Tax proposals change how you advise clients

Earlier this year, one of Canada’s largest employers boosted its workforce by thousands of people, without increasing its payroll by a cent. In fact, if you are a Canadian taxpayer or an accountant, lawyer, financial planner, investment advisor, or insurance agent – anyone who receives fees for assisting Canadian taxpayers with a tax plan that provides tax benefits – you have a new employer: the Canada Revenue Agency.

Your income won’t change, but you will have some significant new responsibilities. If you don’t fulfill them, you can be fined.

Your new position is a result of the March 4, 2010 Federal Budget announcement, the Backgrounder of May 7, 2010 and the Draft Legislation released by the Ministry of Finance on August 27, 2010. The terms of your employment can be found under proposed section 237.3 of the Income Tax Act, which outlines the details of the Aggressive Tax Proposals that were proposed to come into force in January 2011 and confirmed in the 2011 Federal Budget.

Since 1972, various federal and provincial governments have been taking steps to eliminate loopholes allowing the 250,000 high-net-worth Canadians to use domestic and international tax-efficient plans to avoid taxes. The AT proposals are the most recent addition to this series of measures.

History

In 1988, the Mulroney government introduced the General Anti-Avoidance Rule (GAAR). The rule was aimed at types of planning deemed not to be in the spirit of public policy, even if the plans met the technical terms of the Income Tax Act. In the 1990s and 2000s, the government introduced tax identification regulations and penalties for professionals providing negligent tax advice.

The CRA also established an aggressive tax planning unit to help identify legitimate and illegitimate plans promoted by tax advisors and engaged in by taxpayers. The detailed proposals released on May 7, 2010 by the Honourable Jim Flaherty, Minister of Finance are designed to help the CRA identify instances of aggressive tax planning, which can undermine our tax reporting system.

These new AT proposals outline which transactions should be reported (unfortunately, ‘avoidance transactions’ are equated with ‘reportable transactions’), how they are to be reported, who should report them (that’s you, in most cases) and what happens if transactions are not reported. The details are critical and should be reviewed by anyone who provides tax advice to clients.

This started in 1936, with the principle established in the U.K. by IRC vs. Duke of Westminster. The judgment stated, “Every man is entitled, if he can, to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be.” The principle hasn’t changed. It’s just that Canadian taxpayers and advisors need to report the ordering of these affairs to the CRA under specific circumstances. This creates a huge reporting obligation for advisors, as well as a mammoth-sized reviewing obligation for the paid employees of the CRA.

What is reportable?

In general, a reportable transaction is one entered by or for the benefit of a taxpayer that meets the definition of an avoidance transaction as defined by two of three hallmarks:

• If the promoter is entitled to a fee that to any extent is attributable to the amount of tax benefit derived, contingent on obtaining a tax benefit, or attributable to the number of taxpayers who participate in the transaction or who have been given access to the tax consequences of the taxation;
• If the promoter requires confidential protection; or
• If the taxpayer is provided contractual protection in respect of the transaction.

An avoidance transaction is governed by the existing definition in subsection 245(3) of the Act and is any transaction or series of transactions that, but for GAAR, would result in a tax benefit. If the taxpayer can prove she entered the transaction for bona fide purposes other than to obtain a tax benefit, the transaction would not be considered an avoidance transaction.

The general principles define the terms of confidential protection, contractual protection, promoters, tax advisors and fees. It appears whenever anyone who is involved with tax planning meets two of the three hallmarks, all tax plans need to be reported.

Finally, the proposals apply to avoidance transactions entered into after 2010, and similar transactions that commenced before 2010 and were completed after December 2010.

The reaction

The government welcomed submissions criticizing the proposed legislation. Many stakeholders made submissions, including the Society of Trust and Estate Practitioners (STEP), the Conference of Advanced Life Underwriters (CALU), the Canadian Bar Association (CBA), and the Joint Committee on Taxation of the Canadian Bar Association (CBA) and the Canadian Institute of Chartered Accountants (CICA).

The CBA’s concern: “If adopted in their current form, [the AT proposals] will create a serious incursion into solicitor-client privilege and will compromise the independence of the legal profession.”

CALU wants to ensure “the reporting and penalty requirements do not apply in unintended ways to normal commercial transactions involving the sale of financial products for bona fide non-tax purposes.”

STEP is worried the introduction of these proposals could result in taxpayer reluctance to comply, based on the fear that acknowledging beforehand that a reportable transaction is an “avoidance transaction” undertaken solely for the purpose of securing a tax benefit will inevitably result in CRA characterizing the transaction as abusive.

It is no surprise advisors who are involved with tax planning for clients are concerned about these far-reaching proposals. Everyone agrees that some measures are required to control overly aggressive tax planning. But the tax regime should be fair; the approach suggested by the legislation might be too all-encompassing and complex.

