Tax Quarry

In October 2003, the Department of Finance released legislative proposals regarding the deductibility of interest and other expenses for income tax purposes.  According to the government, the proposals were drafted in response to certain court decisions that departed significantly from what was believed to have been the law on this issue. 

Generally, expenses incurred to earn income from property or business are deductible under the Income Tax Act.  The CRA has always interpreted income to mean net revenue and capital gains were excluded from the calculation.  A number of recent court decisions offered an alternative approach that challenged this interpretation.  These decisions interpreted income as gross revenue and included capital gains as part of the calculation.  Because of the uncertainty these diverging view points created, the government believed it was necessary to clarify the law and ensure a consistent approach to this issue by introducing proposed section 3.1.

Essentially, under proposed section 3.1, a taxpayer would be able to claim a loss from business or property if it is reasonable to expect that a profit would be realized for the period that the taxpayer has carried on, and can reasonably be expected to carry on a business or has held property.  The proposal specifically excludes capital gains and losses from the calculation of profit. 

After announcing the draft proposal, the government provided a public consultation period that was extended to August 2004.  A number of concerns were raised during the consultation period regarding the structure of the proposal.  The main concern was that the introduction of an objective “reasonable expectation of profit” test into the statutory language of the Act would inadvertently limit the deductibility of ordinary business expenses.  Specifically, there was a concern that the proposal would deny losses even where there was a reasonable expectation at the beginning of a venture that subsequently did not generate profit.  Since disallowed losses could not be carried forward this would be a disadvantage to many start-up businesses.

On February 23, 2005, in response to these concerns, the Department of Finance announced that it would develop “a more modest legislative initiative” that would still achieve its goals.  Unfortunately, with the change in government leadership in 2006 the proposal was placed at the bottom of the new government’s priority list.  It is uncertain when this draft legislation will be enacted nor what form it will take.  However, the Department of Finance has provided reassurance that the intention is only to return the law back to the status quo.  Prior to enactment, the Department will update the proposal to reflect the concerns expressed during the consultation period.

The Department still continues to informally receive comments on the draft legislation.  Once the Minister of Finance takes a position on the proposal the issue may become open for official comments but this has not been decided yet.

There has been no government announcement indicating whether the effective date of January 1, 2005, will be changed.

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On June 29, 2006, the Department of Finance released draft legislation and explanatory notes regarding changes to eliminate double taxation of large corporation dividends.  The draft will introduce a number of new provisions including subsection 249(4.1) which will provide a deemed taxation year-end that applies any time a corporation becomes or ceases to be a Canadian-controlled private corporation (CCPC), as defined under the proposed legislation, other than by an acquisition of control.  According to the explanatory notes this change will prevent a corporation from being treated as CCPC for part of a taxation year, which will allow better access to claim the small business deduction.  The change also affects the tax treatment of eligible dividends, as defined under the proposal, with respect to the timing of inclusion in income.  If enacted, the proposed amendment will be effective as of January 1, 2006. 

Because of its retroactive application, tax practitioners and clients are concerned about the implication for transactions executed or substantially completed prior to the release date of the proposal and after the proposed effective date.  On August 3, 2006, I spoke with representative at the Department of Finance about whether the department had provided any advance notice about the proposed changes and if the Department considered the impact the changes would have on transactions occurring before the release date. 

The representative confirmed that prior to June 29, 2006, there were no government releases to alert the public about the proposed amendment.  He indicated that many taxpayers have communicated their concern to him about this issue and he intends to recommend that the Department amend the proposed legislation to provide for a grace period.  However, until this issue is addressed, the representative suggested that taxpayers should consider whether making an election under proposed 89(11), which essentially allows corporations to choose not to be treated as a CCPC, can be used an alternative to counter the effect of the new deemed year-end rule.

The representative is not certain when the legislation will be enacted but expects it to be sometime in the fall - shortly after the Department’s review period, which ends September 15, 2006.  For more information on this proposal, you can contact Ryan Hall at 613.996.5155 until August 18, 2006.  After this date, all enquiries should be directed to Lawrence Purdy at 613-996-0602.

