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Tax Court holds that advisor penalties under section 163.2 of the ITA constitute criminal offences

In what is certain to be the first step in a very important precedent, the Tax Court of Canada held on October 2, 2012 that the advisor penalties created under section 163.2 of the Income Tax Act constitute criminal offences and entitle the taxpayer to all of the constitutional protections that entails, including a standard of proof beyond a reasonable doubt: Guindon v. The Queen, 2012 TCC 287.

The case involved a tax avoidance scheme that was deeply flawed from a technical perspective:

[1] The participants in a donation program (the “Program”) were to acquire timeshare units as beneficiaries of a trust for a fraction of their value and donate them to a charity in exchange for tax receipts for the actual value of the units. No donation ever took place as the timeshare units never existed and no trust was settled. The Minister of National Revenue (the “Minister”), on the basis that the Appellant made, participated in, assented to or acquiesced in the making of 135 tax receipts that she knew, or would reasonably be expected to have known, constituted false statements that could be used by the participants to claim an unwarranted tax credit under the Income Tax Act (the “Act”), assessed against the Appellant on August 1, 2008 penalties under section 163.2 of the Act in the amount of $546,747 in respect of false statements made in the context of that donation program. The Appellant appealed the assessment.

The appellant was a lawyer with no experience or expertise in tax law. Nevertheless she prepared an opinion that was used by the Program promoters to attract potential donors. The opinion was found to be badly flawed and purported to rely upon documentation which the appellant had never examined (and which, in fact, did not exist):

[105] The Appellant wrote and endorsed a legal opinion regarding the Program, an opinion which she knew would be part of a promotional package intended for potential participants in the Program. Her legal opinion clearly states that she reviewed the principal documents relating to the Program when these documents had in fact never been provided to her. She knew, therefore, that her legal opinion was flawed and misleading.

[106] The Appellant chose to rely on the Program’s Principals. They pressured her into providing them with an executed version of the legal opinion without providing her with the supporting documents on which to found her opinion. Yet her legal opinion does not reflect this reality. Rather, it indicates that the documents were reviewed.

[107] When the Appellant chose to involve the Charity in the Program and, later, to sign the tax receipts, she knew she could not rely on her legal opinion. She again decided to rely on the Principals. However, the Principals had relied on the Appellant to attest the legality of the Program. The Appellant knew her legal opinion could not be relied on and, for that reason, she could not be entitled to blindly rely on the Principals. In other words, the Appellant would have been entitled to rely on the Principals if a different professional had signed the legal opinion. She could not, however, rely on her own legal opinion which she knew to be incomplete.

[108] Her conduct is indicative either of complete disregard of the law and whether it was complied with or not or of wilful blindness. The Appellant should have refrained from involving the Charity and signing the tax receipts until she had either reviewed the documents herself or had another professional approve the Program’s activities. When the Appellant issued the tax receipts, she could have reasonably been expected to know that those receipts were tainted by an omission, namely, that no professional had ever verified the legal basis of the Program.

[109] The Appellant cannot agree to endorse a legal opinion and then justify her wrongful conduct by saying she did not have the necessary knowledge — either of tax law or of foreign law — to write that opinion.

[110] Moreover, the Appellant’s conduct after the tax receipts were signed negatively affects her credibility and reflects badly on her character. When the Appellant was informed, after the tax receipts had been issued, that the legal titles were not in order, she co-signed a letter informing the participants of the situation. At that point, the Appellant knew she could not rely on the Principals — the same individuals who had never provided her with the documents she was supposed to review and the same individuals she had trusted in signing the tax receipts. Yet when Ploughman sent out a letter, days before the end of the fiscal year, stating that all was in order and that the participants could submit their receipts, the Appellant blindly relied on him again, without asking any further questions.

Thus, it is reasonably clear that if the test under section 163.2 were a normal burden of “balance of probabilities” the advisor penalties against the appellant would have been sustained.

Justice Bédard, however, performed a very thorough and detailed analysis of section 163.2 to determine whether the penalties imposed amounted to criminal sanctions. At the end of that careful analysis he concluded that they did create criminal offences and allowed the appeal:

[69] The Respondent submits that it is not the penalty that would stigmatize the Appellant but rather her unlawful conduct and the professional sanctions that could result from it. What the Respondent fails to recognize is that this judgment, when rendered, will be public. That professional sanctions may be imposed subsequently does not alter the fact that there will be a public document setting out all the details of the Appellant’s conduct, whether that conduct was found to qualify as culpable conduct or not, and indicating the amount of the penalty that she is being assessed. This constitutes a form of stigma which one should not fail to consider.

[70] In conclusion, applying the rationale enunciated in Wigglesworth, section 163.2 of the Act should be considered as creating a criminal offence because it is so far-reaching and broad in scope that its intent is to promote public order and protect the public at large rather than to deter specific behaviour and ensure compliance with the regulatory scheme of the Act. Furthermore, the substantial penalty imposed on the third party — a penalty which can potentially be even greater than the fine imposed under the criminal provisions of section 239 of the Act, without the third party even benefiting from the protection of the Charter — qualifies as a true penal consequence.

This case will almost undoubtedly be appealed, quite possibly to the Supreme Court of Canada. Nevertheless, the rationale of the decision seems balanced and well-reasoned. If it is sustained on appeal it may very well sound the death knell for advisor penalties under section 163.2 since the burden of proof on the Crown, i.e., proof beyond a reasonable doubt, will normally be far too onerous to justify prosecuting such penalties.

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Tax Court holds that advisor penalties under section 163.2 of the ITA constitute criminal offences

Taxpayer wins an important and complex case – Tax Court orders CRA to pay 60% of his out-of-pocket costs

Traditionally in a Tax Court appeal the costs awarded to a successful taxpayer have been no more than a small fraction of the out-of-pocket costs actually incurred in pursuing the appeal. The Court made very rare exceptions in the case of improper or vexatious conduct on the part of CRA. In recent years, however, the Tax Court has shown an increasing willingness to award substantial costs in cases where the taxpayer has been successful on important and novel issues. The recent decision of the Tax Court in Dickie v. The Queen (September 19, 2012) is an important example of how the law is evolving in this area.

In order to understand the implications of the cost award one must briefly examine the background of the underlying tax issue which was reported as Dickie v The Queen (July 10, 2012). The taxpayer was an aboriginal person living on a Reserve. He carried on a substantial business of cutting and slashing timber and brush to permit oil and gas exploration companies to carry out seismic testing. The administrative functions of the business were carried on within the Reserve but the physical activity of the business was carried on almost exclusively outside of the Reserve, generally within an 80 kilometre radius of the Reserve:

[8] While the Appellant clearly negotiated and received accepted contracts for work from the Reserve location, it is clear that 99% of the work was conducted off Reserve, within an 80-kilometre radius of the Reserve. In 2003, the Appellant had over 140 workers engaged for his Business and had revenue of approximately $3.4 million. The Appellant testified he hired mainly aboriginal workers, 16 in all from the Reserve, and others from Reserves in other parts of British Columbia, Alberta, Saskatchewan and even as far away as Newfoundland and Labrador. In all, the evidence is that approximately 105 of the 140 workers were aboriginal workers.