According to the CBA/CICA joint submission, “Several of the proposed concepts could be too broad and could cause significant problems.”

What about commissions?

CALU pointed out an interesting twist to the issue in its presentation to the Finance Department. One of CALU’s major concerns was whether or not insurance commissions are defined as “fees” for the purpose of determining if a transaction is reportable. According to the draft legislation, a “fee” would mean any consideration that is, or could be, received or receivable by a promoter or tax advisor in respect of a transaction for:

• Advice on the transaction
• Implementing the transaction
• Preparing the documents supporting the transaction, including tax returns or any information returns to be filed under the Income Tax Act.
• Contractual protection.

In addition, the CRA would consider if the fee is attributable to the amount of tax benefit. In response to CALU’s submission, Finance officials indicated it was their view that commissions received for placing an insurance policy would not be considered a fee that would create a reporting obligation. This is good news for life insurance agents. But if the agent receives any other compensation, such as a client consulting fee or a referral payment in respect of a tax planning transaction, the transaction becomes reportable. Hence, agents are best just to earn their money from commissions.

This puts a wrench in the ongoing discussion regarding the relative merits of fee-based and commission-based advisors. The opinion exists that the commission method of compensation for certain advisors is non-transparent, which can lead to abuse. Given the similarities between the British and Canadian regulatory regimes, it would seem the same method of compensation should apply to advisors on both sides of the big pond. Commission compensation appears to be good for the new reporting regime, but bad for accountability to the consumers.

Other issues

There are additional practical and technical issues outlined in the various submissions. One concern is that the sheer volume of reporting required could be enormous. The strain on the resources of CRA could become unmanageable. Without the burden of the AT proposals, the CRA processed over 27 million individual and 1.9 million corporate returns, plus 200,000 trust returns, during the last fiscal year.

Since 2004, the CRA has identified aggressive tax planning as one of its top compliance priorities. Millions in additional funds are being allocated to this priority. The stated goal is to provide CRA with an increased ability to enforce the provisions of the Income Tax Act and to counter aggressive tax planning. However, it is a costly endeavour. The agency has spent millions over the past year on information technologies, risk assessment systems and business decision and support software.

CRA distinguishes tax avoidance from tax evasion in that avoidance does not contravene a specific law or rule. Evasion, on the other hand, violates the rules and is illegal. The approach in the AT proposals equates a “reportable transaction” with an “avoidance transaction.”

This in itself creates a problem, because the term “avoidance transaction” only appears in the Act when defining transactions that could be subjected to the GAAR.

On a practical basis, this could lead to taxpayers and advisors sending tens of thousands of reportable transactions a year to the CRA. The provisions require that all transactions must be reported, no matter what the amount of tax benefit involved. It places an incredible increased burden on taxpayers and their advisors, and could detract from the CRA’s ability to review more significant and clearly evasive tax transactions.

From a technical point of view, we are concerned with the method and timing of reporting a transaction. An advisor whose fee is contingent on securing a desired tax benefit for a client must independently report a transaction. If the transaction is not reported, then the advisor will be jointly and severally liable, along with the client, for the penalties imposed if the transaction is not reported. The transaction must be reported if it was entered into after 2010, or if it is an avoidance transaction that is part of a series of transactions that began before 2010 and completed after 2010.

This would create a challenge for clients who move or change their advisor relationship after a transaction has been started but not yet completed. Given the privacy rules and the rights to the client for file ownership, how would an advisor in this case know when a transaction was completed and the tax benefit realized?

It is clear the proposals were designed to stop transactions with the specific hallmark characteristics. Unfortunately, this approach could lead to a whole new industry bent on circumventing the application of the hallmarks.

The Department of Finance is undoubtedly trying to curb the appetite for tax products that do not have a bona fide reason other than saving taxes, such as products that include contingent fee arrangements, contractual guarantees, confidentiality requirements and contractual protections. On the surface, the proposals seem to accomplish what Finance is trying to do, which is to limit the use of these types of tax plans.

We all need to protect the integrity and legitimacy of our tax system. The AT provisions could go a long way in this regard. They need, however, some significant refinement in order to maintain the integrity of our current system, the principles on which it is based and our ability to advise our clients efficiently and effectively.

What can you do?

Write your local MP and explain the challenges and lack of clarity inherent in this legislation. Ask for additional clarity in the reporting rules. Until we receive more direction and clarity from legislators, be extremely mindful of the types of transactions you and your clients are getting involved in.

David Wm. Brown, CFP, CLU, Ch.F.C., RHU, TEP, and a member of the MDRT, is a partner at Al G. Brown and Associates in Toronto.