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          Generally, under the Canadian Income Tax Act (the “Act”) inter-company dividends between two Canadian corporations are deductible by the recipient of the dividend in computing its income for a given year.  However, there are a few exceptions to this rule.  The rules that govern dividend rental arrangements are examples of such an exception.  The Act prohibits a corporation from deducting dividends received on a share that is part of a dividend rental arrangement.  To be considered a dividend rental arrangement under the Canadian Income Tax Act the arrangement must meet the following requirements: 

• The corporation has borrowed a share under a securities lending arrangement
• The corporation has retained or disposed of the share and acquired identical shares
• The corporation has compensated the lender of the shares for the amount of dividends received on any shares that provides the same risk as the borrowed shares

          If these elements are in existence, it must then be determined whether the main reason for entering into the arrangement was to receive a dividend and there must be an increase or decrease in the value of the shares that will accrue to someone other than the corporation.  Canada Revenue Agency Document no. 9511155 provided an opinion on this very issue.  The question was whether the proposed transaction met the definition of dividend rental arrangement.  The CRA declined to provide any comment on whether the main reason for entering in to the transaction was to receive a dividend since this issue was a question of fact that required a more detailed review than what could be provided.  If this requirement was considered to be satisfied, then the CRA felt there was sufficient information about the proposed transaction to provide an opinion that someone other than the corporation would benefit from the gain or take the risk on the loss of the loaned shares.  Therefore, the arrangement would clearly be a dividend rental arrangement.

          If it were not for the dividend rental arrangement rules a corporation would be able to take advantage of the inter-company dividend deduction and place itself in a more favorable tax position without any additional risk.  This result would be inconsistent with the intention of the Act.      

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First published by the Canadian Tax Foundation in (2003) Vol. 51, No. 2 Canadian Tax Journal

The Queen v. Toronto Refiners and Smelters Limited considered the meaning of “eligible capital amount” for the purposes of subsection 14(5) of the Income Tax Act.[i] The taxpayer, Toronto Refiners and Smelters Limited (“Refiners”), had received $9 million as damages because it could not relocate its business after surrendering its property to the city of Toronto. The issue addressed by the court was whether the payment was an eligible capital amount or a non-taxable capital receipt.

The definition of “eligible capital amount” requires that the taxpayer be put into the position of a payer in order to determine whether a payment received by the taxpayer is an “eligible capital amount”.  The language in the definition suggests that the question the court should have asked was: Had Refiners purchased the property transferred to the city in exchange for the $9 million, would any payment made by Refiners have been an “eligible capital expenditure”? This is not the approach adopted by either the Tax Court or the Federal Court of Appeal.

Refiners carried on a secondary lead-refining business in Toronto on land and in buildings that it owned. Apparently, the city wanted to purchase the real property because it had pollution- and noxious use-related concerns about Refiners' use of the property. For several years, Refiners and the city negotiated unsuccessfully about the sale of the real property conditional on Refiners’ being able to relocate its business. In 1988, Refiners entered into an agreement to transfer its real property to the city. Under this agreement, which was made in accordance with section 31of the provincial Expropriations Act,[ii] Refiners consented to the acquisition of theproperty by the city under the following terms:

• the transfer was not conditional on Refiners' being able to relocate its business;

• the city and Refiners agreed that the other party could apply to the Ontario Municipal Board (OMB) under section 31 of the Expropriations Act for an assessment of the compensation that Refiners would have been entitled to receive had the city expropriated the property;

• if Refiners did not relocate its business, the city agreed to acknowledge in all future proceedings that such a relocation was not feasible;

• Refiners could recover inventory, equipment, and chattels located on the property and dispose of it on its own account; and

• if Refiners claimed compensation for the loss of its business, it would disclose the proceeds from the sale of the inventory, equipment, and chattels, and these amounts would be taken into account in the calculation of its compensation entitlement.

In this connection, it should be noted that section 13 of the Expropriations Act provides that the compensation payable by the statutory authority is based on the market value of the expropriated land, damages attributable to “disturbance” and injurious affection, and “any special difficulties in relocation”. Section 19 of the Expropriations Act provides that compensation may also include an amount not exceeding the value of the goodwill of a business that it is not feasible for the owner of the business to relocate.

