Avoid these T1135 tax traps

If you have more than $100,000 in foreign property, you need to file Form T1135. It’s one of CRA’s more challenging forms, but even the best accountants can’t ensure proper filing if they don’t have the information they need. Here are the key issues.

Foreign insurance

If you relocated to Canada for work or other reasons, you may already have had insurance before the move, notes Zaheed Alibhai, senior manager in Deloitte’s tax practice. Inheriting policy ownership from a relative outside Canada is another reason you might hold a foreign-issued life insurance policy.

The policy needs to be reported in Box 6 of the T1135, “Other property outside Canada.” The form asks for “cost amount,” which CRA explains is the policy’s adjusted cost basis.

When you need to find out the adjusted cost basis (ACB) of Canadian-issued insurance, you usually ask the policy’s broker, who gets it from the insurer. But when you need the ACB for a foreign-issued policy, the process may be far more complex because the foreign issuer wouldn’t use Canadian formulas to calculate cost, Alibhai warns. “They may have their own cost basis calculation, but it doesn’t line up with the Canadian definition.”

That foreign version of cost basis won’t cut it for T1135 reporting purposes, adds Alibhai. “The taxpayer has to figure out what the ACB is in line with the Canadian definition.”

Step one is to ask the insurer that issued the policy. “Some foreign issuers may have systems to advise what the Canadian ACB is, especially if they have substantial Canadian customer bases,” notes Alibhai. If the insurer hasn’t determined the Canadian ACB, the calculation must be done from scratch.

But don’t reach for your calculator. The formula for ACB, detailed in section 148(9) of the Income Tax Act, “is a complex calculation even for a tax professional,” says Alibhai.

This means you’ll need to hire accountants and actuaries to crunch the numbers. “And [that] has to be done every year, because the ACB changes every year,” explains Alibhai. “As time goes on, the mortality rate — the chance of dying — increases, and therefore the ACB will [be] reduced.”

While the foreign insurer may not have the Canadian ACB, it will have the raw information needed to do the calculation. Since the T1135 is an annual requirement with late-filing penalties ($25 per day, up to $2,500), it’s critical you obtain this information promptly at year-end so there’s ample time to do the calculation before the April deadline. Alibhai suggests taxpayers make arrangements with their brokers to provide the necessary information as a matter of routine at the start of every year.

Doing the ACB from scratch every year will definitely hike your accounting bill. “It is without question an administrative burden on the taxpayer,” says Alibhai. But it needs to be put in context of the overall filing requirement, he adds. “It may be a drop in the ocean for a high-net-worth individual whose tax [situation] has so many other components.”

What’s a resident?

Box 2 of the T1135 is for reporting shares of non-resident corporations, other than foreign affiliates. (CRA’s instructions on the T1135 define a foreign affiliate corporation as “a non-resident corporation […] of which you hold at least 1% of the shares individually, and, either alone or with related persons, hold 10% or more of the shares.”)

Dale Franko, managing director at Moodys Gartner Tax Law in Calgary, explains the concept of residency for tax purposes takes two main forms: factual and deemed.

Say you establish a corporation in Delaware. “Arguably, it’s factually a non-resident corporation. But CRA also [looks at] central management and control,” Franko notes. This means that while the corporation is factually non-resident, because it’s controlled by persons resident in Canada, it could be deemed resident for tax purposes. So, if the corporation’s deemed resident because the “mind and management” are in Toronto, should it be excluded from the T1135?

CRA has said that for T1135 purposes, you need to report on a factual basis, says Franko, so the corporation shares go on the form.

Box 3, “Indebtedness owed by non-resident,” can also catch you off guard. Say you loaned your sister, who lives in North Dakota, $15,000. Regardless of whether you’re getting interest, it’s a foreign-sourced receivable you should report, says Phil Nadler, a partner at Richter LLP’s office in Montreal.

If you’re receiving distributions from a non-resident trust, you need to fill out Box 4. To do so properly, you need to know what type of beneficiary you are, says Franko. Some beneficiaries are capital-only, some are income-only; others may be both income and capital. Box 4 has separate fields for income and capital, and failure to put the correct amount in the correct field means an incorrect filing. The trustee’s written declaration of the distribution will specify its type.

Box 5 is a good example of why you should never try to complete the T1135 yourself.

It asks for “Real property outside Canada (other than personal use and real estate used in an active business).”

Franko notes most people don’t know CRA’s definition of an active business. So, while the T1135’s instructions say real property should be included in Box 5, the reference to an active business may throw off people who make a lot of money renting out multiple units.

Says Franko: “It’s possible for someone to look at this and say, ‘Is this active? Yes, I rent it out all the time. And is it a business? Yes, it could be.’ So they don’t put it on the form,” even though they should.

ADRs and ETFs

American Depositary Receipts (ADRs) facilitate trading in shares listed on exchanges in non-U.S. markets, such as Europe. The ADRs will be listed on the NYSE, for instance, but the underlying shares in foreign corporations are not.

These investments need to be reported on the T1135 — but how? Say you have an ADR that represents shares in a German-based corporation. CRA’s position, says Franko, is that you need to report them as shares in a German corporation, not as U.S.-based property.

The same goes for ETFs that are based in the United States, potentially creating a significant administrative burden. If a U.S.-based emerging markets ETF has 100 underlying holdings in seven countries, you’re technically required to report on each of those subholdings. “CRA says you have to try to get that information, but a lot of times it’s not available,” explains Jonathan McKearney, a tax advisor at Moodys Gartner Tax Law. In that case, you can report in aggregate by country.

Why CRA might reassess your taxes

Normally the CRA has a three-year window to reassess returns for a given tax year. But the agency has the authority to extend that period to six years if:

• a taxpayer fails to file the T1135, files it late or fails to correctly report all the necessary information; and
• a taxpayer fails to include some part of his specified foreign income on his tax return.

So, if you file late, but complete the T1135 flawlessly and include all foreign income on your tax return, it’s not enough to trigger the extended reassessment period, notes Phil Nadler, a partner at Richter Tax in Montreal. But take this case: she files one day late, fills out the T1135 flawlessly, but on her tax return forgets to report $10 of interest income from a U.S. chequing account she uses when she’s at the condo in Florida. “Being a day late, plus failing to report even a nominal amount could [trigger] that three-year extension.” And the reassessment isn’t just for foreign income: that one-day, $10 mistake opens the entire tax filing to re-evaluation.