Amended Ontario Estate Tax

Republished with permission from the Canadian Tax Foundation.  First published in the March, 2013 edition of the Canadian Tax Highlights, a Canadian Tax Foundation publication.

Ontario’s estate administration tax, better known as the probate tax, was created in 1998 under the Estate Administration Tax Act (EATA). The latest EATA amendments (Bill 173) became effective after 2012 and appear to create new issues for taxpayers.  Ontario taxpayers reacted vigorously when the province trebled what was then known as the probate fee from 0.5 to 1.5 percent on estate assets whose value exceeded $50,000. The probate rate increase arguably triggered planning efforts to ensure that assets were not subject to the fee. Moreover, the probate fee itself was directly and successfully challenged in Eurig Estate (Re) ([1998] 2 SCR 565), in which the SCC held that although the probate fee was a constitutionally authorized direct tax, it had come into force through the lieutenant governor in council and had not originated in the legislature as mandated by the Constitution Act, 1867. The SCC gave Ontario six months to rectify the legislation in recognition of the financial hardship for the province if it could not retain the fees that it had collected over the years. Ontario responded by implementing EATA: the probate fee became a legislatively imposed direct tax that retroactively ensured the legality of the already collected probate fees (but specifically exempted the Eurig estate).

The term “probate” is a universally accepted legal synonym for proof—authentication by a court order that the will on which third parties are being asked to rely is the last effective will, and a declaration that certain executors and trustees are in control. (In Ontario, the former grant of letters probate is now referred to as a certificate of appointment of estate trustee, either with or without a will.) However, a will’s essential validity does not depend on its probate, and an un-probated will may be recognized and accepted by third parties who hold assets of value that devolve under the will.  For years, the probate system relied on valuations that were left to the discretion of executors and their advisers.  For example, if the value of a modest old house was estimated to be $200,000 for probate purposes but the house was later sold for $50,000 over or under the estimate, only $750 in probate fees (at 0.5 percent) was at stake.

A formal valuation was frequently seen as a waste of estate resources, and the payment of additional corrected probate fees and requests for refunds of overpayment were routine and non-contentious. A sworn affidavit of value of realty and personalty supported the application for probate; that requirement was in keeping with the system’s self-reporting nature and relied on the integrity of the practitioners who advised (and deposed) the executors. What was to be included in and excluded from the valuation was not always legislatively clear. The practices of deducting an outstanding mortgage on real estate and excluding insurance payable to a named beneficiary arose from small-print wording in Ontario’s probate application form. Whether registered plans such as RRSPs and RRIFs with named beneficiaries were excluded by analogy to insurance was debatable, and many practitioners may have excluded them because they were subject to income tax.

The bulk of value in most ordinary estates still passes to beneficiaries without the payment of probate, whether via joint tenancy, a joint bank or investment account, designation of a beneficiary to insurance or a registered plan, or a gift inter vivos. More valuable estates employ more sophisticated will substitutes such as family trusts and alter ego and joint partner trusts.  For some time, wealthy international families with multijurisdictional estates have structured multiple-situs wills based on statutory provisions that were intended to accommodate foreign executors. For example, if the representatives of a foreign estate come to Ontario seeking to administer assets located in the province (such as a cottage in Muskoka), they do not need to re-probate the entire foreign estate in Ontario; instead, they can seek a limited grant of probate whose authority is limited to the particular Ontario asset that they want to administer. The probate taxes payable are calculated on those limited assets. Since the 1990s, the “limited grant of probate” format has been used in Ontario to establish dual concurrent wills, although the dual-will strategy is largely unknown to legal practitioners outside the estates and tax areas.

The primary concurrent will recites that it applies to all assets except for those that are defined and covered by the secondary will. The primary will is submitted to the probate process, and probate is paid on the declared values of the primary estate. For example, shares of a private company may be the subject of a secondary will if the company is run by family members who are not concerned about court authentication of the deceased’s will.  Ontario unsuccessfully challenged the dual-will splitting of an otherwise probatable estate in 1998 in Granovsky Estate v. Ontario (1998 CanLII 14913 (ONSC)) and abandoned its appeal of the decision. Greer J, a senior and respected estates judge, confirmed that there was no obligation to pay probate taxes and that a will can be valid with or without probate. Probate was paid in exchange for the benefits of the court authentication process.

However, if an asset can be administered without the authority of a probated will, the executors are not required to apply for probate or to pay probate tax.  The planning for and drafting of two or more concurrent wills is complex, time-consuming, and expensive, and the so-called dual will is thus used only if the projected tax savings warrant its use—for example, if a valuable private corporation forms part of the estate. In an era of ongoing budget deficits, Ontario’s apparently continuing struggle with the collection of probate tax gave rise in its 2011 budget to EATA amendments in Bill 173, which became effective after 2012. The amendments in section 4.1 bring EATA’s enforcement under the jurisdiction of the minister of revenue, but they go beyond harmonization and centralization of monitoring and enforcement.

The section 4.1 amendments adopt the minister of revenue’s assessment powers under the Ontario Retail Sales Tax Act. The minister can assess or reassess the estate in the four years following the probate tax’s due date (section 4.5(1)). However, EATA does not contain a clearance certificate similar to that provided for in the Income Tax Act, and thus the minister can apparently assess and seek to collect additional probate tax from the beneficiaries after the estate assets have been distributed but within the four years after the probate tax fell due. Traditional wisdom says that an estate trustee is liable in a representative capacity only and not personally, but commentators have raised the possibility that the beneficiaries may have legal recourse against the estate trustee personally. (See, for example, Barry S. Corbin, “Estate Administration Tax—The Nightmare Begins,” www.oba.org/en/pdf/sec_news _tru_may11_a1_EAT.pdf.) Given the minister’s broad powers, there may be disagreement over an estate’s valuation for probate, especially if a private corporation is involved. Inspectors appointed under the minister have the same powers set out in sections 31(1) to (2.2) of the Retail Sales Tax Act to inspect books, records, and property at any premises where the estate’s goods, books, and records are kept (section 4.7).

