SCC Update on Rectification – Canadian Tax Lawyer Analysis – Part III

Canada (Attorney General) v. Fairmont Hotels Inc. – SCC Update on Rectification – Canadian Tax Lawyer Analysis – Part III

I and II of this article provided background on rectification in a Canadian tax context and reviewed the facts and judicial history of Canada (Attorney General) v. Fairmont. Part III of this Toronto tax lawyer tax rectification article discusses the Supreme Court of Canada’s decision and its tax planning implications.

Supreme Court of Canada Decision – Canada (Attorney General) v. Fairmont Hotels Inc

The Supreme Court of Canada allowed the CRA appeal and found that Fairmont did not meet the requirements for rectification. Although Fairmont demonstrated a continuing intention to maintain foreign exchange tax neutrality, that intention alone is not sufficient to qualify for rectification. The Supreme Court emphasized that the role of rectification is to correct errors in the recording the terms of an agreement in a written instrument. The parties must have had an agreement in mind with definite and ascertainable terms which they failed to accurately record as a written instrument. In such situations, the Court will use rectification to alter the written instrument so it reflects the terms of the antecedent agreement.

The Supreme Court took the position that it is relevant that Fairmont never had a specific plan in mind as to how they were going to achieve foreign exchange tax neutrality for their subsidiaries. This meant that there wasn’t an agreement with definite and ascertainable terms that Fairmont failed to record. Fairmont’s desire to protect its subsidiaries and maintain tax neutrality by unspecified means was not sufficient to qualify for rectification. The Supreme Court stated that cases like Juliar v. Canada (Attorney General) which allowed taxpayers to qualify for rectification on the basis of their tax objectives for a transaction alone are inconsistent with the Supreme Court’s jurisprudence in Performance Industries Ltd. v. Sylvan Lake Golf & Tennis Club Ltd. and Shafron v. KRG Insurance Brokers (Western) Inc. which emphasize that rectification’s role is to restore the parties to an agreement to their original bargain, not repair an error in judgement. The Supreme Court also relied on the principle established in Shell Canada Ltd. v. Canada that taxpayers should expect to be taxed based on what they actually did, not what they could have done. If you would like a more in depth explanation of this tax rectification decision and how it impacts you, please contact one of our knowledgeable Toronto tax lawyers.

This decision is significant because the lower courts have frequently proved willing to grant rectification on the basis of an intention to achieve a certain tax result even in the absence of the parties having worked out the means of properly achieve that result at the time of the transaction. This decision will likely narrow the scope of tax problems that can be fixed through rectification. Taxpayers will need to be able persuade the Court that they had a specific plan in mind that would achieve their tax objectives for the transaction, and not merely that they had those specific tax objectives. This makes proper tax planning involving a detailed written tax planning memo which sets out the taxpayer’s objectives and the intended means for achieving them even more essential than prior to the decision. Without such a written tax plan it is unlikely that rectification will be granted. If you need help determining how changes to the law of tax rectification will impact your tax situation, please consider speaking with one of our expert Toronto tax lawyers.

Read previous part of this article SCC Update on Tax Rectification Part 2.

SCC Update on Rectification – Canadian Tax Lawyer Analysis – Part III

Tax-Free Savings Accounts– Relief from Assessed Taxes– Toronto Tax Lawyer

The rules relating to Tax-free savings accounts are relatively complex and a failure to abide by these tax rules can result in significant income taxes owing. CRA has also implemented special tax audit projects that specifically target TFSAs, especially those that have accumulated large balances, which further increases the likelihood that technical non-compliance with the TFSA provisions in the Income Tax Act will be detected and correspondingly penalized and/or taxed by CRA. Section 207.02 the Income Tax Act imposes a tax on over-contributions to a TFSA, and section 207.03 taxes contributions made by non-residents. These taxes are punitive in nature and if the contribution(s) which lead to their having been assessed go uncorrected for a lengthy period, the tax amounts owing can be significant. Subsection 207.06(1) of the Canadian Income Tax Act gives the Canada Revenue Agency the discretion to cancel or waive taxes payable under sections 207.02 and 207.03, but only under very specific circumstances. Speak with one of our Canadian tax lawyers to determine if you are eligible for relief on taxes assessed against you due to over-contributions or non-resident contributions made to a Tax-free savings account.

