Year: 2022

A July 28, 2022, Tax Court of Canada case considered whether input tax credits (ITCs) in respect of a farming operation’s expenditures were available. The farming activity consisted of breeding and racing various horses and involved at least four full-time employees at one point. Over a nine-year period (2007 2015), the operations never experienced positive net earnings and more than $4 million in losses were accumulated. The owner partially financed operations with earnings from his law practice.

In order for ITCs to be available, supplies must have been made in the course of a commercial activity. For a commercial activity to have occurred, there must have been a reasonable expectation of profit.

The Court considered the following criteria when determining whether the taxpayer carried on a commercial activity:

• profit and loss experience;
• the taxpayer’s training;
• the taxpayer’s intended course of action; and
• the capability to show a profit.

Taxpayer loses

While the Court noted that the taxpayer was clearly passionate and knowledgeable about horses and had invested significant funds and time, it was insufficient to demonstrate that there was a reasonable expectation of profit. Ultimately, the Court found that the taxpayer’s lack of financial organization (he did not have financial statements) and lack of financial tools left him without the ability to diagnose the causes of his farm losses. Without the ability to understand the losses, he did not have the ability to truly stem them, and therefore he did not have a reasonable expectation of profit. The ITCs were denied.

ACTION ITEM: Ensure to sufficiently compile financial records and information such that you can reasonably identify the profitability problems in your operation.

The Canadian Income Tax law states that taxpayers are deemed to dispose of all of their property at fair market value immediately prior to death.   This can result a significant income tax liability in the year of death.  If the estate includes shares of a small business, the lack of funds to pay this liability may make it difficult to continue the business and keep it in the family.  This deemed disposition can be deferred when assets are left to a spouse or a spousal trust, but this is only a temporary solution to the problem and does not solve the problem when the shares are transferred to the children.

The purpose of an estate freeze is to transfer the future increase in the value of assets to other individuals.  In most cases, this would be other family members but could also include a key employee of the family business.  The transferor retains the current value of his/her shares and defers the income taxes on the capital gain to the time of their actual or deemed disposition.

By entering into a freeze transaction, the transferor can determine the taxes that will be due on his/her death.  Knowing what the future liability will be makes it easier to plan.  For example, a life insurance policy may be considered as an option to fund the liability.

To accomplish the estate freeze an owner of a small business corporation exchanges his/her common shares for fixed value preference shares with dividend rights.  New common shares are then issued to the new shareholders.  They will enjoy the benefits of the future growth of the business. This will result in a lower capital gain on the deemed disposition when the transferor dies. One of the reasons for a freeze is to transfer the business to the next generation.  However, consideration must be given to the share structure to allow the transferor to retain control of the business and, if he/she wants, provide a source of income by paying dividends on his/her freeze shares.

Careful consideration must be given to the value of the shares of the corporation that is being frozen.  In many cases, it is recommended that a Chartered Business Valuator be engaged to determine the value of the shares.  Unwanted tax consequences could result if the Canada Revenue Agency successfully challenges that the value of the fixed value preference shares does not line up with the value of the corporation at the time of the freeze.

What should be done if you as the business owner want to enter into an estate freeze but you are not sure whom you want the future growth to go to or your children are too young to have share ownership?  In this situation, it would be a great idea to create a family trust to hold the new common shares.  A family trust allows you to put off this decision for up to twenty-one years.  Beneficiaries of the trust normally include all family members.  At some date in the future, the trustees of the trust give the shares to the chosen beneficiaries.  This is a non-taxable event.  To provide for maximum flexibility, the business owner would also be a beneficiary of the trust in the event he/she decides not to transfer future growth and effectively decides to cancel the freeze. In certain circumstances income splitting can be achieved by paying dividends to the trust and then allocating the funds to beneficiaries. It is recommended that you seek professional advice before undertaking such tax planning and to help with the creation of a family trust.

Often the freeze shares that the transferor receives are redeemed over a number of years as part of their retirement income.  This spreads out the tax liability and reduces the liability to their estate.

Individuals who have a significant portfolio of investments may want to consider implementing an estate freeze.  To do so they would incorporate a holding company in which to transfer the portfolio.  At the end of the transactions, the individual will own fixed value preference shares of the holding company and possibly a note receivable from the holding company with a combined value equal to the value of the stock portfolio.  Other family members or a family trust will hold the common shares.  Careful planning is required, including proper tax filings in order to transfer the portfolio to the holding company on a tax-deferred basis.  In addition, the transferor needs to be aware of and to plan around the corporate attribution rules of the Income Tax Act, which could have a negative effect on the planning for years into the future.

In summary, an estate freeze can be a very good tax-planning tool but there are a number of items that must be addressed and considered before undertaking such a plan.  A bad plan could result in an unwanted tax bill.   The plan should be tailored to fit your needs. 

On Aug. 9, 2022, the Canadian Department of Finance released draft legislation containing proposed targeted amendments to the foreign accrual property income (FAPI) rules to prevent taxpayers from gaining a tax deferral advantage by earning certain types of income (including investment income) through controlled foreign affiliates (CFAs) that are held by Canadian-controlled private corporations (CCPCs) and substantive CCPCs (SCCPCs). These proposed amendments apply to taxation years ending on or after April 7, 2022.