Because the assessment period is four years, it is unclear how this provision will be enforced after the assets are distributed. Clearly, the trustee must keep meticulous records—a requirement also essential for a trustee’s EATA due diligence defence—but a trustee will be reluctant to distribute all estate assets before the four-year assessment period expires. Holdbacks may not be sufficient to cover the unpaid tax in the case of undervaluation. A new EATA provision (section 5.1(3)) allows for the exchange of information with provincial and federal government entities. Any trustee who provides a false or misleading statement may be subject to imprisonment or a fine, but may rely on the due diligence defence if “the statement or omission was false or misleading and in the exercise of reasonable diligence [the trustee] could not have known that the statement or omission was false or misleading.”  The practical compliance burden created by a new duty to provide information has raised concern in the tax community. EATA section 4.1(2) provides that “[i]f an estate representative makes an application for an estate certificate, the estate representative shall give the Minister of Revenue such information about the deceased person as may be prescribed by the Minister of Finance.” No regulations have yet been released. It is hoped that the ministry will consult with practitioners before implementation in order to avoid imposing an increased burden on the probate court system and greater delays in the issuance of certificates of appointment of estate trustee. In our view, additional information obtained under section 4.1(2) should not invalidate the dual-wills strategy, which has not been specifically addressed under EATA.

The estate administration tax is levied on the “value of the estate” (a reference is made to the definition of “value of an estate” in section 32 of the Estates Act). Section 32 has not been changed since it was considered in Granovsky, and section 32(3) clearly provides for a limited grant of probate: “Where the application or grant is limited to part only of the property of the deceased, it is sufficient to set forth in the statement of value only the property and value thereof intended to be affected by such application or grant.” In contrast, some other high-probate provinces’ legislation is directed at the dual-wills structure and other strategies. For example, section 86(2) of the Nova Scotia Probate Act expressly provides that the probate tax is imposed “on all assets of the deceased person that pass by a will or wills or that are transferred or will be transferred to a trust under a will or wills.” Even the beneficiary of substantial estate property may hesitate to assume an estate trustee’s role under the amended EATA. Increasingly, affluent testators may plan in order to remove their estate from the reach of the Ontario EATA.

Sunita Doobay

TaxChambers, Toronto

Glenn M. Davis

Toronto

Ten Plus Years to Enactment

Recently published in the Canadian Tax Highlights, a Canadian Tax Foundation Publication and reposted with permission here:

In Edwards (2012 FCA 330) the FCA reversed the TCC motions judge and granted to the taxpayer an adjournment of the hearing of his appeal to the TCC on the merits. The taxpayer sought to adjourn the trial pending enactment of proposed ITA amendments.

In 2003 the taxpayer contributed cash of $3,150 to a leveraged donation program; he was provided with a charitable donation receipt in the amount of $10,000 and claimed the receipted amount for a donation credit. Upon reassessment the minister denied the full credit on the basis that the donation did not qualify as a gift within the meaning of section 118.1 because the taxpayer was deemed to have received a benefit and, alternatively, because section 245 denied the credit. In 2002 the federal government had announced its intention – effective from the date of announcement - to amend the act to deal with leveraged donation programs and the 2012 budget showed an intention to enact those amendments. The CRA had been treating those proposals as if they were enacted, but a taxpayer who is not assessed favourably based on proposals cannot appeal and challenge the minister’s view because the proposals are not in fact law.

On April 23, 2008, the taxpayer commenced an appeal to the TCC under the informal procedure but it was moved to the general procedure upon the Crown’s request. The Maréchaux case was proceeding through the courts at the same time and the taxpayer in Edwards received an abeyance when the taxpayer in Maréchaux was denied leave to appeal to the SCC. The taxpayer in Edwards sought a further abeyance and in July 2012 moved to adjourn the TCC hearing for a maximum of one year from November 26, 2012 on the possibility that the December 2002 proposed amendments would be enacted by then.    

Proposed subsections 248(30), (31) and (32) may allow a credit for the actual cash donated net of the “advantage” received as a result: on the facts the taxpayer argued that he should receive a credit for $3,150, the amount of cash he donated. The technical notes provide that the amendments “are intended to reflect the policy that the amount eligible for an income tax benefit to a donor, by way of a charitable donation deduction or credit or a political contributions tax credit, should reflect the economic impact on the donor (before considering the income tax benefit) of the gift or contribution.” The CRA said that Mr. Edwards lacked the donative intent required to establish the existence of any donation.

The motions judge concluded that denying the adjournment would potentially prejudice the taxpayer by denying him the benefit of arguing that the legislation applied and possibly making the CRA more receptive to settlement. Also the denial might necessitate further litigation for other taxpayers. However, that potential prejudice was outweighed by the public interest in the administration of justice that was inherent in tax litigation proceeding in a timely manner, particularly because tax deductions for $500 million of donations might be affected. According to the TCC, about 18,000 taxpayers participated in similar programs and some 8,000 had been reassessed. Mr. Edwards’ case was selected as the lead case for 8 other appeals held in abeyance pending his appeal to the FCA. The motions judge said that “thousands of other taxpayers are waiting in the wings.” Furthermore the motions judge noted that the appeal involved transactions that occurred almost 9 years ago and the appeal was first set down over two years ago. At the time of the motion’s hearing, “there was very little indication that the legislation will be enacted soon” or if the proposals even applied to Mr. Edwards.

