denied on the basis that it is not voluntary.
Furthermore, if a third party closely associated with the taxpayer receives a communication from the Agency or if any enforcement action against that third party is initiated and such action is sufficiently related to the taxpayer in the eyes of the CRA, the taxpayer’s voluntary disclosure may be denied on the basis it is not voluntary.

Completeness

The CRA is unequivocal that the taxpayer must provide full and accurate facts and documentation for all taxation years where there was previously inaccurate, incomplete or unreported information.  In most instances, the agent reviewing the voluntary disclosure will most likely request additional specific documents or information corroborating the initial application.
Should the taxpayer fail to provide the information requested, or should the facts in the initial application not withstand the scrutiny of the CRA, the voluntary disclosure will likely be denied.
As is always the case in tax matters, the onus of proof lies with the taxpayer. It is the responsibility of the taxpayer to prove that the information submitted provides a complete and accurate account of the facts involved.
However, it is worth noting that minor errors or omissions shall not disqualify the disclosure. Further, the CRA clearly states that each submission will be reviewed on its own merits.

Monetary Penalty

Another criterion is the obligation that the voluntary disclosure must involve the application, or potential application, of a monetary penalty.  There are different reasons as to why a penalty would be levied (such as a late filing penalty, a failure to remit penalty, an installment penalty or a discretionary penalty) but in order for a voluntary disclosure to be valid, it must involve a monetary penalty applying to one reporting period.

One Year Past Due

The last criterion for a valid disclosure is that it must include information that is (1) at least one year past due, or (2) the disclosure is to correct a previously filed return.

10 Year Limitation

CRA will only grant penalty relief for a period of 10 years.  (§220(3.1) of the Income Tax Act was amended in 2004 to only provide relief for a period of 10 years prior to the application for relief of interest and penalties).
This is quite unfortunate as a taxpayer that would like to rectify past filings must take into consideration this 10 year limit.  Indeed, should a taxpayer opt to file a disclosure concerning taxation years dating back more than 10 years from the application, they run the risk of being liable for penalties.
CRA does not advertise such a limitation period and this further emphasises the importance of seeking professional assistance prior to proceeding with a voluntary disclosure.

Conclusion

The VDP is worthy of consideration by any taxpayer that wishes to rectify a previous filing and avoid any penalties or prosecution.
However, the criteria of a valid voluntary disclosure are precise and one should always seek professional assistance given the significant risks that an invalid application may invoke.
Should you be interested in proceeding by way of a voluntary disclosure, Tierney Stauffer LLP would be glad to assist and advise you.  If you have any questions, please do not hesitate to contact us.

Sébastien Desmarais
LL.B., LL.L., J.D.
Lawyer, Tierney Stauffer LLP
This article is provided  as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter  referenced in this document before making decisions. Any use of this document does not constitute a lawyer-client relationship.

Net Worth Assessment – Avoid it at all costs

A net worth audit is one of the most powerful techniques available to the Canada Revenue Agency (CRA) to unilaterally deem a taxpayer to have a certain amount of unreported income. The net worth audit is a method which, on its premise, assumes the taxpayer has hidden or failed to disclose annual income, and as a result CRA is not able to rely on the accuracy of the amount of taxpayer income from tax returns filed. Subsequently, CRA will use the results of a net worth audit to deem a taxpayer to have unreported income, resulting in allegations of tax evasion or civil fraud against the taxpayer.

In recent years tax professionals have noticed an increase in CRA’s use of net worth audits against taxpayers. The CRA appears to be targeting their net worth audits to cash-based businesses, owner-manager businesses and illegal businesses (such as drug dealers).

The following will attempt to answer two primary questions, first, what is a net worth audit and second, what is the burden on a taxpayer faced with a net worth audit.

What is a Net Worth Audit?

A net worth audit is a two-step audit by the CRA. First, the Agency will look at the taxpayer’s assets and liabilities at the beginning and end of the tax year and determine the increase and/or decrease in the taxpayer’s net worth. Second, the CRA will review the taxpayer’s expenditures for that same tax year and compare them with standards of expenditures according to Statistics Canada.