Tax on Over-contributions and Non-resident Contributions to TFSAs

As the name implies, income earned in a tax-free savings account is sheltered from Canadian income tax. For that reason there are strict limits on how much money can be validly contributed to a TFSA. The annual contribution limit was $5,000 for 2009 through 2012, $5,500 for 2013 and 2014 and $10,000 for 2015. The contribution limit has been reduced to $5,500 for 2016 and is to be indexed to inflation and rounded to the nearest $500 moving forward. Therefore, an individual who has made the maximum contribution every year since 2009 will have deposited $46,500 into their TFSA as of 2016. Section 207.02 assesses a tax on over-contributions made to a TFSA equal to 1% of the maximum amount of the over-contribution during the month, for every month the over-contributed amount remains in the TFSA. For instance, If an individual had $5,000 of contribution room in their TFSA and then deposited $20,000 in January of that year and did not rectify the issue by the end of that year, they would be assessed under section 207.01 of the Tax Act for $1,800 (1% of $15,000×12), in addition to any applicable penalties and interest.

Only resident Canadians are entitled to the benefits of tax-free savings accounts and all contributions made to TFSAs by non-residents are subject to tax under section 207.03 of the Income Tax Act. As with over-contributions, non-resident contributions to a TFSA are subject to tax equal to 1% of the maximum amount of the non-resident contribution during the month, for every month the non-resident contribution amount remains in the TFSA. In fact, it is CRA practice to assess non-resident contributions under both 207.02, as an over-contribution, as well as a non-resident contribution, resulting in a double-penalty being charged. Our Toronto tax lawyers are experts on the Income Tax Act and can make sure your tax planning strategies stay onside the TFSA contribution rules.

TFSA Income Tax Relief

For anyone who has received a tax assessment for taxes payable as a result of an over-contribution or a non-resident contribution to a TFSA, income tax relief is available under subsection 207.06(1) of the Income Tax Act. Subsection 207.06(1) allows CRA to cancel or waive taxes assessed against a taxpayer under either section 207.02 or 207.03 if the taxpayer satisfies CRA that he or she ran afoul of the TFSA contribution rules as a result of a reasonable error, and if the taxpayer rectifies the error forthwith by withdrawing the over-contribution or non-resident contribution, in addition to any income earned.

“Reasonable error” is not defined in the Income Tax Act and whether or not income tax relief will be given will likely depend on the unique circumstances of each case. Complete disregard for the TFSA contribution rules, for instance if a taxpayer were to recklessly contribute $250,000 to a TFSA without getting tax advice, will almost certainly not warrant tax relief. However, as mentioned above, the rules regarding TFSAs are complex and an innocent mistake that puts a taxpayer offside the tax rules should warrant tax relief under subsection 207.06(1) of the Tax Act if the facts are presented properly. For instance, contribution room that is “freed up” by a withdrawal in a given year is not credited to a taxpayer’s “contribution room” until the following year. For example, if a taxpayer had $25,000 of contribution room on January 1 and decided to contribute the full $25,000 to his or her TFSA, then subsequently withdrew the $25,000 to finance a family emergency, before re-contributing the $25,000 in February of the same year, the final $25,000 contribution would be an over-contribution and subject to a 1% tax for every month it remains in the TFSA, until January 1 of the next year when the previous withdrawal will be credited to the taxpayer’s contribution room. In a case such as this, our Toronto tax lawyers can make submissions to CRA on your behalf for tax relief and explain that the over-contribution error was the result of a misunderstanding of the TFSA contribution rules.

In the event CRA does not agree with a taxpayer’s request for tax relief, they are able to have a Canadian tax lawyer apply to the Federal Court of Canada to have the decision of CRA to deny relief subjected to judicial review by a Federal Court judge. The power of CRA to give relief for taxes imposed by sections 207.02 and 207.03 of the Income Tax Act is discretionary, and taxpayers applying to Federal Court to challenge CRA’s decision to deny relief therefore face a high bar to success because the Court will typically afford discretionary decisions significant deference. Our Canadian tax lawyers routinely apply for judicial review to challenge wrong tax decisions of CRA and can evaluate a taxpayer’s circumstances to formulate a plan that maximizes the chances of receiving tax relief for TFSA taxes imposed by Revenue Canada.

