5 ways to reduce tax exposure

David Soknacki’s number came up, as he likes to put it, three years ago when an auditor from Revenue Canada called to say she planned to spend two weeks camped out at Ecom Food Industries Corp., the ingredients and flavour business he founded in 1986. Instead of dispatching the auditor to an unheated corner of the warehouse, Soknacki invited her to set up in an office and let her do her thing. She gratefully acknowledged the gesture, and said it was unusual, but added the bit of goodwill didn’t do much to blunt her search for unreported dollars.

“We do a lot of exporting,” he says. “She challenged a trip overseas that I went on.” Soknacki had to produce notes from the trip, as well as evidence his wife, who accompanied him, also attended meetings and participated sufficiently to justify the claimed expenses.

But when the auditor turned to his life insurance premiums, which he claims as a business expense, Soknacki balked. After he set up Ecom, his bankers refused to advance loans unless he had enough life insurance to cover the loans. The bank is listed as the beneficiary.

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“I wasn’t cross, but I gave some push back.” The auditor wouldn’t budge, and he ended up remitting the taxes and penalties on the life insurance.

For entrepreneurs like Soknacki, a visit from Revenue Canada is almost inevitable, and, by all appearances, increasingly likely. The agency is clamping down on business owners, especially in cash-driven sectors like construction and food service. And the ongoing aftermath of the 2008 credit crisis has prompted officials to go after wealthy investors who avoid taxes by hiding assets in off -shore accounts in low-tax jurisdictions with opaque banking laws.

But Revenue Canada’s so-called Related Party Initiative, announced earlier this year, is the enforcement campaign that’s really put wealthy business owners on high alert. According to the government, RPI is targeting people with at least $50 million in net assets who also own or control family companies with 30 or more subsidiaries or, as they call them, “entities.”

The decision to closely scrutinize such conglomerates arose when Revenue Canada identified compliance concerns in selected private firms with $20 million to $250 million in revenues. The companies in question also had complicated corporate structures composed of nested subsidiaries, off-shore trusts, and partnerships. Several other countries, including the U.S., Great Britain, and Germany, have embarked on similar collection campaigns.

The result could be a rapidly widening net of enforcement activity as Revenue Canada’s auditors work their way through these far-flung corporate food chains.

“Depending on how high-net-worth individuals have structured their holdings and operations, it is possible some of the entities would include incorporated small or medium sized businesses,” says Revenue Canada spokesperson Nicole Eva Pigeon. “These businesses would be considered in the course of the risk assessment process and may be subject to audit under the RPI.” The audits, she adds, are integrated and focus on all the related companies simultaneously.

So if you have some kind of corporate link to one of the family empires targeted by the RPI, expect a visit someday soon.

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Tax solutions that work

While Revenue Canada’s campaign is clearly meant to put the fear of God into business owners determined to hide income, don’t get too spooked. There are still many legitimate ways to reduce tax exposure, and the key is to follow the rules and keep a meticulous paper trail. Here are some of the most promising, but commonly overlooked, ways to shelter income:

Scientific Research and Experimental Development (SR&ED) Tax Credits

Many manufacturing and even agricultural firms leave cash on the table by neglecting to claim SR&EDs for process or design improvements, even minor ones and those that don’t involve patents or other intellectual property.

For example, a tax advisory firm was working with a steel fabricator who’d designed a locker with new security features. When the client revealed that he had invented a couple of other product lines, the firm dispatched an R&D consultant to document how these new products represented a previously unknown design solution. The client received $500,000 in SR&ED tax credits over three years, a hefty sum for a $5 million firm.

Allocating Income to Family Members

It’s legitimate to add spouses and children to the payroll of a family business, provided their salaries are at market rates (Revenue Canada can check, so don’t pay your 16-year-old $50,000 to move boxes).

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And there’s a flip side. Tax experts note some owners actually undervalue labour by a spouse who does a lot of bookkeeping and administrative work behind the scenes. Bruce Ball, national tax partner at BDO Canada, adds that properly structured corporations can distribute current year dividends to family members, which means further defraying the tax burden.

A more structured approach to income splitting that’s gained popularity is establishing a family trust to own the company’s shares. But it’s critical to respect the rules and procedures. If the trust declares a dividend and distributes cheques to family members, for example, the trustees need to record the minutes of the meeting where the decision was made. And the cash must flow from the company, to the trust’s bank account, to the beneficiaries—no skipping steps.

You need a paper trail, says Angela Ross, an associate partner in the high-net-worth practice at PricewaterhouseCoopers. She points out many business owners who set-up trusts end up tripping over the technical requirements, which exposes them to scrutiny.

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Allocating Dividends and Capital Gains to Family Members

When they want to retire, business owners have three basic options: pass the company to their children, sell it to employees, or sell it on the open market. If the business stays with the family, Revenue Canada will make sure the sale adheres to related-party transaction rules, which require adult children to pay fair market value.

The owner will be taxed on any capital gain above the lifetime exemption of $750,000, so there’s an incentive to understate the price. Andrew Logan, a partner with Teed Saunders Doyle & Co. in Saint John, N.B., tells clients to obtain a third-party valuation as a means of defending the sale price, and resulting taxes. “It’s like buying insurance,” he says. “If Revenue Canada ever comes looking to review the transaction, you’re untouchable.”

Where a family trust exists, each beneficiary is eligible for the lifetime exemption, meaning the tax savings could be several multiples of the $750,000 cap. High-net-worth individuals sometimes structure their wills to include testamentary trusts, i.e., trusts established for various family members that come into effect after the person dies. These trusts are taxed at more favourable rates; in Ontario, for example, a testamentary trust will save $17,000 per year on $130,000 of income, compared to a conventional inheritance.

Jamie Golombek, managing director of tax and estate planning for CIBC Private Wealth Management, adds that distributing dividends through a trust to university-bound children over 18 can also bring extensive tax sheltering. Once tuition, education, and textbook credits are factored in, the recipients typically pay virtually no tax.

Off-Shore Trusts

Not for the faint of heart, given Revenue Canada’s clampdown, but some tax experts say these structures are still relevant for estate planning and asset preservation. Toronto tax lawyer Jonathan Garbutt cites two very recent federal tax court rulings involving judgments against off-shore trusts that suggest Canadian courts will uphold such entities, provided they’re established legally and Canadian taxes have been paid.

“There are non-tax benefits to off-shore trust planning, and if done properly, with real trustees and underlying structures that actually work, there can be tax savings,” says Garbutt.

Ross points out Revenue Canada now closely scrutinizes cross border exchange arrangements, especially those involving tax havens. Off-shore trusts, she says, “have some limited uses,” but mainly in situations that involve someone who doesn’t live in Canada and who wants to contribute funds. “You have to be cautious.”

Strategic Charitable Giving

Many high-net-worth individuals can avoid capital gains taxes while achieving non-financial personal goals through a savvy approach to donations; either to a self-administered family charitable foundation or an established public one (i.e., United Way).

By donating shares in publicly traded corporations that have seen significant appreciation, the donor will not only receive a charitable receipt but also forego the capital gains tax, says Golombek. John Lorinc is a freelance journalist based in Toronto. This article was originally published on capitalmagazine.ca.