The FCA acknowledged that the granting of an adjournment is generally within the motions judge’s discretion and discretionary decisions of a trial or motions judge are generally subject to significant deference on appeal. The FCA concluded that the motions judge did not commit an error in principle, misapprehend the facts, or otherwise reach an unreasonable decision in the exercise of the broad discretion conferred on her. The trial in Edwards was meant to be a test case: thousands of taxpayers were situated similarly. Perhaps most significantly, on November 26, 2012 - five days before the appeal’s hearing - the proposals and other technical amendments received first reading as Bill C-48; this was a new fact that had not and could not reasonably have been put before the motions judge in July 2012. Moreover if Mr. Edwards’ appeal was heard before the proposals were enacted, another lead case would have been chosen and therefore refusing the adjournment would not promote judicial economy. The introduction of Bill C-48 substantially reduces the uncertainty around the proposals’ enactment and thus an adjournment would cause less prejudice to the public interest in the timely administration of justice. Moreover further delay may have been inevitable because it was not clear that the TCC could reschedule a hearing within the next 12 months in any event.

           

The FCA went on to say that

…there seems something fundamentally unfair in the CRA's administration of proposed amendments to the Income Tax Act for the past ten years as if they were already law. A taxpayer is not able to challenge a decision by the CRA that the proposed amendments do not apply to the circumstances of the taxpayer. I emphasize, however, that I am expressing no view as to whether Mr. Edwards will benefit from the proposed amendments when and if they are enacted.

It seems appropriate for the government to make tax changes retroactive to their announcement in order to prevent taxpayers from re-organizing their affairs to avoid a change’s intended effect. However, in this case the government announced a statement of its intent – which may differ from the court-determined legislative intent – and for a decade the CRA seems to have adopted that stated intent and treated the proposals as if they were enacted law.  

The FCA did not offer insight into any recourse that the taxpayer might have in such cases other than to say that the result seemed fundamentally unfair. Retroactivity is an expectation by a government that its citizens will govern their behaviour based on rules that are not yet law and is also a concession to practical realities: (a) a government must annually decide fiscal priorities, and how to achieve them; (b) the process of transforming priorities into enacting legislation takes time; and (c) the effectiveness of fiscal policy suffers without retroactivity to prevent tax planning and other devices from circumventing policy during the gap between announcement and enactment. However, this rationale assumes that the intervening period is a reasonable length of time. What is a reasonable time frame is a matter for further discussion but is not likely to be made specific by the courts. The FCA has commented on the unfairness of the situation; whether the government will respond and give taxpayers some means of redress is yet to be seen.

Sunita D. Doobay

TaxChambers LLP, Toronto

Darcy L. MacPherson

Faculty of Law, University of Manitoba, Winnipeg

The amendments to the Ontario Estate Administration Act

I will be publishing an article on this topic but wanted to provide in the mean time a link to a presentation I gave to the CMAs here in Toronto a few weeks ago.

When will Canada implement pet trust legislation?

On November 22, 2012, my beloved Rottweiler Paco passed.  He was diagnosed with osteo sarcoma (bone cancer) in October.  The cancer had spread into his lungs.  He would have been 7 on January 19, 2013.  His diagnosis and then death hit me hard.  We had never been informed of this type of cancer by the breeder or by his vets despite the fact that research has deemed this form of cancer as fairly prevalent in large breeds such as the German Shepherd and the Rottweiler.  Not sure what we could have done to prevent him passing from osteo sarcoma but maybe knowledge of this cancer would have enabled us to have caught the cancer at an earlier stage thereby prolonging his life.

He was smart – would open the refrigerator whenever there was filet mignon and help himself and there would be none left for us.  After his diagnosis I ensured that he had filet mignon every night.  Although I had hoped for a miracle we had no choice but to say goodbye once the fentanyl (a drug stronger than morphine) could not mask his pain.  His death emphasized the fragility of life and the intense grief we all felt at the diagnosis and passing and continue to feel illustrate the love we had for him and the love one typically has for a pet.  Although I outlived Paco, I always worried what would happen to him if we were all to pass and leave him behind.  Canada unlike the United States does not have legislation allowing us to create a statutory pet trust which would allow us to settle a trust with our pets as beneficiaries.    

Canada lags behind the United States where to use the language from the Animal Legal Defense Fund valid trusts can be created for “non-human animals”.    The District of Columbia including 41 States ( Alabama, Alaska, Arizona, Arkansas, California, Colorado, Connecticut, Delaware, Florida, Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Maine, Maryland, Michigan, Missouri, Montana, Nebraska, Nevada, New Hampshire, New Jersey, New Mexico, New York, North Carolina, North Dakota, Ohio, Oregon, Pennsylvania, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Utah, Vermont, Virginia, Washington and Wyoming) recognize these trusts as valid.  This recognition of the validity of a trust created for the welfare of non-human animals allowed Leona Helmsley to establish an inter vivos trust under New York State law for the care of her dog of Trouble which was later funded with $12 million as directed by her will.    This amount was reduced to $2 million by the Court when her will was challenged.    

When funding a pet trust in one of the States or in the District of Columbia several considerations need to be made.  The cost of the care giver, will a residence need to be purchased to enable all pets plus the caregiver to reside in the same location.  A valuable overview of issues to be considered by practitioners drafting a trust fund and the settlor of a pet trust are found in HelmsleyPet Trust raises Issues for Owners of all Income Levels  by Frances Carlisle. This article also points out that an inter vivos trust is preferred over a testamentary trust.  An inter vivos trust is created during the life time of the settlor and allows for the care of the animal during the life time of the settlor where the settlor is incapacitated and is thereby unable to look after the animal.

.   