Conclusion

Tax-free savings accounts are an excellent tool to save on income tax, but they are heavily regulated and consistently subject to tax audits by CRA. Over-contributions and non-resident contributions are subject to significant taxes thereon which function as penalties. Relief for taxes assessed on over-contributions and non-resident contributions to TFSAs is available, but whether or not tax relief will be granted is in the sole discretion of CRA. Our Toronto tax lawyers make detailed submissions to CRA on a daily basis and can give you the best chance of having the Canada Revenue Agency exercise discretion to offer relief for taxes assessed due to misunderstanding of the TFSA contribution rules.

Tax-Free Savings Accounts– Relief from Assessed Taxes– Toronto Tax Lawyer

Manufacturing and Processing Tax Credits – Toronto Tax Lawyer

Introduction

Various provisions of the Income Tax Act (the “Act”) allow corporations to claim tax credits.  This article by a Toronto Tax lawyer will discuss the legal tests used to determine if the activities of your Canadian Controlled Private Corporation (“CCPC”) can qualify for the Manufacturing and Processing Tax Credit (the “M&P Credit”).

The M&P Credit

Paragraphs 125.1(1)(a) and (b) of the Act allows a Corporation to claim a portion of either “corporate taxable income” or “Canadian manufacturing or processing profits” as a credit, subject to certain conditions. The M&P Credit for a CCPC is closely tied to the Small Business Deduction under s. 125 of the Act as the Small Business Deduction Limit of $500,000 must be met before the M&P Credit can be claimed. This isn’t necessarily a bad thing though because the Small Business Deduction rate of 17% exceeds that of the M&P Credit. The M&P Credit rate is equivalent to the General Rate Reduction or 13%. The s.125 Small Business Deduction considerations only come into play when a corporation eligible for the Small Business Deduction is attempting to claim the M&P Credit. Corporations that are not eligible for the Small Business Deduction also qualify for the M&P credit and do not have these considerations.

The language in the M&P Credit provision with respect to the Small Business Deduction can be confusing. To paraphrase, the provision reads “the M&P Credit can be claimed on the amount that exceeds the least of three Small Business Deduction amounts.” This language provides two options: 1) the least of the three amounts is not the Small Business Deduction Limit, therefore there is no excess to use to claim the M&P Credit and 2) the least of the amounts is the Small Business Deduction Limit, therefore anything exceeding the Small Business Deduction Limit is an amount on which the M&P Credit can be claimed. The Aggregate Investment Income of CCPCs is also referenced in the M&P Credit provisions and must be taken into consideration.

The Act is rife with difficult language and related provisions. If you are having difficulty interpreting the Act or tax rules that apply to you or your SME you should consult with one of our experienced Canadian tax lawyers.

Manufacturing and Processing (M&P) Defined

Another feature which makes the act a difficult piece of legislation to interpret is the way in which terms are defined. The Tax Act contains broad provisions and often the definition of a term will only explicitly define what it is not.  For example, the definition of “M&P” for the purpose of “Canadian M&P profits” under subsection 125.1(3) of the Act:

“manufacturing or processing” does not include

  • (a)farming or fishing,
  • (b)logging,
  • (c) construction,
  • (d)operating an oil or gas well or extracting petroleum or natural gas from a natural accumulation of petroleum or natural gas,
  • (e)extracting minerals from a mineral resource,
  • (f)processing
    1. (i)ore (other than iron ore or tar sands ore) from a mineral resource located in Canada to any stage that is not beyond the prime metal stage or its equivalent,….

Since M&P is not clearly defined and since the M&P Credit may be claimed on Canadian M&P profits, a Canadian tax lawyer must examine the relevant case law to determine what the definition of M&P is for the purposes of section 125.1 of the Act.

Processing – Two Legal Tests

There are two tests used to determine if taxpayer activities consist of “processing,” They are, (i) whether there is a change in the form, appearance or other characteristics of the goods subject to the operation, and (ii) whether the product becomes more marketable. These tests were developed in the leading case of Minister of National Revenue v Federal Farms [[1996] Ex. CR 410].

The second test or marketability test may be an easier bar to meet as goods may be found to be processed without undergoing a change in form. For example, in the Farms case vegetables that were selected, washed, brushed, sprayed, graded, sorted and packaged were found to be “processed goods.” The product sold was still very much a vegetable. It was not minced into baby food, or pressed into juice, but still sold as a whole vegetable. The processing that occurred gave the vegetable improved keeping qualities which made it more attractive to the consumer.