[9] The Appellant testified that the Business would bid on between 20 to 25 tenders a year and was usually successful 20% of the time, hence was awarded four to five contract bids a year. He also testified a small portion of the work of the Business was from small job requests but that the great majority of the Appellant’s Business revenue was from the larger bid contracts. The evidence is clear that all of the clients of the Business, generally oil and gas exploration or distribution companies, were not located or based on the Reserve and in fact most were based in Calgary, Alberta, the place of their office. The Appellant also testified that in 2003 the Business was a competitive one, evidenced also by the fact he was only successful on 20% of his bids.

The taxpayer claimed that his income was exempt for taxation by virtue of paragraph 81(1)(a) of the Income Tax Act:

81(1) There shall not be included in computing the income of a taxpayer for a taxation year,

(a) statutory exemptions [including Indians] – an amount that is declared to be exempt from income tax by any other enactment of Parliament, other than an amount received or receivable by an individual that is exempt by virtue of a provision contained in a tax convention or agreement with another country that has the force of law in Canada; . . .

Traditionally the courts construed this exemption somewhat narrowly placing significant emphasis on physical connection to the reserve and displaying a certain reluctance to apply the exemption to activities in the commercial mainstream.

Two recent decisions of the Supreme Court of Canada, Bastien Estate v. Canada, 2011 SCC 38, [2011] 2 S.C.R. 710 and Dubé v. Canada, 2011 SCC 39, [2011] 2 S.C.R. 764, substantially changed the law in this area. In a nutshell they held that the commercial mainstream test should no longer carry the degree of weight it had historically:

[21] Cromwell J. made it clear that the expression “Indian qua Indian” referred to by La Forest J. and Gonthier J. in Williams does not mean one can import into the purpose of the legislation “an effort to preserve the traditional way of life in Indian communities” or consider as a relevant factor “whether the investment income benefits the traditional Native way of life”. While Cromwell J. found that he did not read the judgments in Mitchell or Williams “as departing from a focus on the location of the property in question when applying the tax exemption”, he also found that neither decision mandated an approach that assessed what is in fact, to use the parlance of the Appellant here, the “Indianness” of the activity. In paragraph 27 of Bastien Estate, Cromwell J. stated:

[27] . . . A purposive interpretation goes too far if it substitutes for the inquiry into the location of the property mandated by the statute an assessment of what does or does not constitute an “Indian” way of life on a reserve. . . .

[22] And in paragraph 28 stated:

[28] . . ., a purposive interpretation of the exemption does not require that the evolution of that way of life should be impeded. Rather, the comments in both Mitchell and Williams in relation to the protection of property which Indians hold qua Indians should be read in relation to the need to establish a connection between the property and the reserve such that it may be said that the property is situated there for the purposes of the Indian Act. While the relationship between property and life on the reserve may in some cases be a factor tending to strengthen or weaken the connection between the property and the reserve, the availability of the exemption does not depend on whether the property is integral to the life of the reserve or to the preservation of the traditional Indian way of life. . .

[23] Likewise Cromwell J. cautioned against elevating considerations of whether the economic activity was in the “commercial mainstream” as a factor of determinative weight in determining the situs of investment income, which he felt was done in Recalma v. Canada, 98 DTC 6238 (F.C.A.) and other decisions of the lower courts, as “problematic” as he stated in paragraph 56 :

[56] . . . because it might be taken as setting up a false opposition between “commercial mainstream” activities and activities on a reserve. Linden J.A. in Folster was alive to this danger when he observed that the use of the term “commercial mainstream” might “… imply, incorrectly, that trade and commerce is somehow foreign to First Nations” (para. 14, note 27). He was also careful to observe in Recalma that the “commercial mainstream” consideration was not a separate test for the determination of the situs of investment property, but an “aid” to be taken into consideration in the analysis of the question (para. 9). Notwithstanding this wise counsel, the “commercial mainstream” consideration has sometimes become a determinative test. . . .

Justice Pizzitelli applied the new test enunciated by the Supreme Court and came to the conclusion that the taxpayer had demonstrated an entitlement to the exemption claimed and made the following direction as to costs:

[74] The appeal is allowed with costs to the Appellant; however, the parties are invited to file written submissions within 30 days as to costs if any of them feel a standard cost award should not stand.

In making his cost award roughly two months later Justice Pizzitelli was critical of CRA’s reliance upon the “commercial mainstream” argument in light of the Bastien and Dubé decisions:

[20] I do however also agree with the Appellant that having regard to the clear wording and intention of the Supreme Court of Canada’s decisions effectively reducing the importance of the commercial mainstream factor, if not obliterating it, that the Respondent could have shortened the proceeding by conceding this fact before trial. While the Respondent’s counsel acknowledged the reduction in weight to be given to the issue in argument at trial, she nonetheless maintained its assumptions in its pleadings regarding the commercial mainstream and argued forcefully that such factor would grant an advantage to aboriginal businesses over non-aboriginal businesses, an argument in my opinion clearly not consistent with the Supreme Court of Canada’s decisions on the issue. As I referred to in my decision, if the other factors are sufficient to establish the income was situate on a Reserve, then any such resulting advantage was acceptable. In my view, the Respondent could have significantly reduced the length of the hearing by conceding the argument before trial on receiving the Appellant’s counsel’s letter. In my view, this matter falls under the heading of Rule 147(h) the denial or the neglect or refusal of any party to admit anything that should have been admitted. In my opinion, the Respondent paid lip service to the Supreme Court of Canada’s decisions on the importance of the commercial mainstream argument yet proceeded to trial on the basis it was one of its strongest arguments.

In the result he awarded the taxpayer 60% of his out-of-pocket costs and 100% of his disbursements claimed:

[26] In my view, having regard to the clear victory of the Appellant in this matter, the sizeable amount of taxes in dispute including for other years for which this case served as a test case, the importance of the commercial mainstream issue in particular and the complexity of the issue in light of the Respondent’s position notwithstanding the Supreme Court of Canada’s decisions in Bastien Estate and Dubé and the amount of work generated for the Appellant as a result of the Respondent’s position on that issue and the importance it continued to give to the commercial mainstream factor as above discussed, which in my view should have been conceded before trial to shorten the trial and narrow the issues, there clearly exist special circumstances justified by the application of factors listed in Rule 147(3) to merit awarding the Appellant costs in excess of the Tariff.

[27] The Appellant asked for between 50 and 75% of solicitor and client costs plus disbursements, consistent with the range of traditional awards cited by author Mark Orkin in the Law of Costs, 2nd ed., Vol. 1 (Aurora: Canada Law Book, 2008) at 2-3 as quoted by Campbell J. in Re Zeller Estate above at paragraph 9. The Appellant’s costs on a solicitor and client basis claimed are $133,000 plus $10,000 in disbursements. In my opinion, the Appellant is deserving of 60% of such claim, amounting to $80,000 plus $10,000 in disbursements, for a total award of $90,000.