The aforementioned however does not work in Canada.  In Canada a non-human animal cannot be a beneficiary of a trust as an animal cannot enforce the terms of the trust.  I currently don’t have a solution on how to ensure the welfare of one’s pets here in Canada after passing.  I would encourage that we lean on our policy makers to enable a statutory pet trust in Canada similar to the United States.

Can a Charitable Foundation with a Single Trustee be designated as a Public Foundation?

Recently published in the Canadian Tax Journal and reproduced with permission here.

Introduction

The Federal Court of Appeal recently released its decision in Sheldon Inwentash and Lynn Factor Charitable Foundation v. Canada. At issue in the case were the requirements for a charitable foundation to qualify as a “public foundation” for the purposes of the Income Tax Act.

The Effect of the Designation

There are several differences between a private charitable foundation and a public foundation. The main difference from a non-tax perspective is that a private foundation is typically funded by related individuals while a public foundation is typically funded by unrelated parties.

From a tax perspective, there are several additional differences. One important difference is that the Act strictly prohibits a private foundation from carrying on any business. A public foundation, on the other hand, may carry on a business related to the charitable objects of the foundation.

Another notable difference from a tax perspective is that a private foundation, unlike a public foundation, cannot issue donation receipts for non-qualifying securities unless and until such securities are disposed of within 60 months of the date on which the donation was made. A non-qualifying security for these purposes is a security, obligation, or share of a non-arm’s-length corporation. In other words, where a shareholder of a related corporation gifts his or her shares to a private foundation, the donor is unable to take an immediate tax benefit from this transaction, and if the foundation does not  dispose of the  qualifying shares within  the  statutory  time frame, the tax advantage to the donor will be lost.

The Facts

In Sheldon Inwentash, an inter vivos trust was settled by Mr. Inwentash and capitalized by him, his spouse (Lynn Factor), and /or entities controlled by them. While the trust qualified as a charitable foundation and a registered charity under the Act, the min- ister designated the trust as a private foundation, as opposed to a public foundation, in large part on the basis that the trust had only one trustee.

Pursuant to paragraph 172(3)(a.i), the trust appealed the designation directly to the Federal Court of Appeal.

Analysis

The Current Statutory Ambiguity

The court considered the intent of Parliament with respect to whether a charitable foundation with a single trustee could be designated as a public foundation. The Act does not explicitly address this issue. However, section 149.1 does define the term “public foundation” to mean, essentially, a charitable foundation of which

1. more than 50 percent of the directors, trustees, officers, or like officials deal with each other at arm’s length, and

2. not more than 50 percent  of the capital contributed  was paid by a related group.

Neither  the definition nor any other provision of the Act specifies whether a public foundation  must have a minimum number  of directors, trustees, etc., in order to meet the first requirement.

A charitable  foundation  that  is not a public foundation  is considered  to be a “private foundation,” as defined in section 149.1.

The Court’s Decision

Textual Interpretation

The appellant’s main argument was that, while the trust had only one trustee, on the basis of the wording of the definition of “public foundation,” this did not constitute a violation of the arm’s-length requirement.

The court disagreed. The court held that the intention of Parliament was to ensure that public foundations have more than one trustee. There were three reasons for this. First, it is implicit in the reference in section 149.1 to “more than 50% of the . . . trustees” that there be more than one. Second, section 149.1 states that all of the trustees and other like officials should be dealing with “each other”; if the trustees are required to “deal with each other,” there must be more than one. Third, if the trustees must deal with each other at arm’s length, there is a requirement of multiple trustees. One cannot be at arm’s length from oneself. The court therefore held that there must be more than one trustee.

During the oral argument, counsel for the appellant suggested that the court should read out or not apply certain words in the definition when there was only one trustee. Yet the legislature is presumed not to speak in vain. Every word in the statute is generally considered to be in the statute for a reason [Ruth Sullivan,  Sullivan on the Construction of Statutes, 5th ed. (Markham, ON: LexisNexis Canada, 2008), at 530.].  This, the court held, was a reason not to accept the statutory interpretation put forward by the appellant.

It appears that Dawson JA was prepared to decide the case on this textual interpretation, but she chose to extend her analysis:

In my view, by the use of this language Parliament has precisely and unequivocally evidenced its intent that public foundations must have more than one trustee (or director, officer or like official). This means that the ordinary meaning of the words used should play the dominant role in the interpretation of the definition. For completeness, however, I will review the statutory context and purpose of the definition.

Context and Purpose

The court held that the statutory context and the purpose of the “public foundation” definition clearly indicated that, in choosing different treatment of public and private foundations, the federal government was concerned about potential abuse through self-dealing transactions.[1]

Charitable foundations can be used to mask self-dealing transactions and avoid taxes for the principals behind the foundation. The court provided two examples of such transactions:

 1. having the charity rent premises from the donor at high rent; and

2. investing in low-yield debt or equity of the donor’s business.

The court reviewed a publication from the Department of Finance and concluded that by creating public and private foundations, Parliament was balancing a desire to promote philanthropy with a concurrent desire to limit the potential for avoidance schemes.[2] A requirement for multiple trustees/managers[3] is one way to ensure that one party cannot control the work of the foundation at issue, and thus to reduce the likelihood of self-dealing transactions. If many people are involved in filling management positions and in giving money, there will likely be multiple layers of oversight of the activities of the charitable foundation.  This makes it more difficult for any individual or group to arrange the affairs of the foundation so as to benefit that individual or group, rather than the charitable purposes for which the foundation was created. If these safeguards against the possibility of self-dealing are in place, the designation of “public foundation” will give greater latitude to the charity. Conversely, if the setup and operation of the charitable foundation is unlikely to prevent self-dealing by its founders, or by other individuals or groups, the law provides specific restrictions  (as noted above) that are designed to remove the tax benefits that may otherwise have been part of the reason for creating the foundation in the first place. Therefore, the law creates an incentive for oversight and commitment to charitable purposes, rather than an opportunity for self-dealing.