If the goods in question were subject to a process where they underwent a material change in form, it is much easier to make the argument that the activities were processing activities than if the good had remained relatively the same throughout.

Application of the legal test for “processing” in tax case law

There have been numerous decisions since the Farms case that ruled on the definition of manufacturing and processing.

The Improved Marketability Test

In TDS Group Ltd. & Her Majesty the Queen [2005 TCC 40], the Tax Court of Canada ruled that the assembly and special packaging of automotive parts into vehicle assembly kits, in addition to the application of a corrosion inhibiting substance was processing. The corrosion treatment was used to better enable transport of the kits to overseas assembly plants. These activities were found to be processing for the following reasons: 1) the activities were an integral part of the overall process of assembling an automobile for sale; 2) the activities added value since the taxpayer was compensated at five times the cost for the parts; and 3) The process was more sophisticated than simply separating and counting out parts. Taken in sum, the judge held that the taxpayer fell within the improved marketability test as the activities at issue were an integral process to prepare the end product for the retail market.

The Material Change in Form Test

Other courts have taken a stricter approach to “processing.” For example, in Tenneco Canada Inc v R [132 NR 62 (FCA) (1991)] the Federal Court of Appeal relied on the Farms decision regarding the improved marketability test as well as additional criteria. The judge in Tenneco ruled that processing required a change in form, appearance or other characteristic of the good. Further, the judge stated that the change in character of the goods must be significant to qualify for special tax incentives. As such, if the activities in question significantly alter the character of the goods being processed, there is a much stronger case that the activities qualify for special tax incentives.

It is important to note that, even though the Tenneco case stresses the importance of a significant change in character to the goods allegedly processed, this criterion is absent from the leading case of Farms. The idea that processing suggests a material change in the goods was explicitly rejected by Justice Cattanach in Farms as he stated that “I do not accept the definition put forward by Mr. Long that processing connotes a material change being made in the texture and structure of the product.”While material change may strengthen the case for “processing,” absence of material change may not be fatal to claim for the Manufacturing & Processing Tax Credit.

Utilizing both the Improved Marketability and the Material Change Test

Some cases look to both elements in order to render a decision; however, at a cursory look, there appears to be ambiguity as to whether both tests must be satisfied. In Mother’s Pizza Parlour (London) & Her Majesty the Queen [85 DTC 5271], the Federal Court held that processing includes some “element of transformation or preservation”.  Transformation of goods would imply a material change in form, while preservation of goods would imply preparation of goods to convert them to a more marketable form. The use of “or” implies that both tests do not have to be met to find in favour of processing.

Ultimately, in Mother’s Pizza Parlour (London) the assembling of pizza’s in the kitchen for immediate consumption in the dining room of the parlour was held not to be processing. In particular, the judge emphasized that the pizza dough used was not made in house. If that key fact had differed, a very different analysis may have been performed.

The case law surrounding the definition of Manufacturing & Processing is nuanced. If you are unsure if the activities of your corporation are eligible for the M&P Credit, or wish to carry out income tax planning to ensure that your activities do qualify, you should consult one of our top Canadian Tax Lawyers for advice.

 

Manufacturing and Processing Tax Credits – Toronto Tax Lawyer

The Truth About Cheating on Taxes – Bottom Line It Costs Us All

Cheating on taxes does not have the social stigma attached to it that drunk driving now does. It should. Taxes are the main way governments raise revenue for infrastructure, defense, and social services.

The underground economy is estimated at $41 billion. This means a loss of taxes of between $10-$20 billion annually that has to be met by the tax paying public. Statistics Canada has estimated that almost $444 billion of unreported income was earned in Canada from 1992-2008, excluding illegal activities.

Have you ever paid cash to avoid paying GST? Saving a bit of tax on a pair of shoes or a tennis racket may seem innocent enough. But you know that your vendor is not collecting GST and is not reporting income on the sale. Welcome to the underground economy!

Kevin Lee, CEO of Canadian Home Builders’ Association said “The underground economy in home renovations exposes homeowners to significant risk they often don’t understand and that can threaten their financial security. Furthermore, legitimate businesses suffer when they are forced to compete with those who cut corners, and don’t pay their fair share of taxes.” No tax, no receipt, no warranty for a pair of shoes or a tennis racket is one thing. If you pay for a house renovation with no receipt, or a reduced receipt for a part cash job, your risk is much greater if there is any problem with the work.