The net worth method relies on the concept that when a taxpayer accumulates wealth during a tax year, he shall either invest it or spend it. For an auditor conducting a net worth audit, they will consider an increase in the taxpayer’s net worth throughout the year as taxable income. From that starting point, the auditor will add all non-deductible expenditures to the taxpayer’s net worth and then compare the taxpayer’s net worth at the beginning of the taxation year and the taxpayer’s net worth at the end of the taxation year. Any increase in the taxpayer’s net worth will be considered income for tax purposes.

Interestingly, at the audit stage, the CRA has essentially free reign in their assessment and interpretation of the taxpayer’s net worth. Indeed, CRA may assume facts or use general statistics from Statistic Canada in their assessment; in most instances, to the taxpayer’s detriment.

Burden is on the Taxpayer

It is important to understand that because the Canadian tax system is a self-assessing system, the onus is on the taxpayer to rebut all of the Minister’s assumptions and findings.

The Courts have consistently taken the view that once CRA issues a reassessment based on a net worth audit, the taxpayer must rebut all of CRA’s assumptions and findings by either:

Challenging whether the net worth assessment is needed or is the most appropriate method of computing the taxpayer’s income; or

Challenging every specific aspect of the net worth assessment calculations.

In the context of a net worth audit, the taxpayer’s onus of proof is a considerable one. Indeed, in most net worth audits, the auditor will have requested all available taxpayer records including, but not limited to, a list of all inventories, physical assets, debts to creditors, bank records, securities, and any other statements of assets.

From the documentation provided, the auditor may have interpreted some book entries and assume facts that may not be accurate, however, the onus is on the taxpayer to provide proof to clarify, explain and rebut all of the auditor’s assumptions and interpretation of facts.

When combating a net worth audit, the devil is in the details. Every item, interpretation and assumption of the auditor must be analyzed in great detail and dissected for correctness.

Indeed, with every error found, the trustworthiness of this inherently untrustworthy method is called further into question.

If the matter is to proceed before the Tax Court of Canada, pointing out the auditor’s errors in their interpretation shall contribute to discrediting the auditor’s findings and tilt the judge’s opinion in favor of the taxpayer. However, the taxpayer will also need to provide evidence explaining and clarifying the increase in his net worth over the year.

A valid explanation, such as the receipt of an inheritance, will undoubtly favor the taxpayer in his pursuit of rebutting the auditor’s finding. However, if the taxpayer lacks any evidentiary documentation attesting his point then the matter becomes one of credibility; something a taxpayer should always avoid.

Conclusion

Maintaining well-organized documents and financial records is truly the sole solution for succeeding over a net worth audit. Indeed, documenting all receipts of significant funds received during the taxation year, especially any foreign funds, is the very best way to beat a net worth audit.

My former colleague Arthur Drache once wrote: “good paper almost always will prevail, but in a contest of your unsupported word against CRA, you’ll almost always lose.” This remains the gold standard in a net worth audit.

 If you are the subject of a net worth audit, we highly recommend you consult with your accountant and lawyer. Tierney Stauffer LLP would be glad to assist and advise you. If you have any questions, please do not hesitate to contact us.

Sébastien Desmarais
LL.B., LL.L., J.D.
Lawyer, Tierney Stauffer LLP
This article is provided  as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter  referenced in this document before making decisions. Any use of this document does not constitute a lawyer-client relationship. 

Dealing with the Canada Revenue Agency

It is not uncommon for people, often in a dire state, to seek advice after receiving a notice of assessment or reassessment from the Canada Revenue Agency (the “CRA”). When it comes to effectively addressing tax issues and notices of assessment or reassessment, there are several rules and deadlines that we should be aware of in order to avoid the pitfalls The following sets out and discusses some of the key relevant deadlines and rules governing dealings with the CRA.