On February 20, 1989, Refiners transferred vacant possession of its land and buildings to the city after it had disposed of most of its other assets located on the property. The city made an initial payment of $1 million to cover Refiners’ legal, appraisal, and other costs. Refiners did not relocate its business and in 1989 applied to the OMB for a determination of the compensation it should receive under the agreement. The valuators retained by Refiners and the city for the purposes of the OMB hearing valued the goodwill of the business at between $3.85 million and $8 million. The property was valued at between $1 million and $6.8 million.

After the hearing started but before the OMB made a determination, the parties entered into, and die OMB approved, a settlement. Under the settlement, dated January 27,1992, the city agreed to pay Refiners

• $2.9 million for the land,

• $ 100,000 for the buildings, and

• $9 million for damages arising from Refiners' inability to relocate its business.

Refiners included the $9 million of damages it received in its income for financial statement purposes in 1992. For tax purposes, however, it did not include the $9 million in income, claiming that it was a non-taxable capital receipt. The minister reassessed Refiners on the basis that three-quarters of the $9 million was an “eligible capital amount” and should be treated as a capital gain. Refiners appealed. “Eligible capital amount” is defined in subsection 14(1) of the Act, by reference to the definition of “cumulative eligible capital” in subsection 14(5), as

an amount which, as a result of a disposition ..., the taxpayer has or may become entitled to receive, in respect of the business carried on or formerly carried on by the taxpayer where the consideration given by the taxpayer therefor was such that, if any payment had been made by the taxpayer after 1971 for that consideration, the payment would have been an eligible capital expenditure of the taxpayer in respect of the business.

Historically, courts applying this definition have adopted the “mirror image” rule; that is, they have looked to the payer's position when determining whether a payment received by a taxpayer should be treated as an eligible capital amount.[iii] In the Tax Court decision in Toronto Refiners, Bell TCCJ embraced this approach, stating that “the actual payer's circumstances must be taken into account” to establish whether “the payment of damages ... [was] an eligible capital expenditure within the definition” in subsection 14(5).[iv] In other words, whether an amount received by a taxpayer is an eligible capital amount depends on the particular circumstances of the payer. Accordingly, in Toronto Refiners, the pivotal question was whether the payment was an eligible capital expenditure for the city.

In Toronto Refiners, the city acquired the property in the public interest and in accordance with section 31 of the Expropriations Act, which essentially required the city to fully compensate the taxpayer for its property, including any losses occasioned by the termination of its business. This section must be read in conjunction with the definition of “eligible capital expenditure” in subsection 14(5) of the Act, which provides that an expense incurred to acquire intangible non-depreciable property will generally constitute an eligible capital expenditure provided that the property is acquired for a business purpose.

After reviewing section 31 of the Expropriations Act and the parties’ agreement, the Tax Court found that the $9 million payment was not an eligible capital expenditure because it was not made by the city on account of capital for the purpose of gaining or producing income from a business. The city had entered into the agreement with Refiners, under its statutory authority derived from the Expropriations Act, to facilitate the city's purchase of Refiners' land and buildings and to provide for the payment of damages by the city if the taxpayer was unable to relocate its business. The evidence indicated that the payment by the city was not incurred for a business purpose, and the Crown conceded this point.

Moreover, the court decided that the $9 million damage payment by the city to Refiners must be regarded from the city's perspective as part of the cost of the real property acquired from the taxpayer and on this basis could not be characterized as an “eligible capital expenditure”.

The Crown appealed the decision of the Tax Court to the Federal Court of Appeal. In her judgment, Madam Justice Sharlow closely examined the language in the definition of “eligible capital amount”. After determining that the $9 million payment made by the city had been received by Refiners in respect of the business it had formerly carried on, Madam Justice Sharlow continued her analysis by reviewing the nature of the consideration given by Refiners for the payment. She found that Refiners’ agreement to release the city from any further claims for compensation under the Expropriations Act was the consideration referred to in section 14. She then applied the mirror image rule to characterize the payment.

