Increase your knowledge about the commonly used tax traps utilized by the Canada Revenue Agency to help you better avoid them.
As someone who specializes in Canadian tax law, I believe there are various tax traps utilized by the Canada Revenue Agency (CRA) of which owners and managers of small- and medium-size Canadian businesses should be aware. Let’s look at several of them.
The laws of the land give the CRA an exceptionally wide range of powers and privileges. As such, the deck is heavily stacked in its favor from the outset. According to the Income Tax Act, taxpayers must disclose their income annually and estimate the tax payable according to guidelines provided by the tax agency each year. Failure to do so accurately, and in a timely manner, can result in criminal prosecution. The following are the relevant excerpts from the Income Tax Act:
Income Tax Act, Section 238(r)
- Failure to file return at required time and in required manner
- Failure to deduct or withhold tax
- Failure to keep proper books and records
Penalty: On summary conviction, a fine of $1,000 to $25,000 and imprisonment for up to 12 months.
Income Tax Act, Section 239(r)(2)
- Making false or deceptive statements in documents
- Alteration, falsification or destruction of accounting books or records to evade payment of taxes
- Willful evasion or attempt to evade payment of taxes
Penalty: On summary conviction, a fine of 50 percent to 200 percent of tax sought to be evaded and imprisonment for up to two years. If by indictment, a fine of 100 percent to 200 percent of tax sought to be evaded and imprisonment for up to five years.
INCOME SPLITTING AND EMPLOYING FAMILY MEMBERS
In the spirit of arranging one’s affairs to pay as little tax as is necessary, many owneroperated businesses put family members, such as spouses, children and siblings, on the company payroll to reduce the business’ taxable income. The agency tracks this with its matching program and usually throws up a red flag for further investigation.
Fair market value for family
Upon investigation, the agency will send a field agent out to visit the business. This agent will try to speak to employees without the owner present. The agent might casually ask questions such as: Does the owner’s wife work here too? Is she in the office every day? What does she do here? Does she ever take money out of the cash register? Caught off guard, an employee may often reveal that the owner’s wife is only in the office once or twice a week—if that—and when she does come in, she usually sits in the owner’s office and makes personal phone calls.
Or, perhaps she does answer the phones or manage the bookkeeping. In that case, the field agent will cross reference this information against what she is paid. Is her pay consistent with what a receptionist or bookkeeper is typically paid? If she is being paid $80,000 per year for these duties, for example, the CRA will want to delve more deeply into the business’ operations. This is especially true if the money paid to her is not salaried income, but simply a transaction on the books. If this is the case, the CRA will review whether or not she is paid regularly and at the same intervals as the other staff. The CRA’s goal is to prove that these payments are: (1) not reasonable for the service supposedly provided, and (2) not an arm’s length transaction between an owner and an employee.
Proper designation of family members
It is important to ensure that family members employed by your company provide legitimate services at a reasonable market value for any salary. If you are not paying the family member a salary, make sure he or she issues you regular invoices for the services provided. Pay the family member as you would any other contractor: by check, and in a timely manner. (Don’t forget to factor in the cost of GST if the family member is billing more than $30,000 per year.)
Also, consider incorporating—your family members can become shareholders of the corporation, which allows you to pay them dividends whether they actually perform services or not. Dividends are typically taxed at a lower rate than employment income, which may help you legitimately arrange your affairs to pay less tax. However, it is important to note that if the CRA decides your family employee is receiving a salary in excess of fair market value, they will deny the excess expense to your company.
NON–ARM’S LENGTH TRANSFERS OF PROPERTY
The following are some taxation issues that can arise when parties are not independent businesspeople.
Simple transfers at a less than fair market value
Section 160 of the Income Tax Act was put in place to prevent the taxpayer from avoiding payment of outstanding taxes by transferring property in a non-arm’s length transaction for less than the receipt of fair market value. If the tax debtor transfers property in a non-arm’s length transaction during or after the taxation year in which the tax debtor is liable, the transferor and the transferee can be jointly and severally liable for payment of the tax debtor’s liability to the agency. This liability can apply even if no assessment was made against the tax debtor.
Under Section 160, if the transfer is made during the taxation year in which the tax is owed, or at any time thereafter, the recipient of the property (the transferee) can be held personally responsible for all or part of the tax owed by the transferor up to the shortfall for the fair market value paid for the property.