Role of the CRA

The Canadian tax system is a self-assessing system. As a result, the CRA has broad powers and authority to audit and investigate information provided by taxpayers to ensure compliance with the Income Tax Act (the “ITA”). These powers and authority range from requisitioning documents or other information for their review, conducting audits and inspections, formal searches and seizure of documents under a search warrant and formal inquiries and investigation authorized by the CRA.

The CRA is required to examine the return and make an assessment “with all due dispatch” following receipt of the taxpayer’s return. Although “all due dispatch” is not defined in the ITA and does not refer to a specific period of time, the jurisprudence establishes a criterion of reasonableness depending on the facts of the matter.

Upon reviewing the taxpayer’s income tax return and all other documentation requested, the auditor will issue his final report and, if he believes amendments to the return are required, the CRA will issue a notice of assessment or reassessment setting out the amendments to the taxation year at issue.

Notice of Assessment/Reassessment

The CRA has three years from the date of mailing the notice of assessment to issue a notice of reassessment or a further notice of assessment and this interval is referred to as the “normal reassessment period.”
If the taxpayer disagrees with the Minister’s notice of assessment or reassessment, he is entitled to file a notice of objection within 90 days from the date the notice of assessment or reassessment is mailed.

The notice of objection must be in writing and must set out all relevant material facts, reasons and grounds on which the taxpayer is relying. It is important to understand that the onus is on the taxpayer to rebut all of the Minister’s assumptions and findings within the notice of objection.

Failure to object to all of the Minister’s findings will result in the taxpayer’s objection being “incomplete” and the Minister’s obligation is only to review the arguments raised in the notice of objection. This potentially leaves the taxpayer with the unfortunate result of having to pay taxes because some grounds were not raised in the notice of objection.

The Minister will only review those points of objection that are raised in the notice of objection. Consequently, it is advisable that the person drafting the notice of objection consult with the taxpayer, the taxpayer’s accountant and the taxpayer’s lawyer to ensure all points are covered.

Appealing to the Tax Court of Canada

Once the Minister has issued its final ruling on the taxpayer’s objection, he will issue a confirmation or a reassessment. From the date of the issuance of the confirmation or reassessment, the taxpayer has 90 days to appeal to the Tax Court of Canada (the “TCC”).

There are two sets of Rules governing an appeal before the TCC and, depending on the amount of money at issue, the taxpayer may have to choose whether to appeal under the Informal Procedure or the General Procedure.

If the aggregate amount at issue is equal to or less than $12,000.00 or the amount of the loss is equal to or less than $24,000.00, the taxpayer may elect to file his notice of appeal under the Informal Procedure. If the amount at issue exceeds the two thresholds, the taxpayer must then appeal under the General Procedure.

If the taxpayer appeals under the General Procedure Rules, the notice of appeal must state all material facts, all grounds of appeal, alternative arguments and any specific relief sought. The notice of appeal must also refer to the statutory provisions relied upon.

Final Thoughts

For many, dealings with the CRA represent a period of severe stress and frustration. Seeking proper advice and guidance from experienced professionals (lawyer, accountant and others) is essential to insure that your interests are well protected. If you have any questions concerning tax reassessment, please do not hesitate to contact me directly.

Sébastien Desmarais,
Associate, Tierney Stauffer LLP

 

This article is provided  as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter  referenced in this document before making decisions. Any use of this document does not constitute a lawyer-client relationship. 

Trusts and the 21-Year Rule

Trusts, once considered a tool exclusively for the wealthy, have become enormously popular in the last ten years for middle income persons and for good reasons: trusts provide great flexibility in tax planning strategies and estate planning.  

Trusts are subject to specific tax rules that ought to be fully understood and complied with.  One of those is the “21-year deemed disposition” rule where, for tax purposes, a trust is deemed to dispose of certain types of property for fair market value proceeds.  Failing to acknowledge this rule may result in the trust realizing capital gains, ordinary income or recapture without receiving actual proceeds of disposition.