Background

Certain passive income (including investment income) earned by a CFA of a Canadian taxpayer is included in the Canadian taxpayer’s income on an accrual basis as FAPI. If the Canadian taxpayer is a CCPC, it is potentially not liable to tax on the FAPI because of the offset available due to the current relevant tax factor (RTF) of four. That is, if the CFA pays a foreign tax of at least 25 per cent, the CCPC can claim a foreign accrual tax (FAT) deduction of four times the FAT which results in a complete deferral of Canadian tax on FAPI earned by a CCPC until amounts are paid out to individual shareholders as dividends. However, a similar income earned by the CCPC in Canada would have been subject to a tax rate of approximately 50 per cent, which is why the government introduced the change.

The most recent budget and the draft legislation proposed to amend the RTF for CCPCs and SCCPCs to 1.9 such that there will be some income inclusion for CCPCs and SCCPCs from FAPI earned by their CFAs. This will result in immediate tax implications on the CCPCs and the SCCPCs as illustrated below.

For illustration purposes, assume a CFA earns a FAPI of $1,000 and pays a foreign tax of 25 per cent (i.e., FAT of $250) and no withholding tax is applicable. The below considers the tax implications on the payment of dividends by the CFA to its Canadian parent corporation (Canco).

*The current RTF is four. The government has proposed to change the RTF to 1.9.

Further, to address integration as a result of the changes to the RTF, certain amendments have been proposed to the capital dividend account (CDA), the general rate income pool (GRIP), and the low rate income pool (LRIP). Although there are proposed amendments to LRIP, for the purposes of this article, we will focus on the CDA and the GRIP account.

1. CDA allows amounts that have borne a sufficient level of tax to be declared tax-free to the shareholders. Although the calculation for CDA is long and complex, the most common inclusion is the non-taxable portion of capital gains. The draft legislation has proposed to add to the CDA the amount computed as (RTF-1) multiplied by foreign income tax paid by the CFA less any withholding tax paid in respect of the dividend (our illustration did not consider a withholding tax in the foreign jurisdiction). From the example above, $250 multiplied by (1.9-1), or $225, would be added to the CDA of the Canadian recipient corporation which can be paid tax-free to its shareholders.
2. GRIP reflects the amount of a corporation’s after-tax income that was subject to tax at the general corporate tax rate. The existing legislation adds to the GRIP all amounts that are received as dividends from FAs to the extent they are deductible under section 113 of the ITA. The draft legislation proposes to remove from GRIP of a CCPC the amounts that would be deductible under section 113 (applies to amounts paid from hybrid surplus or taxable surplus). However, amounts paid from exempt surplus (or pre-acquisition surplus) can still be added to the GRIP.

From the example above, under the existing legislation the entire amount of dividends received from the CFA, i.e., $750, are added to the GRIP which can be paid as eligible dividends to Canco’s shareholders. However, subsequent to the passing of the draft legislation, no amount would be added to the GRIP. Instead, the amount of taxable dividend would be declared as a non-eligible dividend which is subject to a higher tax.

The below table illustrates the tax implications when Canco receives the dividends from its CFA and pays them to the shareholder. Please assume no withholding tax for the purposes of the illustration.

*Tax deduction computed as (RTF-1) * foreign tax paid.

**Computed as FAPI less permanent portion of corporate tax from the table above.

***Under the proposed rules, the amount computed as (RTF-1)* foreign tax paid is added to the CDA pool that can be declared tax-free to shareholders.

****Under the current rules, this amount of deduction under subsection 113(1), see * above, is added to the GRIP and can be declared as an eligible dividend.

*****Under the proposed rules, only non-eligible dividends can be declared on investment income.

As the illustrations above highlight, there is currently a tax deferral of $295 available to the extent Canco does not declare dividends to its shareholders immediately. This deferral will not be available once the proposed legislation is enacted.

What to do?

Shareholders of CCPCs that earn FAPI should examine their structure to understand the impact of the proposed legislation and whether there are restructuring options available to minimize the potential tax exposure.

This article was written by Austen Ramsay, Nakul Kohli, Carina Tong and originally appeared on Dec 11, 2022 RSM Canada, and is available online at https://rsmcanada.com/insights/services/business-tax-insights/new-rules-for-canadian-corporations-earning-passive-income.html.

The information contained herein is general in nature and based on authorities that are subject to change. RSM Canada guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM Canada assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

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Directors can be personally liable for payroll source deductions (CPP, EI, and income tax withholdings) and GST/HST unless they exercise due diligence to prevent the corporation from failing to remit these amounts on a timely basis.

An August 31, 2022, Tax Court of Canada case found that the director was not duly diligent and therefore was personally liable for the corporation’s unremitted payroll deductions, interest, and penalties of $78,121 from January 2011 to April 2012.

The taxpayer argued that he was duly diligent as he asked at the directors’ meeting each month whether the tax remittances were up-to-date and received oral confirmations that they were. The taxpayer stated that he had “checked the box” at each directors’ meeting. He also argued that his decisions were driven by materiality; he focused his efforts on the corporation’s overall well-being and safeguarding the millions of dollars of investment, rather than the payroll remittances that he considered “tiny.”

Taxpayer loses

The Court ruled that the taxpayer was not duly diligent in preventing the failure to make adequate payments. It noted that the taxpayer never contacted CRA to confirm whether payroll remittances were current, which was particularly problematic as he was unable to obtain reliable financial statements and was aware ofthe difficult financial situation. While it was the taxpayer’s view that this was someone else’s job, there was no evidence of the taxpayer ever asking anyone else to follow up with CRA.

ACTION ITEM: Prior to accepting any role as a director, ensure to fully understand your responsibilities and potential exposure to personal liability. If currently acting as a director, make sure to be duly diligent in ensuring payroll and GST/HST payments are properly made.