A parallel concept to the distinction in the Act between a “public” and a “private” charitable foundation can be found in corporate law. In that context, the same nomenclature is often used in popular discourse to describe the distinction between corporations subject to public securities regulation and other corporations. Generally, there are different rules governing the control of public corporations. For example, under the Canada Business Corporations Act (“CBCA”), “distributing  corporations”  (which generally would all be “public” corporations) are expressly required to have at least three directors, at least two of whom must not be either officers or employees of the corporation.

The point of this requirement is to ensure that management[4] is accountable to persons who are not dependent on the corporation for their livelihood.[5]  In a “public” or “distributing” corporation, a solicitation of funds from the public is made.[6]  At the same time, the involvement of most shareholders in the corporation is minimal and intermittent, through shareholder meetings.18  Yet shareholders are the residual beneficiaries of the activities of the corporation.19 Thus, certain safeguards are put in place to ensure that the members of management do not enrich themselves at the expense of the shareholders.20  In the simplest terms, the use of outside directors (who are neither part of management nor employed by the corporation) is designed to discourage self-serving behaviour. In the same way, public foundations are subject to a less restrictive regulatory regime under the Income Tax Act than that applied to private foundations, presumably on the basis that the involvement of arm’s-length directors and funding from third parties will prevent any self-dealing that would allow unwarranted tax benefits.

The Interpretation Act Argument

The appellant argued that section 33(2) of the federal Interpretation Act applied. That provision states that “words in the plural include the singular.” The court rejected this argument, relying on section 3(1) of the Interpretation Act, which states as follows:

 (1) Every provision of this Act applies, unless a contrary intention appears, to every enactment, whether enacted before or after the commencement of this Act [emphasis added].

The court held that the use of the terms “more than 50%,” “deal with each other,” and “at arm’s length” in the definition of “public foundation” clearly indicated a contrary intention to the application of section 33(2) of the Interpretation Act.

Conclusion

Sheldon Inwentash is an example of a case where the court reached the right result on the facts before it, using a textual, contextual, and purposive interpretation. However, in the end, it is not likely a decision that will present a major obstacle to taxpayers, since it should be easy for a foundation to appoint two arm’s-length trustees. Rather, it is the second branch of the “public foundation” definition (whether as currently drafted or as proposed in technical amendments released on July 16, 2010)[7] that will present the bigger obstacle. While this second branch was at issue in Sheldon Inwentash, the court decided that it need not address it, given its finding on the first branch.

---

[1] CBCA section 120 provides a series of procedural and substantive requirements to validate a self-dealing transaction. Absent compliance with this provision, under both the statute (CBCA section 120(8)) and the common law (Aberdeen Railway Co. v. Blaikie Bros., [1843-60] All ER 249 (HL)), the transaction will be invalidated by the court.

[2] The court cited Canada, Department of Finance, Discussion Paper: The Tax Treatment of Charities (Ottawa: Department of Finance, 1975). In addition to the issues identified by the court, the discussion paper contained the following comments (at 9, paragraphs 20-21): “The creation of such [private] charities may have significant tax consequences. Most importantly, the charity is exempt from all taxes on its income, subject to the distribution rules which normally require that 90 per cent of the annual income be paid out each year. Other tax consequences follow from the fact that subsequent contributions to the charity are tax-deductible within prescribed limits and that bequests are, in some provinces, free of succession duties. It has become evident in recent years that a few taxpayers have been abusing the opportunity to establish private charities. The most common abuse has been in arranging investments and expenses to ensure that the charity has little income and pays out a relatively small sum annually in comparison to its capital. This may be done by having the charity invest in low-yield debt or equity of the donor’s business, by renting premises from the donor at high rent, by paying family members high salaries for relatively little work or by lending money to family members at low rates of interest.”

[3] In our view, the words “directors, trustees, officers or like officials” in the definition of “public foundation” in section 149.1 is meant to cover all categories of management personnel. Regardless of the title given to the person (director, officer, trustee), or the legal form used (corporation, trust, or other legal form of a charitable foundation), if the person is reasonably part of the management team of the foundation, he or she is subject to the rules that are designed to reduce the likelihood of self-dealing with the foundation. For further discussion, see the text following note 5 below.

[4] “Management” in this case refers to the collectivity of directors and officers of the corporation who manage its strategic directions as well as its day-to-day affairs. See J. Anthony VanDuzer, The Law of Partnerships and Corporations, 3d ed. ( Toronto: Irwin Law, 2010), at 15 and 254-55. Section 102(1) of the CBCA requires that directors either manage or supervise the management of the business and affairs of the corporation. Practically, it is far more common for directors to do the latter while leaving day-to-day management concerns to the officers of the corporation. The board of directors often meets a limited number of times throughout the year to review the affairs of the corporation and make large-scale strategic decisions: VanDuzer, supra, at 255. Therefore, depending on how the power is divided, both officers and directors effectively have management power.

[5] Officers and employees are generally expected to devote most (if not all) of their professional efforts to the business and affairs of the corporation, and it is their actions that often determine corporate success. The appointment of non-executive directors, as required by CBCA section 102(2), is therefore intended to provide an important check on the power of officers and other employees. For a fuller discussion of the role of non-executive directors in governance in both theory and practice, see, for example, Derek Higgs, Review of the Role and Effectiveness of Non-Executive Directors (London: Department of Trade and Industry, January 2003).

[6] Jeffrey G. MacIntosh and Christopher C. Nicholls, Securities Law ( Toronto: Irwin Law, 2002), at 139 and 254.