This newsletter will review the 21-year deemed disposition rules and some tax strategies to help avoid or defer the tax implications.

The 21-Year Deemed Disposition Rule

The 21-year deemed disposition rule exists in order to prevent property held by a trust from being passed from generation to generation on a tax-free basis. 

The 21-year deemed disposition rule does not apply to all trusts or all types of assets held in a trust. Indeed, the rule applies to trusts which hold depreciable property, non-depreciable capital property, Canadian and foreign resource properties, land inventory and NISA funds No. 2.  More specifically, the deemed disposition rule applies to:

§  Qualified small business corporation shares

§  Qualified farm property and qualified fishing property

§  Mutual funds and other shares

§  Real estate and depreciable property, bonds, debentures, promissory notes and other properties

§  Personal-use property

§  Listed personal property (as defined by the ITA)

§  Land held as inventory

Interestingly, for estate planning purposes, life insurance does not fall into any of the above classifications and therefore is not subject to the deemed disposition rule.

Strategies for Dealing with the 21-Year Rule

For obvious reasons, trustees and beneficiaries want to avoid the 21-year deemed disposition rule as no one wants to pay taxes if they can be avoided. Happily, there exists several strategies allowing for the deferral or avoidance of the 21-year rule.

The easiest way to avoid the 21-year deemed disposition rule is to simply have the trust property distributed to the Canadian resident beneficiary on a tax-free basis (the Income Tax Act allows such tax-free distribution). One of the drawbacks of this option is that the beneficiaries lose their opportunity for income splitting and other tax planning strategies and the trustees lose control of the assets.

Depending on the assets held by the trust, another option is to distribute only a portion of the trust’s assets to the capital beneficiaries.  Essentially, all assets with accrued gains would be distributed to capital beneficiaries on a tax free basis while the assets that do not have a component capital gains could be retained by the trust. 

If a trust holds shares of a private corporation the trustees must consider the 21-year deemed disposition rule because failure to do so could result in double taxation; indeed the trust would realize a capital gain on the deemed disposition of the shares and, if the shares were later redeemed, the trust would also realize a deemed dividend. 

To avoid any double taxation, one strategy is to incorporating a new company (Newco) which shares will be owned by a new trust (most likely with the same trustees and beneficiaries as the first trust).  The trustees of the first trust would then make Newco a beneficiary of the first trust (if there is a power to appoint new beneficiaries).  Then, the first trust would distribute the Oldco shares to Newco prior to the 21-year deemed disposition date. 

There are other very similar strategies, to the one above, when dealing with a trust holding shares of a private corporation and the 21-year deemed disposition rule and the trustee(s) should consult with his or her tax advisors as to which strategy might be best.  The trustees must also be aware of the uncertain nature of the GAAR (General Anti-Avoidance Rules under the Income Tax Act) when implementing a 21-year deemed disposition strategies.

Estate Planning, the use of Trusts and the 21-Year Deemed Disposition rule

In estate planning, it is common to establish a trust under the Last Will and Testament and fund such trust with assets flowing through the estate of the deceased.  Such trusts are referred to as a “testamentary trust:” a trust that arose as a consequence of the death of a testator.  Testamentary trusts provide a unique opportunity as they pay tax on a graduated basis allowing for a variety of tax savings and income splitting.

In estate planning, the 21-year deemed disposition rule is often misunderstood and too often we have advisors recommending that the testator or the estate trustee avoid the 21-year rule “at all costs.”  As a result, the Will may have a clause requiring the trustee of the testamentary trust (or the estate trustee) to distribute the capital of the trust to the beneficiary before the 21-year deemed disposition in order to avoid a capital gain. 

Although such advice is not technically wrong, it is often given without an adequate explanation or understanding of the 21-year deemed disposition rule and may not realize the maximum benefit from the trust.  For instance, what if the assets of the trust do not have a capital gain component, i.e., no capital gain is arising at 21 year limit?  What if the tax savings of a testamentary trust in the long run are far greater than the capital gain to be realized on the 21 year deemed disposition?  In these two examples, why would someone want to lose the tax savings and income splitting opportunity simply to avoid a small capital gain, if any?