The underground economy is sophisticated. Electronic Suppression of Sales software (zapper software) is used to hide sales to evade the payment of GST and income tax. Zapper software selectively deletes or modifies, without a record of the deletion or modification, sales transactions from the records of point-of-sale systems (electronic cash registers) and businesses’ accounting systems.

CRA estimates zapper use could account for $3.25 billion in unreported sales annually. Fighting zapper use is a priority for CRA and a major initiative in their underground economy strategy. In 2012-2013, CRA audited 10,822 underground economy files, with a total dollar value of taxes assessed of $305 million.

Tax cheating is also as simple as not reporting income. A 2012 CRA audit of income earned by 145 wait staff at 4 establishments in St. Catharines, Ont., revealed $1.7-million in unreported tips. Wait staff earn up to double their wages in tips, but report at most 10% of it (and in some cases none). Statistics Canada estimated $36 billion in income went undeclared in the underground economy (not including illegal activities) in 2008. Of that, $1.3 billion was from tips.

I had a client who ran a small furniture store and did not report all of his income. He had a separate bank account, albeit at a different bank, where he deposited all of unreported sales. CRA found the bank account and assessed him for the unreported income. We were able to avoid prosecution for tax evasion, but he had to pay full penalties.

Failure to remit trust funds, either payroll source deductions or GST collected, is another common tax cheat. Payroll audits are fairly common, and CRA reviews more than 250,000 GST/HST and 480,000 payroll account files a year and they identify over $1.8 billion in non-compliance. Actual non-compliance is probably much higher.

The simple failure to file an annual income tax return is another prevalent tax cheat, although for many Canadians it arises due to family or business problems rather than a deliberate attempt to evade taxes. Every year, CRA identifies 600,000+ non-filers and finds $2.7 billion in non-compliance.

The ever popular offshore bank account, while still in use to evade taxes, is becoming obsolete. Bank secrecy in traditional tax obscuring jurisdictions, including the grandfather of them all, Switzerland, is very much a thing of the past. There have been leaks to tax authorities from some offshore banks. The Panama Papers tax leak in early 2016 was unprecedented in the scope of offshore information revealed. Canada has implemented the Offshore Tax Information Program (OTIP) that gives whistle blowers up to 15 per cent of taxes collected by CRA. Canada will be joining the OECD tax transparency agreement by 2018.

The CRA voluntary disclosure program allows non-filers and tax evaders to come forward to CRA before CRA approaches them and not be prosecuted or penalized. The participation in the program is increasing annually. For the year ended March 31, 2015, CRA processed over 10,000 voluntary disclosures, almost doubled from the previous year. The amount of previously unreported income more than doubled to $780 million.

Tax cheating costs all of us. For every tax dollar that someone doesn’t remit, another Canadian has to take up the slack to make up the shortfall.
David J Rotfleisch, CPA, JD is the founding tax lawyer of Rotfleisch & Samulovitch, P.C. a Toronto-based boutique tax law firm. With over 30 years of experience as both a lawyer and chartered professional accountant, he has helped start-up businesses, resident and non-resident business owners and corporations with their tax planning, with will and estate planning, voluntary disclosures and tax dispute resolution including tax litigation. www.Taxpage.com and david@taxpage.com

The Truth About Cheating on Taxes – Bottom Line It Costs Us All

Employee Stock Options Tax Planning– Vancouver Tax Lawyer Commentary

Employee Stock Options- Introduction

The income tax planning for the structure of a stock option plan requires the income tax law and corporate law expertise that our experienced Vancouver tax lawyers bring to all client tax issues. In a stock option plan, the employee is given or earns the right to acquire shares of the corporation, usually at some fixed period of time in the future. Sometimes the employee acquires certain shares at the inception of the stock option plan with rights to acquire additional shares in the future. The vesting of the stock option rights may be deferred for some period of time and will usually only vest if the individual is still employed by the corporation.

Employee Stock Option Agreement- Requirements

There has to be a written stock option agreement which specifies how the employee earns rights to additional shares, the price to be paid for those shares and requirements for vesting. For privately held corporations continued employment with the corporation is generally a prerequisite for exercising the stock option and for keeping the shares. In the event of a departure from employment, even if the employee is fired, the shares are usually reacquired by the corporation on some basis since a closely held corporation does not want shareholders who may have adverse interests. Our top Vancouver tax lawyers are experienced in tax planning for the structuring and drafting of stock option agreements.