While the background of this case is somewhat uncommon, the issues it presents occur frequently in serious commercial tax litigation: important, novel issues involving a great deal of tax. When this is combined with a stubborn refusal on the part of CRA to acknowledge the obvious weaknesses of some of its arguments, we may begin to see more significant costs awards in the mold of the Dickie decision.

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Taxpayer wins an important and complex case – Tax Court orders CRA to pay 60% of his out-of-pocket costs

Mother Bruno knows best – Weighing the evidence in tax appeals

In my recent blog post on the Newmont Canada Corporation decision I examined the importance that the Federal Court of Appeal attached to credible evidence put forward by taxpayers in tax appeals. The recent decision of Justice Woods in the Tax Court in Bruno v. The Queen is a good illustration of a fair and balanced approach to weighing that evidence.

The taxpayer, Mrs. Bruno, had a business that specialized in supplying custom window coverings. During the 2007 and 2008 taxation years she employed two of her children in the business on a part-time basis and paid them (in the aggregate) $18,000 and $7,000, in each respective year, for their services.

Justice Woods summarized the evidence as follows:

[6] In the 2007 taxation year, Ms. Bruno reported income from the business in the amount of $11,944. In the 2008 taxation year, she reported a loss from the business in the amount of $16,963.

[7] Ms. Bruno’s two children were 15-16 and 13-14 in the years at issue and helped out in the business on weekends and holidays.

[8] According to Ms. Bruno’s evidence, the younger child did less skilled tasks such as cleaning and answering phones, and the older child did mainly clerical work. Both children also spent time learning sales.

[9] Ms. Bruno entered into evidence a summary of the hours worked and wages earned by the children. Wages were payable at the rate of between $10 and $12 per hour. The summary showed that the children generally worked store hours on both weekend days during 2007 and on one weekend day during 2008, as well as on holidays in both years. The reduction in the hours worked in 2008 was explained by Ms. Bruno on the basis that the business was not doing as well in that year.

[10] The wages were not paid by cheque. Instead, Ms. Bruno paid for some of the children’s personal expenditures which in aggregate are approximately equal to the wages shown on the summary. According to Ms. Bruno’s testimony, the expenditures were luxury items that the children chose to purchase out of the money that they had earned. A list of the expenditures with a brief description was kept by Ms. Bruno.

[11] Ms. Bruno stated that her accountant advised her that she could not take a deduction for expenditures on the children’s basic needs, but that she could take a deduction for luxury items. She said that she followed this advice and kept track of the expenses that would qualify.

[12] Ms. Bruno testified that she could veto any of the children’s purchases that were inappropriate but that she usually approved them.

The Crown’s position was short and to the point:

[15] At the outset, I would comment that the Crown did not argue that the wages were unreasonable based on the services performed and there was virtually no cross-examination of Ms. Bruno on this point. I will therefore accept that the amounts are reasonable.

[16] The Crown argued that the expenditures are not deductible because they are personal or living expenditures of Ms. Bruno and the children did not have sufficient discretion over the funds.

Justice Woods dismissed the Crown’s arguments that the children did not have sufficient discretion over the application of the funds:

[22] As for the Crown’s argument that the children did not have sufficient discretion over the funds, this argument is based on the decision of Beaubier J. in Bradley v The Queen, 2006 TCC 500, 2006 DTC 3535. Paragraph 9 of that decision reads:

[9] But in a related family, parent-child situation, payment must be made and deposited as it would be to a stranger. The payee must receive and control the alleged payment in his or her name and be able to use it for his or her benefit without any further control by the payer. That did not happen in this case.

[23] This comment suggests that the children must have complete discretion over the expenditures made. I would respectfully disagree with this and note that Bradley is not a binding precedent since it was an informal procedure case. I see nothing wrong with parents having a veto over expenditures made by their children.

Her conclusion on this point seems unimpeachable. There is little merit in the suggestion that a minor child must have entirely unfettered discretion as to what to do with his or her earnings in order for those amounts to constitute the child’s income. Would it be any less the child’s income if the parents could veto a decision by the minor to purchase a pit bull or pay for hang-glider lessons?

On the broader issue whether wages paid to children were deductible, Justice Woods relied upon the Symes decision of the Supreme Court of Canada:

[19] In considering the interplay between s. 18(1)(a) and (h), the majority decision in Symes concluded that the prohibition for personal expenditures in s. 18(1)(h) does not apply to an expenditure that was laid out for the purpose of earning income. Justice Iacobucci stated, at page 6014:

Upon reflection, therefore, no test has been proposed which improves upon or which substantially modifies a test derived directly from the language of s. 18(1)(a). The analytical trail leads back to its source, and I simply ask the following: did the appellant incur child care expenses for the purpose of gaining or producing income from a business?

[20] Accordingly, if a taxpayer incurs an expense for the purpose of gaining or producing income from a business, the deduction will not be prohibited pursuant to s. 18(1)(h) on the basis that it also has a personal benefit to the taxpayer.

[21] Applying this principle to the facts in this case, if the children are owed wages in reasonable amount, a deduction may be claimed if the wages are paid in the form of purchasing luxury personal items chosen by the children.

Justice Woods then turned to what was undoubtedly the most difficult aspect of this case: weighing and assessing the taxpayer’s evidence.

[24] Turning to the facts of this case, the difficulty that I have with Ms. Bruno’s argument is that the evidence about the expenditures was not sufficiently detailed for me to be satisfied, even on a prima facie basis, that all the expenditures were made for the children’s benefit, let alone that they were for luxury items.

[25] The evidence concerning the nature of the expenditures consisted mainly of Ms. Bruno’s oral testimony and the list that she prepared. As for the oral testimony, it is self‑serving and not sufficiently detailed for me to be satisfied on most of the expenditures. As for the accounting records, a great many of the descriptions of the expenditures were simply too general to be of great assistance.

[26] Based on the evidence as a whole, I am satisfied that some of the expenditures are luxury items for the children’s benefit. However, the evidence is not detailed enough for me to determine which items qualify. It is appropriate in these circumstances, where the appeal is governed by the informal procedure, for the Court to make a rough estimate. On that basis, I propose to allow a deduction for 50 percent of the amounts claimed.

On the one hand she accepted that the services were provided; that the children’s labour actually constituted a tangible benefit to the business. On the other hand the taxpayer had not put forward a sufficiently strong case to persuade Justice Woods that there was not an element of personal benefit to the parents. As a result she split the difference and allowed 50% of the salary expenses claimed.

While the Bruno decision is an informal procedure case and involved relatively small amounts, in my view it clearly illustrates the difficulty a trial judge has in assessing the evidence of a credible witness dealing with difficult or imprecise facts. It further demonstrates the importance of careful preparation of witnesses and the documentary evidence that must be introduced. Finally, it shows once more that counsel must have a finely-tuned ear to anticipate and deal with the types of issues that will likely concern the trial judge.