[7] Canada, Department of Finance, Legislative  Proposals To Amend the Income Tax Act and Related Legislation To Effect Technical Changes and To Provide for Bijural Expression in That Act (Ottawa: Department of Finance, July 16, 2010), part 1, subclause 109(1).

DEATH OF THE SHAREHOLDER – A REVIEW OF THE PIPE LINE STRATEGY

In December, 2012 I successfully obtained a pipeline ruling from CRA.  However prior to that I had written an article for the newsletter I edit titled "Privately Held Companies & Taxes", published on TaxnetPro, Carswell, a division of Thomson Reuters.  I have reproduced the article with permission here and hope you find it as interesting as I did in writing it.

Introduction

It is human nature to not contemplate the possibility of death even though it is a certainty rather than a possibility. Usually when a shareholder of Canadian Controlled Private Corporation (“CCPC”) contemplates estate planning such planning is often limited to an estate freeze and no consideration is given to post-mortem planning.  Post-mortem planning is important because under the Income Tax Act (“ITA”) – a deceased shareholder of a CCPC and their beneficiary would otherwise be double taxed on his/her holding in such CCPC.

Double taxation at death

Upon death, shareholders are deemed to have disposed of all of their assets immediately before death at fair market value to the estate of the deceased shareholder.  The tax on the capital gains triggered on the disposition is reflected on the terminal return of the deceased shareholder.  As the estate is deemed to have acquired the deceased’s shares at fair market value (“FMV”) at time of death, the adjusted cost base (“ACB”) of such shares is bumped up to the FMV at time of death.  If there is a purchaser for the shares then there would be no additional level of tax assuming that the acquisition would be at FMV equal to the FMV at time of death. 

However, it may be difficult to find a purchaser for the shares of a CCPC thus requiring a distribution of the CCPC’s retained earnings to the beneficiaries of the deceased shareholder and subsequent wind-up of the CCPC.  Winding up the corporation will trigger a second level of tax pursuant to subsection 84(2) of the ITA  because a redemption of the shares will be deemed a taxable dividend.  Subsection 84(2) comes into play because although the ACB of the deceased’s CCPC shares has increased, the paid up capital of such shares has  not increased to reflect the fair market value at death.  Nor would the ACB of the assets held by the corporation have increased.  The sale of such assets and distribution of the proceeds will trigger a taxable dividend regardless of the recent capital gains paid on the shares on the terminal return of the deceased shareholder.

The following example best illustrates the double taxation that is levied on a deceased shareholder’s corporate assets:

1.       Mr. A., a widower, dies owning all of the shares in Holdco, which is not a small business corporation.  Holdco holds cash of $100,000.  The fair market value of Holdco’s shares is $100,000 and Mr. A’s cost in the shares is $10.00. Mr. A leaves the company to his adult daughter S.

2.       Under the deemed disposition rules of subsection 70(5) ITA, the estate is deemed to have acquired Mr. A’s shares at a tax cost of $100,000 triggering  a capital gains on Mr. A’s terminal return of $99,900 .  As a resident of Ontario, Mr. A.’s tax on the taxable capital gain of $49,995 at the top marginal rate on income under $500,000 of 46.41%   would be $23,203 .

3.       Assuming no further tax planning – S’s cost base in Holdco’s shares would be  the FMV  at which the estate acquired the shares   A wind-up of Holdco would result in a taxable dividend pursuant to subsection 84(2) of the ITA to S.

Mr. A on his terminal return would have paid $23,203 on the $100,000 FMV of his shares which reflected the value of the assets held in the corporation at time of death.  On the receipt of the distribution of $100,000 cash, the daughter of Mr. A. would have to pay $32,570 in tax at the top marginal rate on income under $500,000 resulting in the $100,000 value of the corporation being taxed twice.

The “pipe line” strategy is a strategy used   to minimize exposure of the second level of tax pursuant to subsection 84(2).

The Pipe Line Strategy

The pipe line strategy avoids the triggering of a deemed dividend under subsection 84(2).  It is a post-mortem strategy whereby only capital gains tax is payable at death under the deemed disposition rules of subsection 70(5) of the ITA.  It allows for the extraction of assets equal to the gain realized on death on a tax-free basis.  This is achieved by the estate transferring the inherited shares to a new holding company in exchange for a promissory note equal to the ACB of the shares transferred.  In other words the pipe line strategy converts the ACB of the shares held by the estate into a loan allowing for the extraction on a tax-free basis the assets of the corporation equal to the ACB of the shares held by the estate.

The following example cited by the illustration of the 2009 APFF – Round Table on the taxation of financial strategies and instruments is as follows:

·         Assume the taxpayer is holding all of the shares of a taxable Canadian corporation (hereafter called “ACO”), which is not a SBC, having a FMV of $100,000 and a cost of $100;

·         ACO has cash totaling $100,000, no liabilities, $100 in capital stock and $99,900 in retained earnings;

·         At his death, the taxpayer is deemed to have disposed of his shares for $100,000 and realizes a capital gain of $99,900;

·         The estate of the taxpayer is deemed to have acquired the shares for an amount of $100,000, which corresponds to the cost and the fair market value of the shares for the estate;

·         The estate incorporates a new taxable Canadian corporation (hereafter called “BCO”) and subscribes to 100 common shares therein for $100;

·         The estate sells the shares of ACO to BCO for a price of $100,000 payable by the issuance of a non-interest bearing demand note.  No tax arises from this.

·         ACO is then wound-up into BCO and all of its property is transferred to BCO;

·         Upon receipt of the property of ACO, including the cash totaling $100,000, BCO repays the note of $100,000 which is payable to the estate;

·         BCO is then dissolved;

·         Estate gives the amount of $100,000 which came from ACO to the heir(s).