As an aside for estate matters, it is important to know that the 21-year deemed disposition timeline commences at the death of the testator/settlor and not on the day the residual beneficiary receives his or her share in a testamentary trust.

Conclusion

We can see that a trust may be viewed as a vehicle that provides a 21-year window of tax opportunities.  The 21-year deemed disposition rule ought to be reviewed and fully understood by any trustee of a trust; whether a family trust, a testamentary trust, an alter ego trust, a spousal trust, etc., in order to take advantage of those opportunities and realize the maximum benefit from a trust.

If you have any questions concerning the 21-year deemed disposition rule or concerning trusts in general, please do not hesitate to contact me directly 613.288.3220 or by email at sdesmarais@tslawyers.ca

Sébastien Desmarais
Lawyer

 

This article is provided as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter referenced in this document before making decisions.

U.S.A. Real Estate – Ownership Considerations for Canadians

A strong Canadian dollar combined with the epic collapse of the U.S. housing market in recent years has helped turn many Canadian heads south to consider purchasing US real estate at a “bargain.”  For some, the purchase is solely for personal use but others see a sweet investment opportunity.  Informed professionals may see a potential problem.

 Canadians contemplating a purchase of US property are well advised to fully investigate the associated tax rules and planning requirements of any prospective purchase with the same attention to detail as to the nature of the property they are considering buying.  They should  consider income tax, estate tax and gift tax ramifications related to the ownership of US real property. Failure to conduct the proper tax planning may result in adverse tax consequences for the buyer(s) or their estate.

 This newsletter will shine a light on the different ownership structures available.  It is important to remember that there is no single approach that works best in every situation and many factors need to be considered in determining which ownership structure to adopt.  

 Ownership Structures

 There are several ownership structures available to Canadians, the most common being personal ownership (joint ownership and tenancy in common), ownership through a trust, and ownership through a corporation.  Each has their advantages and their drawbacks.

 Let’s review the advantages and drawbacks that should be considered prior to making a US purchase.  For example, you may want to consider the U.S. estate and gift tax, the issue of U.S. rental income, the taxation of gain under the 1980 Foreign Investment in Real Property Tax Act (FIRPTA), the deemed disposition on death and the income attribution rules.  Those cross-border tax issues may have to be dealt with at some point and failure to have recognized the tax obligations may result in unfortunate consequences.

 One needs to be aware that the US imposes a federal estate tax on the taxable estate of a decedent who was not a US citizen or domiciliary for transfers of “US situs property” upon death.

 Personal Ownership, Joint Ownership or Tenancy in Common

 In common-law provinces, joint ownership is the most common form of ownership of real estate by couples. In joint tenancy the property will transfer on death to the surviving owner.  The alternative is tenancy in common in which case property devolves on death pursuant to the instructions in the deceased owner’s Will.

 Individual ownership of US real estate is probably the simplest ownership structure for Canadians.  It is worth noting that personal ownership offers no shelter from the US estate tax, but with the proper estate tax planning, it is possible to mitigate exposure to the estate tax.  In many instances, depending on the value of the individual’s estate, he or she may not have to worry about the US estate tax as they will be entitled to claim the pro rata US estate tax exemption based on the ratio of US assets to worldwide assets.

 Consider one example showing how complex (and expensive) proper tax planning can be for personal ownership of US real estate.  A couple owns a U.S. property jointly with right of survivorship.  The first spouse to die may be liable to pay U.S. estate tax because the full value of the property will be included in that spouse’s estate (unless the surviving spouse proves that he or she also contributed to the purchase of the property).  Upon the death of the first spouse, the surviving spouse will own 100 percent of the property and, if he or she did not sell the property before his or her death, then the U.S. estate tax may again be applicable on the property on the death of that spouse.