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Mother Bruno knows best – Weighing the evidence in tax appeals

FCA: Trial court cannot ignore taxpayer’s evidence without good reason

The decision of the Federal Court of Appeal in Newmont Canada Corporation v. Canada delivered July 27, 2012 was primarily concerned with an unsuccessful attempt by the taxpayer to write off the principal amount of a large loan.  What makes the case quite interesting, however, is a side issue concerning the taxpayer’s claim to write off accrued interest on the loan.  That is where the Federal Court of Appeal parted company with the Tax Court of Canada and provided a useful reminder about the importance of evidence in tax appeals.

The interest in question arose in the 1988, 1989 and 1990 taxation years.  The CRA auditor allowed a portion of the interest expense:

[173]  During the course of the CRA audit, [the taxpayer] provided the CRA auditor, Mr. MacGibbon, with the details of the entries recorded in its general ledger account 2101 between August 1, 1989 and the end of May 1990. [The taxpayer] used this general ledger account to record amounts due from Windarra, including accrued interest on the Windarra Loan.

[174]  Mr. MacGibbon testified that [the taxpayer] did not provide him with any books or records for periods prior to August 1, 1989.

[175]  Based upon his review of the general ledger for account 2101, Mr. MacGibbon was able to identify entries totalling $183,336 that recorded interest income in respect of the interest accrued on the Windarra Loan. As a result, he allowed a deduction under subparagraph 20(1)(p)(i) in respect of the accrued interest.

While it is not clear why the earlier records were not produced, it is a reasonable inference that they were simply misplaced; they related to periods 20 or more years prior to the trial, which was held in 2009.

The taxpayer’s evidence was simple and direct:

[176]  The Appellant argued that the Minister understated the subparagraph 20(1)(p)(i) deduction by $156,888. It arrived at this number by performing the following calculation:

First, it determined the amount of accrued interest as at December 31, 1989 as follows:

a. The amount shown on the balance sheet at December 31, 1989 in respect of the Windarra Loan: $8.513 million

b. Less: the principal amount of the loan at December 31, 1989: $8.25 million

c. Equals the amount of accrued interest as at December 31, 1989: $263,000.

The Appellant then compared the $263,000 with the amount of interest income Mr. MacGibbon had calculated for the periods prior to 1989, namely $106,112.

[177]  It is the Appellant’s position that the difference between $263,000 and $106,112, which is $156,888, represents additional accrued interest income that was included in the income reported in [the taxpayer’s] 1988 and 1989 income tax returns.

[178]  During his testimony, Mr. Proctor summarized the Appellant’s argument as follows: “Because we have it on the balance sheet and, since debits must equal credits, it must have been on the Income Statement and we did not adjust it in arriving at net income for income tax purposes. For financial statement purposes it must be in the net income for income tax purposes.”

The Tax Court Judge rejected the taxpayer’s evidence:

[181]  I cannot accept the Appellant’s argument. [The taxpayer] could have recorded the offsetting amount as interest income. Alternatively, it could have recorded the offsetting amount on a balance sheet account such as a deferred revenue account or a reserve account. The only way to determine how the offsetting amounts were recorded in 1988 and the first half of 1989 would be to review the relevant books and records. Unfortunately, the relevant books were not provided to either the Minister or the Court.

[182]  The only evidence before the Court of accrued interest being included in [the taxpayer’s] income was in the working papers of Mr. MacGibbon. I agree with counsel for the Respondent that in order for the Appellant to obtain a deduction in excess of the amount allowed by the Minister “the Court should be presented with something more reliable than a conclusion based on unsubstantiated assumptions.”

Fortunately for the taxpayer, the Federal Court of Appeal held that there was no basis for the Tax Court Judge to reject the taxpayer’s evidence on the point:

[65]  Notwithstanding the auditor’s admission that it was likely that interest accrued in 1988 and the first part of 1989 in the Windarra Loan, the Judge rejected Mr. Proctor’s evidence that additional interest was included in [the taxpayer’s] income on the basis that [the taxpayer] “could have recorded the offsetting amount on a balance sheet account such as a deferred revenue account or a reserve account.” However, for the reasons that follow, there was, in my view, no evidence before the Court to support such a conclusion.

[66]  The Judge found Mr. Proctor to be a credible witness. Mr. Proctor testified that [the taxpayer] would have included the sum of $263,000 in its retained earnings. He reviewed the Reconciliation of Net Income for Tax Purposes form (i.e. the T2S(1) form) provided by [the taxpayer] for each of the 1988 and 1989 taxation years as part of its income tax returns (Appeal Book volume 2, pages 81 and 109) and identified no adjustments “in moving from financial statement income to net income for tax purposes relating to Windarra” (Appeal Book volume 7, page 1699).

[67]  With respect to the Judge’s reference to deferred revenue and reserve accounts, while [the taxpayer’s] 1988 and 1989 balance sheets did show a deferred revenue liability (Appeal Book volume 5, pages 1176 and 1181), the notes to its financial statements specified that the deferred revenue liability related solely to [the taxpayer’s] gold loan owed to a consortium of Canadian banks (Appeal Book volume 5, pages 1178 and 1188). The 1988 and 1989 balance sheets did not record any reserve accounts.

[68]  In this circumstance there was, in my respectful view, no evidence on which to impugn Mr. Proctor’s evidence, so that the Judge committed a reviewable error in rejecting the evidence for the reasons that he gave. Mr. Proctor’s evidence, together with the auditor’s concession established that [the taxpayer] had included the additional sum of $156,888 in interest income in its income tax returns.

[69]  It remained for [the taxpayer] to establish that the interest income was or became a bad debt. This required consideration of whether any monies paid to it pursuant to the Settlement Agreement were allocated to monies owing on account of interest. If so, that portion of the interest income would not be a bad debt.

[70]  Article 1(3) of the Settlement Agreement evidenced the parties’ agreement that the settlement proceeds were to be “applied on account of the principal amount of the [Windarra] Loan.” This established on a prima facie basis that all of the interest owing to [the taxpayer] pursuant to the Windarra Loans was a bad debt.

[71]  To conclude on this point, in my view, this Settlement Agreement combined with the evidence of Mr. Proctor and the auditor’s concession was sufficient to demolish the Minister’s assumption. Further, counsel for the Minister did not point to any evidence which rebutted [the taxpayer’s] prima facie case.

[72]  It follows that [the taxpayer] established its entitlement to deduct $156,888 under subparagraph 20(1)(p)(i) of the Act in 1992.

The case serves as a useful reminder about two important points.  First, the rules of onus are alive and well (as also discussed in my recent blog post on McMillan v. Canada).  Once a taxpayer has raised a prima facie case rebutting the Minister’s assumptions, the Minister cannot succeed unless Crown counsel can adduce additional evidence or otherwise undermine that prima facie case.

Second, and perhaps more important, the case demonstrates that solid evidentiary preparation and strong witnesses are critical if a taxpayer hopes succeed in the courts.  As it is exceedingly rare for the Federal Court of Appeal to overturn findings of fact made by a Tax Court Judge, every effort must be made to adduce evidence, both documentary and viva voce, in the Tax Court of Canada in order to maximize the likelihood of success both at trial and on appeal.