In applying the mirror image rule, Madam Justice Sharlow placed Refiners notionally in the position of the city. She stated that the circumstances of this hypothetical payment would have to be the same as the circumstances of the actual payment. Essentially, this meant that the hypothetical payment by Refiners would be made for the same reasons that the city made the payment: that is, statutory compensation related to property expropriated for a civic purpose. Although the court initially appeared to be considering the nature of the payment from Refiners' perspective, it was the city's perspective that determined the final characterization of the payment. As a result, Madam Justice Sharlow concluded that the payment would not have been characterized as an eligible capital expenditure had Refiners made the payment for the same consideration, because it would have been made for a civic, non-commercial purpose and not for a business purpose.

Since goodwill is not capital property and cannot be subject to capital gains, the court decided that the correct result, under the circumstances, was that the amount was non-taxable.

In light of the existing case law, the judgment in this case was predictable. Clearly, the Expropriations Act and lack of a business purpose for the transfer were critical to the result in both the Tax Court and the Federal Court of Appeal. In this case, the tax consequences of the transaction to Refiners were dependent on the unique character of the payer of the damages (that is, the city). Had Refiners sold its property to a competitor that had shut down or moved the business, the portion of the purchase price that related to the goodwill of the business would have been an “eligible capital amount”.

From a policy perspective, this case is disturbing. Taxpayers who, for any reason, dispose of non-depreciable capital property, such as goodwill, should be treated in the same way as taxpayers who dispose of depreciable capital property. The tax consequences of the disposition should depend on the character of the asset to the taxpayer, not the purchaser.

As pointed out above, it appears to be possible to interpret the definition of “eligible capital amount” in a manner that produces more consistent results. Specifically, instead of determining the character of the payment in question in the hands of the actual payer, as the court did in the Toronto Refiners case, the court should employ the literal interpretation of the section, which seems to require that the character of the payment be determined on the basis of whether the taxpayer made the payment for the same consideration. However, given the existing jurisprudence, it appears that only an amendment to the definition of “eligible capital amount” would eliminate the possibility of inconsistent results that characterizes the current interpretive approach and bring the treatment of eligible capital property in line with the treatment of capital property.

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First published by the Canadian Tax Foundation in (2005) Vol. 53, No.1 Canadian Tax Journal

In Williams v. The Queen, the Tax Court of Canada addressed the question of whether it was appropriate for the taxpayer to deduct certain employment expenses pursuant to paragraphs 8(1)(h) and (i) of the Income Tax Act in circumstances where the employer paid the expenses and the taxpayer, although obligated, had not yet reimbursed the employer.

The taxpayer, Tom Williams, was employed by a securities brokerage firm as a senior technology analyst in 1997 and 1998.  He was responsible for performing due diligence and selling large‑scale high‑tech securities offerings.  There was no written employment agreement.  Instead, Mr. Williams entered into a verbal agreement with his employer that he would be remunerated on a commission basis.  As part of the agreement, he was able to take regular monthly draws as advances against anticipated commissions.  All draws and other advances were treated as employment income paid to Mr. Williams.  He was provided with T4 statements that included these amounts.

In performing his duties, Mr. Williams was required to travel extensively in Canada and the United States.  He was responsible for paying his own travel expenses and the payment of a salary to his sales assistant.  These expenses were necessary for him to arrange and negotiate transactions for his employer.  Although he was not specifically required by the terms of his contract of employment to hire a sales assistant, it was not possible for him to perform his duties without one.  Mr. Williams did not receive an allowance and was not reimbursed or entitled to reimbursement for any of his expenses.  However, the employer paid the expenses on his behalf.  and the amounts paid were treated as a debt owing to it by him.  The employer expected to recover these payments from future commissions earned by Mr. Williams.

In 1998, Mr. Williams ceased his employment with the company.  None of the transactions were completed, and he earned no commissions.[i]  However, he did receive amounts in the form of monthly draws and other advances against commissions.  Pursuant to an agreement with his employer, he was required to repay the advances when he left the company.  However, Mr. Williams did not repay any of the money he received.  In filing his 1997 and 1998 income tax returns, he included the advances as income and claimed the expenses as deductions for those taxation years.  The minister reassessed the returns and denied the deduction of the expenses.

