CRA on the prowl

More and more, the Canada Revenue Agency is taking a keen interest in how companies, both small and large, structure their tax planning. And it is asking increasingly intrusive questions—not quite audits, but compelling questionnaires.

All of this is the name of the GAAR: the General Anti-Avoidance Rule promulgated some 20 years ago. Still, while the GAAR applies as a smell test, the Crown has frequently not made the case that tax avoidance is actually happening.

That’s one changing element in the tax landscape to be concerned about, according to a panel of experts at the Society of Tax and Estate Practitioners (STEP) 13^th annual conference last week in Toronto.

GAAR strikes fear in many folks. Or at least it attempts to, suggests Al Meghli, a partner at Osler in Toronto who has litigated GAAR cases before the courts for some 20 years.

A GAAR proceeding typically sees CRA lawyers arguing three charges: that a transaction has a tax benefit, avoids taxes and is abusive. Such a broad indictment, Meghli argues, would also take into account RRSP contributions: there is a tax benefit and they avoid taxes. They are not, however categorized as abusive.

But the courts have given up on ruling on the first two counts: whether a tax benefit is realized, and whether taxes are avoided. Instead, he says, they start with the allegation of abuse and misuse. And they have become more demanding of CRA lawyers. Often, he says, the Crown starts with an emotive argument, that some individual received extravagant benefits from tax planning.

Meghli’s retort: Which section of the Income Tax Act was violated?

Increasingly, he says, the courts are asking for reference to specific sections of the Act. But there’s a further step: did the section, backed up by tax policy, enumerate something as abusive or a misuse. That can be much harder to prove, because Parliament is often silent on the reasons for this or that provision and how it should be used.

Broadening of GAARStill, CRA is on the prowl, says Craig Jones, a lawyer at Felesky Flynn in Calgary. Provisions in the 2010 federal budget are aimed to crack down on aggressive tax planning. They require disclosure not just by taxpayers, but by people who provide advice—lawyers and accountants. Such a regime is a necessary consequence, he says, of a tax system that includes a GAAR that is not self-assessed., and where the tax authorities have difficulty understanding transactions. Still, he calls the proposed measures “very distasteful and very destabilizing to the solicitor-client relationship.”

Specifically, the Aggressive Tax Planning Reporting Regime tries to alert CRA to potentially abusive schemes, discourage the retailing of such schemes and enable legislation to be drawn up to correct the problem. What constitutes avoidance is determined by three criteria: whether a fee was paid based on the amount of tax saved; whether “confidential protection” is obtained such that the details of the transaction cannot be reported to CRA; and whether the taxpayer or advisor has “contractual protection” should the transaction fail.

Another apparent GAAR initiative is a joint effort between CRA and provincial tax authorities: an auditing process for trusts that seeks to block interprovincial tax arbitrage. Alberta has lower income tax rates than other provinces, and CRA is concerned that trusts are being set up in that province even though the “control and management” of the trust is located elsewhere.

That follows a precedent-setting case, Garron v. R., involving a Canadian holding company owned by a trust resident in Barbados, where the Tax Court of Canada ruled that the trust had its “central management and control” in Canada, and thus was a Canadian resident for tax purposes. Previously that test had been applied only to corporations, not trusts.

There are legitimate reasons for setting up trusts in different provinces, Jones says. To purify the trust in CRA’s eyes, he suggests making a “pass accounts” application before the Alberta Court of the Queen’s Bench. That way, Alberta asserts jurisdiction over the trust.

Then there’s the “Ontario shuffle.” Two Alberta corporations arranged their affairs so that they could refinance their business in Ontario. Alberta said this was an abuse according to the GAAR, since the arrangement exempted the corporations from Alberta (and indeed Ontario) provincial tax. But the Alberta Court of Queen’s Bench upheld the refinancing decision. Interestingly, one corporation said that if refinancing elsewhere was to be considered abusive, then so would the migration of taxpayers from other provinces to Alberta, since they would benefit from lower income tax rates.

Insurance StrategiesBeyond the GAAR, there are a number of other issues that affect tax planning. The use of insurance is one of them as Kevin Wark, senior vice-president at PPI Financial Group explains.

Just as low interest rates have affected income savers and pension plans, so they have affected life insurance companies. A widely used tax planning tool—universal life—often sees life insurance companies setting aside a reserve account. This happens when the UL policy premiums are paid based on a level cost of insurance. A higher than necessary premium is charged in the early years of the policy, given mortality prospects, and a lower one as the client ages. The problem is that the death benefit of the policy is calculated according to today’s interest rates. That means a higher payout potential. For years, life insurers resisted the impact of lower interest rates

But that’s changed. As a result UL premiums have gone up an average of 12% for clients who are 30 and 11% for clients who are 45. On joint last-do-die policies, the premiums are up 20%

Another insurance manoeuvre that is under scrutiny is the so-called 10-8 strategy, where a client has a universal life policy with a cash surrender value—overfunding the policy means it has a value beyond simply the death benefit.

The overfunded portion can be used as collateral for a policy loan—typically at 10%, with a 10-year guarantee. The collateral, in the meantime, is earning 2% less than the loan rate. This can make sense for tax-planning purposes because the money lent can be used to buy income-producing assets, with the interest on the loan eligible for a tax deduction.

Initially, Wark says, CRA was looking at whether this ran afoul of the GAAR. Now, he says, CRA is more concerned about the reasonableness of the loan rate.

As well, Retirement Compensation Arrangements have fallen into CRA’s sights. It’s not so much because they represent tax avoidance. In an RCA, half the contributions are held by CRA—and that tax take is refundable as benefits are paid out.

Instead, the concern is that there has been a large number of RCAs set up, with CRA holding much higher liabilities in the form of refundable taxes.

As with trusts, CRA is on the prowl.