However tax law is never predictable.  Currently in order to obtain a favourable ruling not subjecting the distribution to subsection 84(2) or the GAAR provision of subsection 245(2), CRA has imposed a one year delay for the estate to wind the corporation up into the holding company.   (See rulings 2002-0154223, 2005-0142111R3, Round table discussion at the 2009 APFF – CRA document no. 2009-0326961C6 and 2011 STEPs Roundtable, Q.5 2011 – 0401861C6).

This one year delay is not mandated in the ITA and has caused concern within the tax community.  The one year wait would negatively affect cash companies as evidenced in at the 2011 Annual CTF Conference where CRA stated

“the context of a series of transactions designed to implement a post-mortem pipeline strategy, some of the additional facts and circumstances that in our view could lead to the application of subsection 84(2) and warrant dividend treatment could include the following:

•The funds or property of the original corporation would be distributed to the estate in a short time frame following the death of the testator.

•The nature of the underlying assets of the original corporation would be cash and the original corporation would have no activities or business ("cash corporation").”

Dr. Robert Macdonald v. The Queen, 2012 TCC 123

The validity of the one year waiting period was challenged in the recent case Dr. Robert Macdonald v. The Queen, 2012 TCC 123 (“Macdonald”).  This case, although it did not deal with a deceased shareholder nonetheless employed the pipe line strategy to extract cash from a cash corporation.  CRA challenged the transaction under subsection 84(2) (deemed dividend) and under the section 245(2)  (GAAR) of the ITA.

The pipe line was engaged because the taxpayer Dr. MacDonald was moving to the United States and had ceased his Canadian residency on the 25^th of June 2002.  He had been unable to sell the shares of his medical professional corporation to a third party.  The corporation held $525,068 in cash.  Dr. MacDonald’s ACB in his professional medical corporation shares was only $101.  The dilemma Dr. MacDonald faced was that the entire gain would be taxable in the United States due to his residency in the U.S.  Although he had sufficient capital losses carried forward, (his capital losses accumulated while a resident in Canada),  to offset the gain in Canada  such losses could not be used to offset the gain now taxable in the US. 

The doctor had a choice on whether to structure the extraction as a sale utilizing the pipe line strategy or through a windup meaning he would receive the cash as a dividend. The Tax Court of Canada (“TCC”) in considering the facts stated at paragraph 130:

The reality in this case is that aside from the Appellant’s use of losses, the tax on capital gains in New Brunswick in 2002 differed considerably compared to the tax on dividends. Indeed, in the case of a privately-held corporation, like PC, the lack of integration, at the time the subject transactions were undertaken, favoured capital gain treatment by some nine percent in New Brunswick relative to the tax on a dividend of the same amount.

The pipeline strategy was implemented by Dr. MacDonald’s advisors as follows:

1.       J.S., Dr. MacDonald’s brother-in-law, incorporated a numbered company 601 Ltd on June 20, 2002.

2.       On June 25, 2002, J.S. acquired Dr. MacDonald’s shares in his professional medical corporation (PC) by means of a promissory note to Dr. MacDonald.

3.       601 Ltd. acquired on the 25ht of June, 2002 the shares of PC from J.S.  J.S. received as consideration shares in 601 Ltd. and a note payable by 601 Ltd. in the amount of $525,068.

4.       PC declared two dividends on June 25, 2002, one in the amount of $500,000 and the other in the amount of $10,000.  PC issued two cheques to 601 Ltd. as the PC shareholder at the time the dividend was declared in partial payment of the $500,000 dividend.  601 Ltd. in turn endorsed the cheques to J.S. as partial payment of the 601 note and J.S. in turn endorsed the cheques to Dr. MacDonald as partial payment of the J.S. note.

5.       PC in conformity with the rules of the N.B. College of Physicians and Surgeons changed its name to a numbered company 509 N.B. Ltd as Dr. MacDonald was no longer a shareholder.

6.       A final dividend was declared on September 1, 2002 equal to the amount still owing on the 601 Ltd. note and an amount equal to the unpaid portion of the dividend declared on June 25, 2002 was paid as an acknowledged indebtedness to J.S. booked by 509 NB on direction of J.S. as an indebtedness to Dr. MacDonald.

7.       On July 15, 2002 509 NB paid by cheque  601 Ltd the amount of $10,000 which was deposited on the 27^th of August, 2002.

509NB prepared Articles of dissolution on July 31, 2002 and was officially dissolved on February 4, 2005.

The TCC strongly rejected CRA’s argument for the court to look through the transfer to J.S. and deem Dr. Macdonald to be the ultimate beneficiary of the distribution pursuant to subsection 84(2) of the ITA on the basis that this section is not a re-characterization provision.  The TCC at paragraph 61 and 62 held:

In any event, it is not the promise or foreseeability of a benefit while a shareholder that triggers the operation of subsection 84(2). The requirement of that provision is that there be a distribution or appropriation in any manner whatever for the benefit of a person who is a shareholder at the time of that distribution or appropriation. A structure undertaken while a shareholder that ensures, by a series of transactions, access to corporate funds to satisfy a debt created as a result of ceasing to be a shareholder, is not the same as being in receipt of such funds, or being in receipt of a benefit, qua shareholder.  Accordingly, it remains my view that the words of subsection 84(2) do not impose a requirement to re-characterize payments to a creditor as payments to a shareholder.

The TCC rejected CRA’s imposed one year wait rule in paragraph 78 to 80 as follows:

The CRA has issued advance income tax rulings that such post-mortem pipeline transactions will not be subject to subsection 84(2) if the liquidating distribution does not take place within one year and the deceased’s company continues to carry on its pre-death activities during that period. This post-mortem plan clearly parallels the Appellant’s tax plan in the case at bar. Both plans provide access to a corporation’s earnings in a manner that avoids dividend treatment. As well, both situations deal with a time of reconciliation – death and departure from Canada. The conditions imposed on the post-mortem transactions, if imposed in the case at bar, would show that the CRA’s assessing practice was consistent in trying to apply subsection 84(2). The message seems to be: do the strip slowly enough to pass a contrived smell test and you will be fine.