The minister argued that Mr. Williams did not pay any expenses in the year and, as a result, was not entitled to a deduction under paragraph 8(1)(h), (i), or (f).  The minister’s position was that because Mr. Williams did not repay the amounts advanced by his employer, the expenses were not paid by him.  The minister also argued that Mr. Williams was not entitled to deduct the expenses under paragraph 8(1)(f) because he only received advances on account of future commissions, and no actual commissions were earned.  In his argument, Mr. Williams relied on paragraphs 8(1)(h) and (i).  Paragraph 8(1)(f) was presented as an alternative argument.  The court did not address this provision because the matter was disposed of on the basis of the applicability of the other two provisions.

Pursuant to paragraph 8(1)(h), under certain conditions, a taxpayer may deduct reasonable amounts expended for travelling in the course of employment.  The taxpayer is entitled to a deduction under this provision only if the amount expended was incurred to carry on employment duties away from the employer’s place of business.  The taxpayer must not have received an allowance for these expenditures[ii] and must not claim a deduction under certain other provisions.[iii]  In addition, the taxpayer must be required to pay these amounts under a contract of employment.  In circumstances where all the conditions have been met, courts will disallow deductions under this provision if there is no requirement for the taxpayer to incur these expenses by virtue of his or her employment.[iv]

In this case, Mr. Williams met all the conditions.  However, at issue was whether the amounts were expended by him or by the employer.  A similar issue arose in Nissim v. The Queen,[v] a decision of the Tax Court of Canada, where the taxpayer relied on the Ontario Legal Aid Plan (OLAP) to cover legal expenses.  The taxpayer later attempted to deduct the legal expenses paid by OLAP on the tax return for the relevant year.  The minister denied the claim.  At trial, Justice Bowman found that although the taxpayer did not pay the amount directly, the legal expense was deductible.  The court stated that since the taxpayer had a very real and immediate liability to OLAP to repay the legal costs, the cost should be deductible.[vi]

It was clear that Mr. Williams was responsible for his own travel expenses and did not receive an allowance for those expenses.  He was also not reimbursed or entitled to reimbursement.  However, the fact that the employer paid the expenses on his behalf (notwithstanding that the expenses were treated as debt owing to the employer) appeared to trouble the minister.  Justice Miller found that each time the employer paid Mr. Williams’s expenses, it was his money that was being spent.  Also, the court found that under the agreement, it was clear that the employer expected to recoup the payments from future commissions.  On the basis of this evidence, the court found that an immediate and absolute liability existed and, therefore, that Mr. Williams had made these payments.  The court stated:

It is not the exchange of physical cash or whose credit card was used to pay that determines who expended the money, but it is the legal relationships that are in play which must be examined... .

[The taxpayer] was obliged to reimburse [his employer] on a demand basis...  .  This is more than simply an employee advance only to be recouped from subsequent earnings.  It was more in the nature of a demand loan....  I find that [the taxpayer] effectively made these payments.[vii]

Clearly, one of the factors that motivated the minister in making the reassessment was the fact that Mr. Williams had never repaid the debt to his employer.  However, as Justice Miller points out in his decision, that situation is addressed by subsection 6(15) of the Act, which provides that a debt to an employer that is not repaid must be included in income as a taxable benefit.  In the context of deductibility pursuant to paragraph 8(1)(h), provided that an employee has a genuine liability to repay expenses paid on his or her behalf by the employer, the employee will be entitled to a deduction for expenses, even where the employee has not repaid those amounts.  The court was correct in finding that the amounts expended by the employer were monies expended by the taxpayer, since the taxpayer had a genuine liability to repay those amounts.  As a result, the appropriate treatment of the unpaid amounts should not be to deny the deduction, but to include it in the calculation of the taxpayer’s income.

Mr. Williams also incurred expenses to hire a sales assistant.  Subparagraph 8(l)(i)(ii) provides that an employee may deduct an amount on account of payment of a salary to an assistant, to the extent that the employee has not been reimbursed and is not entitled to reimbursement for the payment.  In addition, the payment must be required under the contract of employment between the employer and the taxpayer.  The leading case on this issue is Cival.[viii]  In Cival, the trial judge concluded that the taxpayer was required under his contract of employment to pay the travel expenses that he incurred in the performance of his employment duties.  The Federal Court of Appeal disagreed with this conclusion.  The Federal Court held that Mr. Cival was not contractually bound to use his car in doing his job and to pay the expenses incurred.  If he had refused to use his car for this purpose, his employer would not have had a cause of action for breach of contract.  As a result, the courts found that Mr. Cival was not required under the contract of employment to pay the expenses he incurred in using his car in the performance of his employment duties, and therefore could not deduct the expense.