 Corporate Ownership

 Until recent policy changes, corporate ownership was commonly used for tax convenience.  By holding U.S. real estate in a single-purpose corporation, the direct personal ownership of the asset was avoided and, consequently, so was the US estate tax on death.  This method was also advisable as the CRA had a liberal administrative policy of not assessing a shareholder benefit (under §15 of the Income Tax Act) on the use of US real estate; that is the CRA would not include the value of the benefit conferred on the shareholder by the personal use of corporate assets as the shareholder’s income.

 However, the CRA reversed their policy and, as a result, a taxable shareholder benefit may now be assessed to the shareholder of the single-purpose corporation holding US real estate.  The “new” policy applies for any single-purpose corporation incorporated since 2005 (there is a grandfather provision for property held in a single-purpose corporation prior to 2005).

 Corporate ownership also raises concerns on the taxable capital gain on the sale of the property, the IRS piercing the corporate veil and the FIRPTA rules. The preferential long-term capital gain rate is not available and the corporation will be taxed at the graduated tax rates. It is important to know that in some States individuals are not subject to personal tax but corporations are.

 Corporate ownership may have been an advisable option in the past but in light of the CRA’s reversal on its shareholder benefit policy concerning single-purpose corporations combined with the US tax implications on the sale of such properties, this option may appear less favorable.

 Ownership Through a Trust

 Another ownership structure available is a discretionary inter vivos trust which, if properly structured, may avoid US estate tax.

 Indeed, the use of a trust for a couple may be an advisable option if implemented prior to the purchase.  The strategy is for one spouse to create the trust for the benefit of his or her spouse and children and then to fund the trust with the required amount of cash to purchase the property.  The drawback for the spouse that creates the trust is that he or she cannot be a beneficiary of that trust and may not have any powers or interest in the trust. 

 The advantages are that ownership within a discretionary inter vivos trust avoids US estate tax and may also minimize the Canadian taxation of accrued capital gains that would result from the deemed disposition on death of property owned by a Canadian-resident individual.  Such ownership structure may be an effective estate-planning approach. However, consideration on the application of the reversionary trust rule in the Income Tax Act (§75(2)) as well as the 21-year deemed disposition rule must also be reviewed carefully.

 We can see that in the right circumstances the use of a trust as an ownership structure may be an interesting option and that there are several tax rules that ought to be considered prior to the implementation of the trust. Used appropriately, a trust ownership may allow the most flexibility to its beneficiaries.

 US Estate Tax and Gift Tax

 The U.S. estate tax is complex in itself and even a general overview far exceeds the extent of this newsletter.  What is important to understand is that Canadians owning US assets at the time of their death may be subject to the US estate tax. 

 Under the Canada-U.S. Tax Treaty, a Canadian resident is entitled to benefit from a tax credit exemption prorated based on the ratio of the U.S. assets to the decedent’s worldwide assets.  Depending on the value of the individual’s US assets, he or she may be subject to the US estate tax.

 What is key to remember is that the U.S. taxation on death stands in stark contrast to Canadian taxation on death as where in Canada, upon the death of a Canadian resident, the deceased is deemed to have disposed of all of his or her capital property at fair market value unless the property transfers to a spouse or a spousal trust.  It can be seen that failure to consider the ramifications of the US estate tax may sour your plans for your estate.

 Conclusion

 The ownership structure of US real estate is only the first consideration of many.  A thorough review of the regulations is essential to assess whether one ownership structure is more appropriate than another. Therefore, if you are thinking of purchasing US real estate, it is advisable that you do your due diligence in considering all appropriate ownership structures. 

 If you personally own U.S. real estate in joint tenancy or in tenancy in common, you may want to review your estate planning to avoid double taxation on the death of you and your joint owner.  Similarly, if you own U.S. real estate by a Canadian corporation or a trust, you ought to familiarize yourself with the relevant U.S. and Canadian taxation rules.