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FCA: Trial court cannot ignore taxpayer’s evidence without good reason

No Medal for CRA’s Questionable Treatment of Canadian Olympic Medalists

On August 13 I came across this article in the Globe and Mail outlining how CRA treated prizes received by Canadian Olympic Medalists.

Gold medalists receive a $20,000 prize from the Canadian Olympic Committee, Silver medalists $15,000 and Bronze medalists $10,000. The CRA asserts that those amounts are taxable. The CRA’s position is based on what can only be described as a questionable interpretation of Income Tax Regulation 7700:

7700. For the purposes of subparagraph 56(1)(n)(i) of the Act, a prescribed prize is any prize that is recognized by the general public and that is awarded for meritorious achievement in the arts, the sciences or service to the public but does not include any amount that can reasonably be regarded as having been received as compensation for services rendered or to be rendered.

This regulation is directly related to the Nobel Prize in Chemistry awarded in 1986 to Dr. John C. Polanyi of the University of Toronto. There was considerable public sentiment that Dr. Polanyi not be subject to income tax on this prize. As a result the Income Tax Act was amended to introduce the concept of a tax exempt “prescribed” prize. It is one of the most straightforward provisions in Canadian tax law. All that is required is:

    1. recognition of the prize by the general public; and
    2. that the prize is awarded for meritorious achievement in the arts, the sciences or service to the public (I am intentionally omitting the irrelevant language about compensation for services).

Surprisingly, the CRA has concluded that Canada’s Olympic medalists were not being awarded for “service to the public”:

I must clarify that the media reports you refer to dealt not with the value of the medals themselves but with the prize money the Canadian athletes who won medals at the Games. Paragraph 56(1)(n) of the Income Tax Act states that the total of all amounts received in the year as, or on account of a prize for achievement in a field of endeavour that the taxpayer ordinarily carries on should be included in the taxpayer’s income. This provision of the Act would not normally apply to your example of a lottery winner; however, paragraph 56(1)(n) is sufficiently broad as to apply to a prize awarded to an athlete for winning an Olympic medal.

I note that the Act provides an exception to this rule for a prescribed prize. For purposes of this exception, section 7700 of the Income Tax Regulations defines a “prescribed prize” as any prize that is recognized by the general public and that is awarded for meritorious achievement in the arts, the sciences, or in service to the public. Although winning an Olympic medal may be an internationally recognized achievement and could indirectly promote a sense of nationalism, such a prize is not awarded in recognition of service to the public and therefore would not be a prescribed prize and would not fall within the exception.

CRA Document 2008-0300071M4 “Olympic medals” (26 June 2009)

Since it first participated in the games of 1900, Canada has won 278 medals in the Summer Games (an average of 11 per Games) and 145 in the Winter Games (an average of 7 per Games). It is astonishing that the CRA and the Department of Finance would regard the taxation of these awards as material. To suggest that these young men and women who spend years of their lives training for the chance once every four years to put the Canadian flag and anthem on display for the entire world to see and hear are not engaged in service to the Canadian public is not only unsupportable in light of the text, context and purpose of the provision, but serves to undermine the federal government’s own financial support of amateur athletics and best and brightest of Canada’s Olympic athletes. It is hoped that the CRA sees the light sooner rather than later and changes its position accordingly.

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No Medal for CRA’s Questionable Treatment of Canadian Olympic Medalists

Federal Court of Appeal: Canada Cannot Tax Treaty Income Twice

It is trite law that one of the main purposes of tax treaties is to prevent double taxation of the same income. In Canada this principle has often been treated with a grain of salt since Canadian domestic rules do not bar double taxation and, in fact, the Canada Revenue Agency often resorts to double taxation where, for example, a shareholder appropriation is disallowed as a corporate expense while fully taxed in the shareholder’s hands.

The recent decision of the Federal Court of Appeal in The Queen v. Sommerer illustrates a refreshing approach to the concept of double taxation, at least in the context of Canada’s network of bilateral tax treaties based on the OECD Model Convention (and, to a lesser extent, the UN Model Convention).

Mr. Sommerer was at all material times a resident of Canada. He was a contingent beneficiary of an Austrian Privatstiftung (the “Sommerer Private Foundation”) created by his father in 1996. The Sommerer Private Foundation was at all material times a resident of Austria for the purposes of the Canada-Austria Tax Treaty. The facts that gave rise to the assessments under appeal are summarized by Sharlow JA as follows:

[30] On October 4, 1996, Peter Sommerer sold to the Sommerer Private Foundation 1,770,000 shares of Vienna Systems Corporation (the “Vienna shares”) for their fair market value of $1,177,050 (66.5¢ per share). The Sommerer Private Foundation paid $117,705 of the purchase price on the date of the agreement and was legally obliged to pay the remainder at a later date, with interest. The sale was unconditional. The cash portion of the purchase price was paid using part of the initial endowment from Herbert Sommerer (paragraphs 67 and 88 of Justice Miller’s reasons).

[31] In December of 1997, the Sommerer Private Foundation sold 216,666 of the Vienna shares for $4.50 per share to three individuals unrelated to the Sommerer family, realizing a capital gain. In December of 1998, the Sommerer Private Foundation sold the remaining Vienna shares to Nokia Corporation for $9.00 per share, realizing a further capital gain.

[32] In April of 1998, Peter Sommerer sold to the Sommerer Private Foundation, unconditionally, 57,143 shares of Cambrian Systems Corporation (the “Cambrian shares”) for $100,000 (approximately $1.75 per share). In December of 1998, the Sommerer Private Foundation sold the Cambrian shares to Northern Telecom Limited for $14.97 (US) per share, plus a further $4.12 (US) per share conditional on certain milestones being met in 1999. That sale resulted in another capital gain for the Sommerer Private Foundation.

CRA assessed Mr. Sommerer on the basis of subsection 75(2) of the Income Tax Act alleging that the proceeds from the sale of the shares by the Foundation could possibly revert to Mr. Sommerer. Both Justice Campbell Miller in the Tax Court of Canada and Justice Sharlow in the Court of Appeal rejected that interpretation holding that subsection 75(2) could not apply on a sale of property at fair market value.

Justice Sharlow did not stop there however. She went on to agree with Miller J. that the position advocated by CRA violated the Treaty’s fundamental principle of avoiding double taxation:

[66] The OECD model conventions, including the Canada-Austria Income Tax Convention, generally have two purposes – the avoidance of double taxation and the prevention of fiscal evasion. Article XIII (5) of the Canada-Austria Income Tax Convention speaks only to the avoidance of double taxation. “Double taxation” may mean either juridical double taxation (for example, imposing on a person Canadian and foreign tax on the same income) or economic double taxation (for example, imposing Canadian tax on a Canadian taxpayer for the attributed income of a foreign taxpayer, where the economic burden of foreign tax on that income is also borne indirectly by the Canadian taxpayer). By definition, an attribution rule may be expected to result only in economic double taxation.