In Slawson v. MNR,[ix] Justice Sarchuk indicated that certain expenses are deductible by a taxpayer where they are incurred in connection with the selling of property for his employer and where, under the contract of employment, the employee was required to pay his own expenses.  The court stated that the evidence must lead to a conclusion that the taxpayer was required by the contract of employment to pay certain expenses he incurred.  Although Justice Sarchuk found that the taxpayer may have been expected to do many of the things that led to his incurring these expenses, on the basis of the evidence he concluded that the taxpayer was not required by his contract of employment to do so.  In his judgment, Justice Sarchuk stated:

I cannot equate the expectations of the employer as described by both [the taxpayer] and by [the employer] to a contractual requirement imposed upon [the taxpayer], breach of which would have given a cause of action to the employer against him.[x]

Further, the courts have held that for a deduction to be claimed under subparagraph 8(1)(i)(ii), a written employment agreement is not necessary.[xi]

The court distinguished Williams from Civil and Slawson.  In Williams, the parties agreed that Mr. Williams could not perform his employment duties without a sales assistant and that it was his responsibility to pay the assistant.  This evidence was sufficient for the court to conclude that hiring an assistant was an implied term of the contract.  In addition, the court found that Mr. Williams was responsible for this expenditure because his employer had loaned him money to cover this expense; therefore, he was entitled to a deduction.  This decision reinforces the principle under paragraph 8(1)(i) that a taxpayer will be entitled to deduct expenses incurred to pay an assistant even though the terms of the employment contract may not specifically refer to the expense, provided that the taxpayer is required to pay the expense as an implied term of the contract.  The court was correct in allowing the deduction.

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A few weeks ago, while reading an article about retirement strategies I came across a paragraph that discussed the benefits of holding a mortgage in an RRSP.  Before this time I had no idea that this could be done, so I decided to do a little bit of research.  Apparently, if you hold your mortgage inside your RRSP, you get to make your monthly mortgage payments to yourself.  It sounds like a great idea, but the process is very complicated and has some clear disadvantages.

To get started, you must open a self directed RRSP and you must have a substantial amount of equity in your home.  Next you must transfer the equity of your home into your RRSP.  Mortgage equity held in an RRSP is not subject to RRSP contribution limits.  To go any further, you must have cash or cashable investments in your RRSP equivalent to the mortgage that will be transferred.  Once the structure is completed, you will have to make your mortgage payments to your RRSP and not to the bank.  Practically speaking, it would work something like this:  With a $100,000 mortgage on your home, and $100,000 available in your RRSP, you can take the money from your RRSP and pay the bank for the outstanding amount of the mortgage.  Now you have a $100,000 RRSP mortgage, and will be required to pay the RRSP instead of the bank.

One advantage of holding your mortgage in your RRSP is that you are able to capitalize on the mortgage amortization to maximize growth in your RRSP. The idea is to lengthen the amortization period and then charge the highest possible interest rate.  Having a very high interest rate is beneficial in this situation because you are able to deduct it.  Also, you have an option to structure it as an open mortgage to allow for early repayment without penalty.

There are disadvantages as well. For example, there are sizable fees, such as appraisal, legal, registration, mortgage insurance and trust fees involved with the set up.  You will also have to pay a few hundred dollars a year in fees to maintain the structure.  For someone with limited cash flow, it may not be worthwhile to do this since paying an higher than normal interest rate would have the effect of reducing immediate cash flow.  When mortgage interest rates were higher than 10% this option was more attractive because it provided an opportunity to deduct more in the long run in the form of interest payments.  However, with the current low interest rates it may not be as beneficial.  It may make more sense to pursue other investments. 

Before considering this option, ensure that you speak to a financial advisor and get all the facts.  It may be a good idea for you.  Or maybe not.

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