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Sales of condominium units under audit by Canada Revenue Agency

A Canada Revenue Agency (“CRA”) audit initiative is targeting taxpayers who have recently sold condominium units they did not occupy or occupied for only a short period of time (the “CRA Condo Project”).

The CRA is reassessing some of these dispositions on the basis that the condo was sold in the course of business, treating the profit as income (instead of capital gains) and, in some cases, assessing gross negligence penalties under subsection 163(2) of the Income Tax Act. In doing so, the CRA may be incorrectly reassessing some taxpayers whose gains are legitimate capital gains and that may be subject to the principal residence exemption (click here for a discussion of the principal residence exemption).

Consider this example. A taxpayer signs a pre-construction purchase agreement for a condo in 2007.  In 2009, the unit was completed and occupied by the taxpayer, before the entire development was finished and registered in land titles.  Land titles registration occurs in 2010, but shortly thereafter the taxpayer sells the condo for a profit.  Ordinarily, one would conclude the condo was held on account of capital and the gain would be at least partially exempt from tax on the basis that condo was the taxpayer’s principal residence.  The CRA may be inclined to reassess on the basis that land title records show the taxpayer on title for only a short time, as though the taxpayer had intended to merely “flip” the condo rather than reside in it.

This assessing position may be incorrect because the buyer of a condo does not appear on title until the entire condominium development is registered.  In fact, several years can pass from the date of signing the purchase agreement to occupancy to land titles registration – and, accordingly, the taxpayer’s actual length of ownership will not be apparent from the land title records.

This type of situation could cause serious problems for some taxpayers. If a taxpayer is audited and subject to reassessment on the basis that their entire gain should be taxed as income, the taxpayer will need to gather evidence and formulate arguments in time to respond to an audit proposal letter within 30 days, or file a Notice of Objection within 90 days of the date of a reassessment.

Taxpayers could respond to such a reassessment by providing evidence that they acquired the condo with the intent that it would be their residence, and that the subsequent sale was due to a change in life circumstances.  Taxpayers may wish to gather the following evidence to support such claims:

  • Purchase and sales agreements;
  • Letter or certificates granting permission to occupy the condo;
  • Proof of occupancy, such as utility bills, bank statements, CRA notices, identification (such as a driver’s license) showing the condo as a residence; or
  • Evidence of a change in life circumstances which caused the condo to no longer be a suitable residence, including:
    • Marriage or birth certificates;
    • A change of employer or enrollment in education that required relocation; or
    • Evidence showing the taxpayer cared for a sick or infirm relative, or had a disability that precluded using a condo as a residence.

Taxpayers should be prepared to provide reasonable explanations for any gaps in the evidence.  If a taxpayer wishes to explore how best to respond in the circumstances, they should consult with an experienced tax practitioner.

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Sales of condominium units under audit by Canada Revenue Agency

Federal Court of Appeal hears argument on whether “break fees” are income (Morguard)

Is a “break fee” received in return for withdrawing from a takeover bid a capital receipt or an income receipt?

That was the issue before a panel of the Federal Court of Appeal (“FCA”) on November 20, 2012 in Morguard Corporation v. The Queen on appeal from a decision of the Tax Court of Canada. The panel consisted of Justice Evans, Justice Sharlow and Justice Stratas. At the conclusion of the hearing, judgment was reserved.

For the facts of the case and our analysis of the trial decision, see here. For a brief review of the issues raised in the factum filed by each party in the FCA, see here.

Arguments of the Taxpayer

Counsel for the appellant argued the trial judge had made an “error of law” in determining that Acktion Corporation (“Acktion”) was “essentially in the business of doing acquisitions and takeovers” (Acktion was the name under which Morguard Corporation (“Morguard”) operated during the period at issue). Counsel argued that Acktion was a holding company and that it had sought the takeover to increase its capital holdings. The standard of review for an error of law is “correctness”.

The panel asked counsel whether there was any error of law. Justice Stratas asked whether the issue was really a factual one, for which the standard of review is much higher, namely, “palpable and overriding error”.

Counsel argued that it is settled law that a corporation cannot conduct a “business” of acquiring capital assets. Accordingly, counsel argued that the trial judge erred in concluding that Acktion had done so. In support of this proposition, counsel cited the 1978 FCA decision in Neonex International Ltd. v The Queen (78 DTC 6339). 

It was not clear whether the panel agreed with counsel on this point, as their other questions focused on whether the Supreme Court of Canada (“SCC”) decision in Ikea Ltd. v. Canada ([1998] 1 SCR 196) had displaced Neonex by instituting a “modern approach” that supports an organic assessment of the circumstances around the receipt.

Counsel argued the break fee was received in the pursuit of a capital acquisition and that, according to the modern approach, it should be characterised as a capital receipt. Counsel stressed that the expert evidence adduced at trial by both parties was that break fees are intended to support the acquisition of capital by deterring other bidders or to compensate for the various costs incurred in a failed takeover bid.