[67] The Crown’s argument requires the interpretation of a specific income tax convention to be approached on the basis of a premise that excludes, from the outset, the notion that the convention is not intended to avoid economic double taxation. That approach was rejected by Justice Miller, correctly in my view. There is considerable merit in the opinion of Klaus Vogel, who says that the meaning of “double taxation” in a particular income tax convention is a matter that must be determined on the basis of an interpretation of that convention (Klaus Vogel on Double Taxation Conventions: A Commentary to the OECD –, UN –, and US Model Conventions for the Avoidance of Double Taxation on Income and Capital, 3rd ed. (The Hague: Kluweer Law International, 1997)).

[68] I see no error of law or principle in the conclusion of Justice Miller that Article XIII (5) applies to preclude Canada from taxing Peter Sommerer on the capital gains realized by the Sommerer Private Foundation.

Unless this case is reversed by the Supreme Court of Canada (at the date of this comment, no leave application has been filed), it is likely to be a very important precedent for tax practitioners plying their craft in the highly complex area of international tax treaties.

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Federal Court of Appeal: Canada Cannot Tax Treaty Income Twice

Federal Court of Appeal Reaffirms the Onus of Proof Rules in Tax Appeals

In the recent case of McMillan v. Canada, the Federal Court of Appeal has reaffirmed the onus of proof rules in tax appeals. While the rules were never particularly unsettled at the federal level, the somewhat anomalous decision of the British Columbia Court of Appeal in Northland Properties v. The Queen in Right of the Province of British Columbia, appeared to cast doubt on prior Federal Court of Appeal pronouncements as well as the decision of Justice L’Heureux-Dubé in Hickman Motors Ltd. v. Canada. In Northland, the B.C. Court of Appeal took issue with the concept, articulated by Justice L’Heureux-Dubé in Hickman, that the onus was on the taxpayer to “demolish” the assumptions pleaded by the Minister by means of raising a prima facie case at which point the burden shifts to the Minister to prove the assumptions on the balance of probabilities:

[29] Before us, counsel for the Crown made persuasive submissions on the issue of the so-called “prima facie” standard: L’Heureux-Dubé J.’s use of “prima facie” was made in the context of a case in which the Crown had not called any evidence whatsoever; it was relying solely on its assumptions. It is certainly possible in such circumstances that a prima facie case, or even one with “gaps”, would be sufficient to displace the Crown’s assumptions, but the prima facie standard described by Justice L’Heureux-Dubé should not be interpreted as having altered the usual standard of proof in tax cases: see the comments in Sekhon v. Canada, [1997] T.C.J. No. 1145 at para. 37; and Hallat v. The Queen (2000), [2001] 1 C.T.C. 2626 (F.C.A.).

The facts in McMillan are uncomplicated and not particularly interesting. The taxpayer had a business in the Dominican Republic and claimed a number of expenses in connection with that business. The Tax Court denied most of the expenses claimed on the basis that they were not proven by the taxpayer. The taxpayer appealed to the Federal Court of Appeal and her appeal was dismissed on the basis that she did not demonstrate any material error on the part of the Tax Court judge.

The interesting part of the decision is the Federal Court of Appeal’s articulation of the rules relating to onus of proof in tax appeals:

[7] Before concluding these reasons, we note that the appellant did not raise in her memorandum of fact and law any issue with respect to the Judge’s statement at paragraph 19 of the reasons, and repeated at paragraph 21, that the appellant “has the initial onus of proving on a balance of probabilities (i.e. that it is more likely than not), that any of the assumptions that were made by the Minister in assessing (or reassessing) the Appellant with which the Appellant does not agree, are not correct.” In our respectful view, it is settled law that the initial onus on an appellant taxpayer is to “demolish” the Minister’s assumptions in the assessment. This initial onus of “demolishing” the Minister’s assumptions is met where the taxpayer makes out at least a prima facie case. Once the taxpayer shows a prima facie case, the burden is on the Minister to prove, on a balance of probabilities, that the assumptions were correct (Hickman Motors Ltd. v. Canada, [1997] 2 S.C.R. 336 at paragraphs 92 to 94; House v. Canada, 2011 FCA 234, 422 N.R. 144 at paragraph 30).

Thus, the Federal Court of Appeal has once again embraced the prima facie standard as the test that must be met by a taxpayer to displace or demolish assumptions pleaded by the Minister. While there may be a different standard applicable in provincial tax appeals in British Columbia, the reaffirmation of the prima facie standard by the Federal Court of Appeal is welcome news in federal tax appeals.

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Federal Court of Appeal Reaffirms the Onus of Proof Rules in Tax Appeals

Tax Court of Canada Limits Shopping for Expert Witnesses: Aecon Construction Group Inc. v. The Queen

In his recent decision in Aecon Construction Group Inc. v. The Queen, Justice Angers of the Tax Court of Canada adopted a practical and sensible approach to the problem of an expert witness potentially being conflicted out of a tax appeal because of having been approached by one of the parties which then decides not to commission a report from that expert.

In Aecon, the disputed turned on the fair market value of mining properties in 1993.  The taxpayer contended that the value was $32 million while the Crown contended that the value was $3 million.  The taxpayer relied on two expert reports.  The Crown originally relied upon one expert report.  Prior to trial Crown counsel approached two other experts, Mr. F and Mr. R, both of whom had already been approached by the taxpayer.  The Crown wrote counsel for the taxpayer taking the position that the taxpayer’s limited contact with Mr. F should not disqualify him from acting for the Crown in the tax appeal.  The taxpayer’s counsel took the position that both Mr. F and Mr. R were disqualified and the Crown took this motion in the Tax Court to have the status of Mr. F determined in advance of trial.

Justice Angers quoted the famous statement of Lord Denning in Harmony Shipping Co SA v. Davis et al. as reproduced by Justice O’Keefe of the Federal Court in Abbott Laboratories v. Canada (Minister of Health), 2006 F.C. 340.

[20] Accordingly, the principles require that the Court balance the interests of the party seeking to retain an expert witness and the party seeking to protect its confidential information. In that regard, counsel for Pharmascience raises the danger of expert witnesses being contacted simply to deprive an opposing party of their expertise. This danger was eloquently described by Lord Denning in Harmony Shipping Co SA v. Davis et al, [1979] 3 All ER 177 (C.A.):

If an expert could have his hands tied by being instructed by one side, it would be very easy for a rich client to consult each of the acknowledged experts in the field. Each expert might give an opinion adverse to the rich man, yet the rich man could say to each, “Your mouth is closed and you cannot give evidence in court against me” ….. Does that mean that the other side is debarred from getting the help of any expert evidence because all the experts have been taken up by the other side? The answer is clearly No …. There is no property in an expert witness as to the fact he has observed and his own independent opinion of them. There being no such property in a witness, it is the duty of a witness to come to court and give his evidence in so far as he is directed by the judge to do so.