If the shares of the corporation are publicly traded then the employee will generally be permitted to keep the shares even after employment is terminated. However, he or she will generally be unable to exercise stock options to acquire any additional shares after leaving employment with the corporation.

Stock option plans are one of the proverbial “golden handcuffs” since the employee’s rights are limited or terminated in the event of termination of employment, so proper income tax planning and business planning is essential in structuring the terms and conditions of the plan.

Most stock option plans are limited to management but some stock option plans are made available to all employees of the organization. In that case there will usually be a different stock option plan for management and for non-management employees.

Another tax planning advantage to stock option plans from a corporate point of view is that there is no cash outflow to the corporation. On the contrary, if the employees are required to buy the optioned shares at fair market value, the corporation actually receives funds. Payments are only required by the corporation if dividends are declared.

Employee Stock Option Plans- Taxation

The issuance of stock options has Canadian income tax implications that vary depending on whether the corporation is private or public and also depend on how long the shares are held after exercise of the stock option and our Vancouver tax lawyers have the experience to properly advise you.

When stock options are given without a tax reorganization, and a benefit is conferred on the employee, the Tax Act has special provisions that are applicable.

Stock option benefits are taxable as employment income because they are, in effect, an alternative to cash compensation.

The common law rule that stock option benefits arose in the year in which the stock option was granted created considerable uncertainty in determining the value of benefits derived from unexercised stock options. The Canadian Income Tax Act resolves the uncertainty by specifying both the method of valuation and the time for inclusion of the benefit in taxable income.

An individual is taxable on the value of stock option benefits derived by virtue of employment. The benefit is determined by reference to the shares actually acquired pursuant to the stock option plan.

The first question is: Was the benefit conferred by virtue of the employment relationship? Issuance of stock for other considerations (for example, as a gift or in return for guaranteeing a loan) does not give rise to a benefit from employment. The tax definition of “employment” includes employees, and Officers are included in the tax definition of “employees”. Case law supports the idea that a director is an officer of a corporation; therefore, directors are bound by these provisions in almost all circumstances. An exception to this rule occurs when the benefit received by the director was not conferred by virtue of the employment relationship.

The triggering event for the recognition of stock option benefits is the acquisition of shares at a price less than their value at the time the shares are acquired. The time of acquisition is determined by reference to principles of contractual and corporate law.

Except in special cases (discussed below), the value of a stock option benefit can be determined only at or after the time the stock option is exercised, that is, when the shares are acquired. The value of the benefit is the difference between the cost of the option to the employee, any amount paid for the shares, and the value of the shares at the time they are acquired from the plan. Shares are considered to be acquired when the option is exercised.

“Value” means “fair market value”. In the case of publicly traded securities, stock market prices will usually be considered indicative of fair market value. Since listed stock prices inherently reflect the value of minority shareholdings, there is no need to further discount their value for minority interest.

The value of shares of a private corporation, which will be the case with owner-manager entrepreneurs and closely held businesses, is more difficult to determine. Shares of private corporations are generally valued by reference to estimated future earnings and the adjusted net value of assets. The pro rata value of the corporation is then adjusted to reflect a discount for minority interests, lack of market, etc.

When it comes to income tax planning for stock option plans there are two special income taxation rules. One applies to options issued by Canadian-controlled private corporations (“CCPC”) and the other to acquisitions of prescribed equity shares. These rules are incentive provisions intended to stimulate equity participation in Canadian corporations.

Shares acquired from a CCPCs stock option plan in an arm’s length transaction receive preferential treatment if they are held for at least two years. This is so whether the shares are issued by the employer corporation or by another Canadian-controlled private corporation with which the employer does not deal at arm’s length.

An employee may defer income tax recognition of any benefit derived from stock options issued by a Canadian-controlled private corporation until disposition of the shares. CCPC employees are also able to deduct 50% of any stock option benefits received from CCPC’s under s. 110(1)(d.1) of the income tax act on the condition that they have not disposed of or exchanged shares for two years after the acquisition date. Upon disposition of the shares, the employee is taxable on the benefit amount less the deduction and the taxable portion of any capital gains realized on disposition.