The panel sought clarification of the appellant’s position that there should be no tax liability arising from the receipt of the break fee. In its written submissions, the appellant argued that the break fee should not be taxed as a capital gain because there were no proceeds of disposition. Justice Sharlow noted that, according to this theory, the break fee could only be characterized either as income or a non-taxable capital gain.

Arguments of the Crown

Counsel for the Crown had to answer fewer questions from the panel. Counsel argued that the characterization of an “unusual receipt” such as a break fee requires a factual determination (relying on the SCC’s decision in Ikea on this point), which the Tax Court had made in this case.

Justice Evans asked about the distinction between conducting a real estate business that acquires companies as capital and being a real estate company in the business of acquisitions and takeovers. Counsel argued that, instead of acquiring real estate directly, Acktion’s business strategy was to acquire businesses that already owned real estate. Counsel further submitted that the corporate information distributed to its shareholders described the corporation as a real estate company and not as a holding company.

Justice Sharlow questioned the Crown’s reliance on the commercial description of Acktion’s business, noting that the technical distinction between income and capital is a legal distinction that would not generally be expected to appear in a commercial context. In response, counsel argued that Acktion treated the takeover bid as part of its regular business. After losing its takeover bid, Acktion negotiated a higher price for its remaining “toehold” in the company, then took the break fee and the proceeds of disposition of its shares and immediately sought to purchase another business. Counsel argued this course of conduct shows that Acktion considered the negotiation of break fees to be part of its real estate business.

In response to the appellant’s position that the break fee was a non-taxable capital gain, counsel submitted that the trial judge was correct in applying the factors set out by the FCA in Canada v. Cranswick ([1982] CTC 69) to determine whether a payment was a windfall. In this respect, the break fee was the product of an enforceable claim negotiated by the Appellant according to common practices in takeover bids and, thus, could not be characterised as a windfall.

*  *  *

The panel reserved judgment. We will report on the judgment when it is released.

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Federal Court of Appeal hears argument on whether “break fees” are income (Morguard)

Federal Court of Appeal to hear argument tomorrow in “break fee” case (Morguard)

Tomorrow morning (November 20, 2012), the Federal Court of Appeal is scheduled to hear an appeal by Morguard Corporation (“Morguard”, formerly operating as Acktion Corporation), regarding the taxation of a “break fee” received as a result of a failed takeover bid.

Break fees are an agreed-upon fee to be paid by or on behalf of a target corporation to a prospective purchaser on the rejection of that prospective purchaser’s bid and the acceptance of another offer. Break fees are intended to reflect, more or less, the monetary and non-monetary costs incurred by the prospective purchaser in making a bid, and are common in sophisticated takeover transactions.

The Morguard case concerns a $7.7 million break fee received by Morguard on withdrawal from a bidding war. In its return, Morguard treated the payment as a capital gain but was reassessed by the Minister of National Revenue on the basis that the amount was an income receipt. On appeal to the Tax Court of Canada, the trial judge agreed with the Minister’s position that, on the facts of the case, the break fee represented income and should be taxed accordingly. For our analysis of the Tax Court decision, see our earlier blog post.

The taxpayer has appealed the trial judge’s decision to the Federal Court of Appeal on the basis that the lower court erred in law and in fact. The Appellant has described the issues raised in the appeal as follows:

(a) Whether the trial judge erred in law by concluding that the taxpayer received the break fee on income account rather than capital account.

(b) If received on capital account, whether the break fee was received in circumstances that gave rise to a capital gain.

(c) Whether the trial judge made palpable and overriding errors in finding that the taxpayer was in the business of doing acquisitions and takeovers, and received the break fee in the ordinary course of its business similar to the receipt of dividends, rents, or management fees.

(d) Whether the trial judge made a palpable and overriding error in finding that the break fee was not linked to a capital purpose of the taxpayer.

(e) Whether the trial judge erred in law in his interpretation and application of the Supreme Court of Canada decision in Ikea Ltd. v. Canada [1998] 1 S.C.R. 196.

(f) Whether the trial judge erred in law by applying the legal test developed by the Federal Court of Appeal in The Queen v. Cranswick (82 DTC 6073) to break fees.

The Crown, on the other hand, has framed the issues as follows:

(a) Whether the trial judge committed a palpable and overriding error in finding that the negotiation and receipt of the break fee by the appellant was part of the ordinary course of its regular real estate business.

(b) Whether the trial judge was correct in concluding that the break fee should be included in the computation of the appellant’s income because it was received in the ordinary course of its business.

(c) Whether the trial judge correctly applied the jurisprudence to conclude that the break fee was not a windfall.

The Appellant’s factum is here. The Crown’s factum is here.

We intend to report again after the hearing in the Federal Court of Appeal.

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Federal Court of Appeal to hear argument tomorrow in “break fee” case (Morguard)

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