This is not a satisfactory state of affairs in my view. The clearly arbitrary conditions imposed are not invited by the express language in subsection 84(2). I suggest that they are conditions imposed by the administrative need not to let go of, indeed the need to respect, the assessing practice seemingly dictated by RMM. Make it “look” less artificial and the threat of subsection 84(2) disappears. This unsatisfactory state of affairs more properly disappears once it is accepted that subsection 84(2) must be read more literally in all cases and GAAR applied in cases of abuse.

The TCC further concluded that GAAR did not apply as subsection 84(2) did not expressly identify a tax benefit.  The fact is that the taxpayer, Dr. Macdonald, had a choice to extract the retained earnings by ways of a dividend or by way of as capital gains.  The TCC concluded at paragraph 132:

The tax avoidance and tax benefit resulting from a lack of integration in this case is systemic. There is no unintended tax slippage in this sense, and in such circumstances GAAR cannot be used to prevent a tax planned approach to accessing retained earnings. Said differently, neither subsection 84(2) nor GAAR can be used to fill a gap between two approaches to taxing an individual shareholder’s realization of accumulated after-tax funds in a company. There must be more. Subsection 84(2) does not employ language that attacks tax abuse issues arising from surplus strips. Section 245 does. As stated earlier in these Reasons – it is a better litmus test to identify strips that offend the spirit and objects of the Act read as a whole. Unless, an abusive tax benefit results from the avoidance series of strip transactions, the tax result stands undiminished. Avoidance transactions alone do not frustrate the principles set out in the Duke of Westminster.

Conclusion

What does this all mean?  Macdonald advocates that the post-mortem pipe line does not invoke subsection 84(2) as it is not a re-characterization provision authorizing a look-through of the steps undertaken to ensure the first shareholder is not ultimately subject to subsection 84(2).  That said it is prudent to follow existing CRA rulings which currently mandate the one year waiting period and to still obtain a ruling to substantiate that position.  After all, although the Tax Court’s decision is very convincing, its decision is being appealed.  On April 17, 2012 an appeal of the decision was filed with the Federal Court of Appeal.

The one year waiting period ensuring that the business continues to be carried on is essential to obtaining a favourable ruling.  As such when planning is undertaken, a shareholder of a CCPC must contemplate the corporation’s survival for one year after death and ensure that his or her heirs is aware of this requirement.  

Income Tax Treaty between Canada and Hong Kong Special Administrative Region of the People’s Republic of China

This article was first published in the December, 2012 edition of Carswell TaxnetPro's publication Private Companies and Taxes.

On the 11^th of November, 2012, the Government of Canada signed a tax treaty (“Treaty”) with Hong Kong.  The treaty will come into force the first day of January in the calendar year following the calendar year in which the treaty is ratified.  Hong Kong continues to enjoy a high degree of autonomy since its 1997 handover to China. Hong Kong is therefore not covered under the Canada – China tax treaty.  The Treaty as will be seen further in this article has more favorable withholding rates to that of the Canada – China Treaty.    The Treaty is similar to the tax treaties Hong Kong has entered to since 2009.  In 2009 Hong Kong was almost placed on the Grey List by members of the OECD as a jurisdiction that had committed to internationally agreed tax standards but had not implemented such standards.  The standard causing grief to the OECD members was “the exchange of information standard” based on Article 26 of the 2004 OECD Model Tax Treaty.  In order to avoid the possibility of being placed on the grey list which would have led to repercussions from member OECD states, Hong Kong was required to enter into 12 comprehensive income tax treaties so as to be regarded as a fully cooperating tax jurisdiction.  Hong Kong complied and has since 2009 entered into comprehensive tax treaties with more than 22 jurisdictions which include the Netherlands, Switzerland, China and Luxemburg.

All of Hong Kong’s tax treaties are based on the exchange of information standard contained in Article 26 of the 2004 OECD Model Treaty but deviate from Article 26 with the provision that the information exchanged must not be disclosed to any third jurisdiction for any purpose.  The exchange of information is only from the date the treaty is ratified and will not apply retroactively. 

The withholding tax rates in the Treaty are as following:

·        5% for dividends where at least 10% of the shares is held by the parent company;

·        10% for dividends paid in all other cases;

·        10% for interest charged between related parties – nil for interest between unrelated parties;

·        10% for royalty withholding.

However as Hong Kong does not have a withholding tax on dividends and interest, the focus of the rates is a reduction of the 25% rate imposed by the Income Tax Act on payments made from Canada to Hong Kong.  Currently the Canada – China Tax Treaty withholding rate is 10% for interest, dividends and royalties and as such the Hong Kong Treaty would be attractive to a Chinese corporation carrying on operations through a corporation in Canada.  However a careful read of the withholding provisions is mandatory to ensure compliance with the Treaty.

Although the Treaty does not contain a Limitation of Benefits clause the wording of a Limitation on Benefits clause is found in the royalty, interest and dividend articles.  This is seldom seen in treaties negotiated by Canada.  The purpose of a limitation of benefits clause is to ensure that a treaty is not used by an entity from a different jurisdiction that is not party to the treaty.    

For Canadian corporations carrying on business in Hong Kong through a corporation the Treaty will be good news as a Hong Kong corporation will qualify upon ratification of the treaty as a foreign affiliate situated in a designated treaty country.  This would allow dividends returning to Canada from the Hong Corporation’s active surplus to be exempt from tax in Canada. 

Sunita Doobay LL.B., LL.M., TEP, TaxChambers, Toronto