Justice Angers concluded that the limited contact between the taxpayer and Mr. F was not sufficient to support a disqualification:

[23] Neither party in this motion, has been able to clarify the nature of the confidential information that may or may not have been communicated. Mr. F’s affidavit does not disclose if he has, in fact, received any and the appellant did not cross-examine Mr. F on his affidavit. It is therefore unclear as to the risk associated with disclosing said information or if, it will cause a prejudice to the appellant. No evidence was put forward that allowing the respondent to retain Mr. F. would prejudice the appellant.

[24] In the light of the evidence presented, one cannot conclude that Mr. F and the appellant shared sufficient information for either one to expect that whatever that information may be would be kept in confidence or is privileged. Mr. F was never retained, no retainer agreement or confidentiality agreement was signed and there is no evidence that the appellant would have requested Mr. F not to discuss the matter with others. Mr. F did not open a file, did not invoice the appellant nor received any payment, nor was he asked to perform any services. It appears to me that the discussions Mr F had with the appellant in 2001 were of an informal nature and nothing more than an attempt to see if Mr. F shared their point of view. In his affidavit, Mr. F did not recall discussing specific legal strategy other than the fact that he refused to be “creative” in responding to CRA’s position. He cannot recall the documents he reviewed nor did he retain any documents. He also said that early on, he communicated to the appellant that, on the basis of previous experience with Watts, it was unlikely that the appellant would agree with his firm’s method of valuation. That is hardly the foundation necessary for the appellant to shield Mr. F from being retained by the opposing party and provide his opinion.  [Emphasis added]

What is clear from this decision is that a limited contact with a potential expert witness will not normally be sufficient to disqualify that witness.  There must be real concerns about confidential information shared with that potential expert and the taxpayer must be able to prove those concerns to the satisfaction of a judge if the potential disqualification is raised before the court.

Tax Court of Canada Limits Shopping for Expert Witnesses: Aecon Construction Group Inc. v. The Queen

Reuters: Corporations Face Long Odds in Tax Cases Heard by the United States Supreme Court – Situation Brighter in Canada

Reuters recently reported a study showing that corporations face very long odds in tax appeals heard by the United States Supreme Court. There were 919 income tax cases in the Supreme Court of the United States from 1909 to 2011. 364 of those cases involved corporations. In “abuse” cases, the government won 61% of the time. In other cases, the government won 68% of the time. The real story is likely much grimmer since the statistics show that the US Supreme Court only grants review in about 2% of leave applications.

The Canadian Supreme Court heard 356 income tax cases between 1920 and 2003. Of these, the statistics show that the government won 223, or roughly 2/3. The record of Supreme Court tax cases between 2004 and 2012 is essentially similar. While an exact breakdown of corporate cases is not available, anecdotal evidence suggests that the success rate of corporations is roughly 1/3 (a more detailed analysis will be available in the future).

While the Canadian experience appears superficially to mirror the American statistics, a very different story is disclosed by Canadian leave to appeal statistics.

Year      Denied Granted
2001

579

79

2002

433

53

2003

523

75

2004

466

83

2005

492

65

2006

406

55

2007

550

69

2008

448

51

2009

444

59

2010

388

54

2011

398

62

Total

5127

705

     
Grand Total

5832

 
     
Average

0.120885

 

As the chart demonstrates, roughly 12% of leave applications are granted in Canada. Thus, corporations and other taxpayers may have as high as 6 times more likelihood of success in a tax appeal before the Supreme Court of Canada than in cases before the Supreme Court of the United States.

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Reuters: Corporations Face Long Odds in Tax Cases Heard by the United States Supreme Court – Situation Brighter in Canada

FCA affirms the importance of GAAP in computing liability for LCT rejecting the Crown’s economic substance argument

The Federal Court of Appeal has once again affirmed the importance of Generally Accepted Account Principles (GAAP) in computing liability for the large corporation tax (LCT) applicable prior to 2006 while rejecting the Crown’s economic substance argument: The Queen v. Bombardier Inc.

The case turned on how Bombardier accounted for advances received in connection with long-term construction contracts:

[9] It can be seen from this agreement that the respondent has two divisions: the Aerospace Division (aircraft sale contracts) and the Transportation Division (public transportation equipment) and aircraft parts and components. It can also be seen that, in the Aerospace Division, as shown at paragraph 6 of the agreement, “[t]he income from contracts for aircraft sales is recognized as work progresses, on the basis of the delivery date, whereas in the Transportation Division, as shown in paragraph 10, “[i]ncome from long‑term contracts is recognized as work progresses, on the basis of costs incurred”.

[10] In summary, in the Aerospace Division, financing for long‑term work is obtained through advances of funds paid on dates predetermined in the contract of sale. The amounts of these advances do not depend on the work in progress or the work completed. They correspond to a portion of the selling price.

[11] Conversely, in the Transport Division, financing for work of the same nature is acquired through payments in amounts determined by progressive billing proportionate to the work completed.

In the case of aircraft sale contracts Bombardier used the “percentage-of-completion” method. The Crown did not dispute that this method was authorized by GAAP:

[27] The fact that the respondent’s balance sheet was GAAP‑compliant in all respects is recognized and acknowledged by the appellant and its expert. Indeed, the appellant’s expert, Mr. Thornton, confirmed this on cross‑examination. He also admitted that the respondent had correctly exercised its judgment regarding the advances, seemed to have applied standard SOP 81‑1 and had used paragraph 6.19 as a basis for its judgment; and that standard SOP 81‑1 was an acceptable source: see Mr. Thornton’s cross‑examination, Appeal Book, Vol. 10, at pages 109 to 114. He also acknowledged that the advances had been allocated to the project for which they had been paid, not used to finance other projects: ibidem, at page 117.

The Crown’s position was that in this case GAAP did not reflect economic reality:

[32] The appellant’s position, with which the Court of Québec agreed [a decision which is currently being appealed to the Québec Court of Appeal], gives precedence to the legal reality over the commercial and accounting reality by not allowing the amount of the advances to be reduced by the cost of the work for the purposes of calculating the taxable capital under paragraph 181(3)(b). According to the respondent’s expert, by designating the full amount of the advances as liabilities, the appellant is refusing to recognize that, on a commercial and economic level, the respondent used its inventory to perform the contract and sold that inventory, although from a legal standpoint ownership had not yet been transferred: see Mr. Chlala’s cross‑examination, Appeal Book, Vol. 9, at pages 40 to 43. In other words, the appellant’s position does not reflect the [translation] “economics of the situation” prevailing between the parties, which [translation] “suggest that a continuous sale occurs as the work progresses, and revenue should be recognized accordingly”: see the excerpt from the work by Messrs. Chlala, Ménard et al., quoted above in connection with the percentage‑of‑completion method.

The Court of Appeal rejected the Crown’s argument citing its earlier decision in Attorney General of Canada v. Ford Credit Canada Ltd.

In that decision Ryer JA wrote:

[27] In my view, this decision is far from helpful to the Minister in this appeal. In essence, Rothstein J.A. determined that the balance sheet of the taxpayer must be accepted for LCT purposes if it was accepted by the Superintendent of Financial Institutions. In my view, the same logic should apply where the corporation in question is subject to subparagraph 181(3)(b)(i) rather than subparagraph 181(3)(b)(ii). On that basis, provided that the balance sheet in question has been prepared in accordance with GAAP and otherwise complies with the specific provisions of Part I.3, that balance sheet must be accepted for the purposes of the determination of the LCT liability of the corporation.