 If you have any questions, please do not hesitate to contact me directly 613.288.3220 or by email at sdesmarais@tslawyers.ca

Sébastien Desmarais
Lawyer
Tierney Stauffer LLP

This article is provided as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter referenced in this document before making decisions.

Dealing With the Canada Revenue Agency

It is not uncommon for people, often in a dire state, to seek advice after receiving a notice of assessment or reassessment from the Canada Revenue Agency (the “CRA”).  When it comes to effectively addressing tax issues and notices of assessment or reassessment, there are several rules and deadlines that we should be aware of in order to avoid the pitfalls The following sets out and discusses some of the key relevant deadlines and rules governing dealings with the CRA.

Role of the CRA

 

The Canadian tax system is a self-assessing system. As a result, the CRA has broad powers and authority to audit and investigate information provided by taxpayers to ensure compliance with the Income Tax Act (the “ITA”).  These powers and authority range from requisitioning documents or other information for their review, conducting audits and inspections, ,formal searches and seizure of documents under a search warrant and formal inquiries and investigation authorized by the CRA.

The CRA is required to examine the return and make an assessment “with all due dispatch” following receipt of the taxpayer’s return.  Although “all due dispatch” is not defined in the ITA and does not refer to a specific period of time, the jurisprudence establishes a criterion of reasonableness depending on the facts of the matter.

Upon reviewing the taxpayer’s income tax return and all other documentation requested, the auditor will issue his final report and, if he believes amendments to the return are required, the CRA will issue a notice of assessment or reassessment setting out the amendments to the taxation year at issue. 

Notice of Assessment / Reassessment

The CRA has three years from the date of mailing the notice of assessment to issue a notice of reassessment or a further notice of assessment and this interval is referred to as the “normal reassessment period.”  If the taxpayer disagrees with the Minister’s notice of assessment or reassessment, he is entitled to file a notice of objection within 90 days from the date the notice of assessment or reassessment is mailed. 

The notice of objection must be in writing and must set out all relevant material facts, reasons and grounds on which the taxpayer is relying. It is important to understand that the onus is on the taxpayer to rebut all of the Minister’s assumptions and findings within the notice of objection.  Failure to object to all of the Minister’s findings will result in the taxpayer’s objection being “incomplete” and the Minister’s obligation is only to review the arguments raised in the notice of objection. This potentially leaves the taxpayer with the unfortunate result of having to pay taxes because some grounds were not raised in the notice of objection.

The Minister will only review those points of objection that are raised in the notice of objection. Consequently, it is advisable that the person drafting the notice of objection consult with the taxpayer, the taxpayer’s accountant and the taxpayer’s lawyer to ensure all points are covered.

Appealing to the Tax Court of Canada

Once the Minister has issued its final ruling on the taxpayer’s objection, he will issue a confirmation or a reassessment.  From the date of the issuance of the confirmation or reassessment, the taxpayer has 90 days to appeal to the Tax Court of Canada (the “TCC”). 

There are two sets of Rules governing an appeal before the TCC and, depending on the amount of money at issue, the taxpayer may have to choose whether to appeal under the Informal Procedure or the General Procedure.  If the aggregate amount at issue is equal to or less than $12,000.00 or the amount of the loss is equal to or less than $24,000.00, the taxpayer may elect to file his notice of appeal under the Informal Procedure.  If the amount at issue exceeds the two thresholds, the taxpayer must then appeal under the General Procedure.

If the taxpayer appeals under the General Procedure Rules, the notice of appeal must state all material facts, all grounds of appeal, alternative arguments and any specific relief sought.  The notice of appeal must also refer to the statutory provisions relied upon.

Final Thoughts

For many, dealings with the CRA represent a period of severe stress and frustration.  Seeking proper advice and guidance from experienced professionals (lawyer, accountant and others) is essential to insure that your interests are well protected. 

If you have any questions concerning tax reassessment, please do not hesitate to contact me directly.

Sébastien Desmarais
Lawyer
sdesmarais@tslawyers.ca

This article is provided as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter referenced in this document before making decisions.