The employee benefits by deferring any income tax liability which would otherwise arise upon acquisition of the shares through an “ordinary” stock option plan and by converting what would normally be fully taxable employment source income into income that is, in effect, taxable at a lower rate. The portion of the benefit that is taxable to the employee is not a capital gain but income from employment, taxed at the same rate as a capital gain.

An employee who disposes of shares in a Canadian-controlled private corporation within two years from the date of acquisition is taxable in the year of disposition on the full value of any benefit derived from their acquisition.

There is also a special rule for stock option plans under which an individual acquires prescribed equity shares in an employer’s corporation or in a corporation with which the employer does not deal at arm’s length. Under these special rules, It is also possible to receive a 50% deduction. The benefit, however, is taxable on a current basis.

The following conditions must be satisfied in order for a stock option plan to qualify for this special tax treatment:

  • The shares must be prescribed at the time of their sale or issuance
  • The employee must purchase the shares for not less than their fair market value at the time the agreement was made; and
  • The employee must have been at arm’s length with the employer and the issuing corporation at the time the agreement was made.
    Employee Stock Option Plans- Vancouver Tax Lawyer Assistance

An employee stock option plan can be an important part of a corporation’s compensation package and has benefits to both employer and employee. Tax planning, structuring and drafting such an employee stock option plan requires advice from one of our experienced Vancouver tax lawyers. If you require tax help or advice with your employee stock option plan contact our Vancouver tax lawyer firm.

Employee Stock Options Tax Planning– Vancouver Tax Lawyer Commentary

Canadian Income Tax – Net Worth Audit and Tax Assessments – Toronto Tax Lawyer Analysis

A normal income tax audit can be an intimidating and costly process for a taxpayer. Taxpayers who carry on a business, particularly one that deals in cash, may be surprised to know that the Canada Revenue Agency (“CRA”) has a number of methods that it can employ to reassess taxpayers, not all of which rely upon the examination of a business’ prepared books and records.

In cases where the CRA believe that the taxpayer’s normal books and records do not reflect an accurate picture of income earned, Canada’s Tax Act provides that the CRA may assess a taxpayer based on indirect methods using information obtained from third-parties or the taxpayer. These tax audit techniques are therefore referred to as indirect verification methods.

One of the most common, powerful and from a taxpayer point of view troublesome methods employed by the CRA to assess the income of a taxpayer is the net worth audit. It proceeds from the premise that a taxpayer has unreported income that the auditor may not be capable of identifying through direct means. The purpose of this article is to explain how a net worth audit proceeds and why any Canadian taxpayer who is faced with this burdensome form of tax audit would be best served by retaining one of our experienced Toronto Tax Lawyers as early as possible in the process.

Net Worth Audit Explained by Toronto Tax Lawyer

The net-worth tax audit is used as a tool for the CRA to identify an increase in a taxpayer’s wealth over the audit period, often three taxation years or reporting periods. The CRA tax auditor starts by examining the taxpayer’s assets and liabilities at the beginning of the chosen audit period, and then compares them to the assets and liabilities at the end of the period. In addition, the auditor will take into account expenditures during the audit period. Doing so allows the auditor to arrive at the closing net-worth of the taxpayer. Any increase over the audit period is income to the taxpayer, and to the extent that the originally reported income in the tax return is lower, the CRA makes the assumption that the difference is unreported income. The formula can be expressed as follows:

Opening Net Worth + Reported Income – Expenditures = Closing Net Worth

Any amount in excess will be treated as income by the CRA.

The net-worth tax audit method relies upon the simple assumption that when a taxpayer accumulates wealth in a taxation year, there are two options; to either spend or invest the income.

The CRA auditor will examine in depth the taxpayer’s expenditures during the selected audit period. Any expenditures can by virtue of the CRA’s powers to make assumptions may be imputed into a taxpayer’s income. In addition, it is common for the auditor’s net-worth methodology to include adjustments to expenditures on the basis of normal standards of spending according to Statistics Canada. However this type of adjustment to business expenses can be easily refuted using supporting evidence. Similarly CRA will use actual expenditures, such as from credit cards, rather than Stats Can data, where records are available.

The draconian power of the CRA to conduct a tax audit in this way is created by subsection 152(7) of the Income Tax Act which states that CRA is not bound by any of the information provided by a taxpayer – such as through the filing of a tax return or the production of books and records – and may assess based on the information it can obtain from both the taxpayer and any third-party sources. Alongside this is the power granted to CRA that allows the auditor to make reasonable assumptions that are supportable by the evidence available. So taxpayers have had victory at the Tax Court through their Toronto tax lawyers by showing that the assumptions made by the CRA auditor were not founded in any real evidence beyond industry averages. .