While LCT decisions are of limited application to most taxpayers, this decision and the Ford Credit Canada Ltd. decision (where David Spiro was the successful lead counsel) form a useful bulwark against attacks mounted by the CRA based on “economic substance”.

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FCA affirms the importance of GAAP in computing liability for LCT rejecting the Crown’s economic substance argument

Further thoughts on the Fundy Settlement decision: Supreme Court offers a nuanced view of trust residence

In Garron Family Trust v. The Queen (2009 TCC 450), Justice Judith Woods of the Tax Court of Canada came down with a very broad new rule for determining the residence of trusts.

[162]  I conclude, then, that the judge-made test of residence that has been established for corporations should also apply to trusts, with such modifications as are appropriate. That test is “where the central management and control actually abides.”

This was viewed widely as a repudiation of the historic test based on the residence of the trustee. Many tax professionals thought that the test for residence of a trust required a determination of the residence of the majority of the trustees and where their functions were performed, and that it was not necessary to go beyond this test.

The Federal Court of Appeal in St. Michael Trust Corp. v. Canada (2010 FCA 309) appeared to endorse Justice Woods’ new legal test but in a somewhat guarded fashion:

[63]    St. Michael Trust Corp. argues that a test of central management and control cannot be applied to a trust because a trust is a “legal relationship” without a separate legal personality. I do not accept this argument. It is true that as a matter of law a trust is not a person, but it is also true that for income tax purposes, a trust is treated as though it were a person. In my view, it is consistent with that implicit statutory fiction to recognize that the residence of a trust may not always be determined by the residence of its trustee.

[64]    St. Michael Trust Corp. also argues that the residence of the trust must be determined as the residence of the trustee because section 104 of the Income Tax Act embodies the trust, as taxpayer, in the person of the trustee. In my view, that gives section 104 a meaning beyond its words and purpose. Section 104 was enacted to solve the practical problems of tax administration that would necessarily arise when it was determined that trusts were to be taxed despite the absence of legal personality. I do not read section 104 as a signal that Parliament intended that in all cases, the residence of the trust must be the residence of the trustee.

When the Supreme Court of Canada granted leave to appeal, some tax professionals were puzzled.  These tax professionals believed that it was unlikely the decision would be reversed since the Crown had a very strong factual case that the trusts in question were managed in Canada by the trust beneficiaries.  The decision released on April 12 by the Supreme Court (Fundy Settlement v. Canada, 2012 SCC 14) in fact dismissed the appeal in somewhat cursory fashion.

[15]    As with corporations, residence of a trust should be determined by the principle that a trust resides for the purposes of the Act where “its real business is carried on” (De Beers, at p. 458), which is where the central management and control of the trust actually takes place.  As indicated, the Tax Court judge found as a fact that the main beneficiaries exercised the central management and control of the trusts in Canada.  She found that St. Michael had only a limited role ― to provide administrative services ― and little or no responsibility beyond that (paras. 189-90).  Therefore, on this test, the trusts must be found to be resident in Canada.  This is not to say that the residence of a trust can never be the residence of the trustee.  The residence of the trustee will also be the residence of the trust where the trustee carries out the central management and control of the trust, and these duties are performed where the trustee is resident.  These, however, were not the facts in this case.

[16]    We agree with Woods J. that adopting a similar test for trusts and corporations promotes “the important principles of consistency, predictability and fairness in the application of tax law” (para. 160).  As she noted, if there were to be a totally different test for trusts than for corporations, there should be good reasons for it.  No such reasons were offered here.  [Emphasis added]

On a close reading it is arguable that the Supreme Court has gently tempered the new rule set out by Justice Woods and, to some extent, by the Federal Court of Appeal.  Where the trustee does what it is supposed to do, including managing the trust and its properties, the operative test remains the residence of the trustee.  It would seem that only where the trustee carries on those “management and control” activities in a place other than where the trustee is resident, or where the trustee abdicates many of its powers to a third party, that Justice Woods’ new test becomes relevant.

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Further thoughts on the Fundy Settlement decision: Supreme Court offers a nuanced view of trust residence

Federal Court Cancels its Earlier Orders Authorizing Issuance of “Unnamed Persons” Requirements as Canada Revenue Agency Failed to Disclose all Relevant Facts

The decision of the Federal Court in Minister of National Revenue v. RBC Life Insurance Company et al., 2011 FC 1249 may have opened the door to new opportunities for judicial review in the context of ex parte orders in federal tax matters only days after the decision of the Federal Court of Appeal in Stemijon Investments Ltd. v. Attorney General of Canada (see our earlier post) appeared to have narrowed those opportunities in the context of so-called “fairness applications” dealing with late-filed forms under federal tax statutes.

By way of background, the case concerned insurance products known in the industry as 10-8 plans. These essentially were a tax-effective insurance structure where, in very general terms, the taxpayer paid a high rate of deductible interest on loans in connection with insurance products where relatively high rates of interest accrued free of tax. The Canada Revenue Agency was aware of these structures at the highest levels and the record disclosed that they had considerable concern that the structures were abusive, violated GAAR, etc. As a result, CRA made ex parte applications under subsection 231.2(3) of the Income Tax Act against a number of the issuers of such 10-8 plans requiring the production of detailed information about these plans and their customers.

What CRA did not disclose to the Court on these ex parte applications was that one of the principal purposes of these applications was to take measures to “chill” 10-8 plan business. This offended the Court:

[58] At the hearing, the Insurers conceded that the Minister had a valid audit purpose in issuing the requirements, but argued that this valid purpose was extraneous to her primary goal, which was to chill their 10-8 plan business. I agree.

[59] I do not believe that the Minister’s central purpose in issuing the requirements is sufficiently tied to her valid audit purpose. Contrary to the Minister’s pretension, I did find evidence that the targeted audit of specific 10-8 plan holders was not only done to test the reasonableness of the 10% payable interest rate or the possible application of the GAAR but to send a message to the industry. I am not satisfied that the Minister’s attempt to “send a message” is a valid enforcement purpose such that subsection 231.2(3)(b) of the Act is satisfied or that this goal is sufficiently connected to the Minister’s valid audit purpose.

Accordingly, Justice Tremblay-Lamer cancelled the earlier ex parte orders with costs.

The Federal Court’s decision is a refreshing affirmation of the Crown’s duty of fairness and candour, particularly in ex parte proceedings. The decision should encourage those in receipt of “unnamed persons” requirements to challenge such requirements with a view to ascertaining whether the facts put forward by the CRA on the ex parte application to obtain the order constituted a “full and frank” disclosure of all the relevant facts.

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Federal Court Cancels its Earlier Orders Authorizing Issuance of “Unnamed Persons” Requirements as Canada Revenue Agency Failed to Disclose all Relevant Facts