Net-Worth Audit Methodology

A net-worth audit can be considered the nuclear-bomb in the CRA’s powerful tax audit arsenal. In general these types of audits are normally conducted in one of two situations:

  1. The taxpayer has inadequate books and records to support their filed returns; or
  2. The initial stages of the tax audit reveal serious discrepancies with the spending habits of the taxpayer and reported income.

It is also important to note that the net-worth audit is just one of several methodologies that the CRA uses when it suspects unreported income. For example the “application of funds” method examines only expenditures. Another technique, the bank deposit analysis method, examines deposits into a taxpayer’s bank account and, to the extent that the amounts are not sufficiently explained, the auditor will characterize them as unreported income.

Though the CRA does have the power to apply these types of audit methodologies this power is subject to review and scrutiny by the Tax Court of Canada. Indeed, in many cases the CRA has had its net-worth, application of funds and deposits techniques scrutinized and overturned by the Tax Court. This is just one of the many reasons why proper legal representation by one of our top Toronto tax lawyers is crucial from the beginning of the audit.

How the Net-Worth Audit Proceeds

Once the auditor has determined that there may be unreported income, and confirmed that the presented books and records may not be adequate the auditor will normally proceed by making third-party demands to financial institutions, credit card companies and suppliers for any information about the spending habits of the taxpayer.

In addition, the CRA will conduct searches of land titles, examine mortgages and the Personal Property Security databases to identify assets and the amount of equity a taxpayer has in them.

CRA will normally, in a personal context, examine the books and records of the audited taxpayer’s family members and impute all of their spending into income as well.

When all of this information is assembled, the tax auditor then begins the painstaking task of transcribing a taxpayer’s personal financial records into a cohesive financial statement based on the formula above.

In essence, the auditor is tasked with determining and comparing asset values at the beginning and end of the period and imputing the difference into a taxpayer’s income. In addition, any expenditures during the audit period that the auditor identifies as personal in nature will form part of the unreported income to come up with a tax liability that can be shockingly high to say the least. Given the overall amount of information that is compiled mistakes are common and proper representation by our Toronto tax lawyers will aid in the reduction of a large income tax assessment.

How to Fight a Net-Worth Assessment with Toronto Tax Lawyer Tax Help

Unfortunately for those who take action too late, the most basic rule of Canadian Income Tax Law applies just as strongly in the net-worth context. That is, once a taxpayer has been assessed using the net worth audit, the onus is on the taxpayer to dispute the amounts on a timely basis and then lead evidence to prove that the CRA’s tax audit was mistaken.

There are essentially only two ways for a taxpayer to rebut the collective assumptions in a net worth audit context. First, a taxpayer may challenge the suitability of the net worth method as not being accurate given the taxpayer’s circumstances. This type of challenge is normally not successful given the CRA’s internal policies and only ever at the Tax Court level.

The second and generally more successful way a taxpayer may challenge the net worth assessment is more onerous and time consuming: a taxpayer will have to analyze and challenge every specific aspect and calculation of the net worth assessment on a line by line and item by item basis. In addition, a thorough analysis to refute a net-worth assessment will include a detailed review of the taxpayer’s assets at the beginning of the audit period as well as an analysis of the taxpayer’s interim and closing liabilities. In order to effectively challenge the net worth audit or tax assessment a taxpayer requires the help of one of our top Toronto Tax Lawyers

Our professional Canadian tax lawyers have successfully opposed net worth assessments by questioning every assumption, item and interpretation made by the auditor and attacking all deficiencies.

Canadian Tax Lawyer Net Worth Audit Tax Help

If you are being subjected to a net-worth audit, give our experienced Canadian Tax Litigation Lawyers a call. Our team of Toronto Tax Attorneys can ensure your rights are protected by dealing directly with the tax auditor on your behalf and challenging their schedules on an item by item basis. Our Canadian Tax Law firm can give you the representation you need to ensure you are not put out of business or forced into bankruptcy when the CRA pulls the net worth assessment weapon out of its arsenal.

Canadian Income Tax – Net Worth Audit and Tax Assessments – Toronto Tax Lawyer Analysis