There is no time limitation on the CRA’s right to assess the transferee for the tax owing. Spouses may be divorced or widowed, business partners
may have long since dissolved their ties and friends may have gone their separate ways. Notwithstanding any or all of the previously mentioned, the tax liability remains. The CRA can go after any party to the transaction.
Transferring the business to the children, or “related party” transactions
Recent statistics indicate that, in the next five to 10 years, a change of ownership will occur among 50 percent of Canada’s small- and medium-size businesses, many of which will be taken over by shareholders’ children. In practice, the capital gains deduction is available to individuals who sell their shares to outsiders, but is almost never an option when shares are transferred to children. Section 84.1 of the Income Tax Act is likely to apply and convert the capital gain that would otherwise be eligible for the capital gains deduction into ineligible dividend income. So, before passing the business torch onto your children, you should set up a comprehensive tax plan that will minimize negative tax consequences under Section 84.1 of the act.
Loan to a family member to acquire shares: Some parents may be tempted to assist their children by lending funds to purchase investments or to establish a corporation. Particular attention should be paid to transactions of this kind because of legislative provisions that counter income splitting. Such loans could trigger undesired tax consequences for lenders wishing to invest in the same project as a related person.
If a loan is made to children or a spouse at a rate of interest below a reasonable rate or the rate prescribed by the government (whichever is lower) and the interest remains unpaid 30 days after the end of each year, income earned on the investments acquired with the loan will be deemed to belong to the lender (except for capital gains realized by the children). The lender will then be liable for the related income taxes without having gained a thing.
Transfer to a related person for less than fair market consideration: It is not uncommon for sellers to transfer property to a “related” buyer for less than fair market consideration without realizing that such a transfer clearly leaves them open to double taxation. More specifically, at the time of transfer, the seller would be deemed to have transferred the property at fair market value and would accordingly have to pay income tax computed on the basis of this assumption. Later, when the recipient eventually disposes of the property, the tax would be based upon the difference between the selling price and the nominal value that he or she previously paid and not upon the difference between the selling price and the deemed proceeds of the disposition when the property was first transferred.
Double taxation through the use of a holding company
Shares acquired through a holding company, followed by a wind-up or amalgamation: Shares are frequently acquired through a holding company so that the purchase price can be paid with corporate funds. This may, however, have a downside when the acquired corporation is eventually wound up or amalgamated. If the tax cost of the shares of the acquired corporation exceeds the net tax value of its property, there may be a loss of tax attributes.
The legislature attempted to remedy this distortion by providing a mechanism to bump up the cost of the property held by the acquired corporation when it is wound up or amalgamated. However, the government has not entirely solved the problem, since the bump-up applies only to certain property (some land or investments) and excludes most property required to operate a business (i.e. depreciable assets and intangible assets).
Transactions between a corporation and its shareholders
Shareholder benefits, loans and advances: Remember that a corporation is a legal and tax entity separate from its shareholders. Situations in which a corporation grants a benefit to its shareholders should be avoided at all costs, as they could be very expensive and even give rise to double taxation. Tax authorities are true professionals when it comes to tracing such tax benefits, and they are not shy about imposing interest and penalties. The most common examples include: personal expenses reimbursed by a corporation, recreational properties (cottages, boats, etc.) and personal cars and houses purchased by a corporation and available for use by shareholders and their families. Generally, the value of the benefit must be added to the shareholders’ income. Advances to shareholders must also be included in computing the shareholders’ income from the moment the corporation extends them, unless the loan is repaid within a prescribed timeframe. Shareholders who fail to do so could deduct the loan payments in computing their income, but they will never be compensated for the interest paid to the CRA.
THE LIPSON DECISION: THE CRA’s NEWEST WEAPON
In January of 2009, the Supreme Court of Canada gave the CRA a big break. In the Lipson case, the court ruled that although it has long been a principle of Canadian tax law that taxpayers may order their affairs so as to minimize the amount of tax payable, this principle is not absolute. Parliament provides the CRA with the general antiavoidance rule (GAAR) to limit the scope of allowable avoidance transactions while maintaining certainty for taxpayers.
The court advises that the GAAR denies a tax benefit where three criteria are met: the benefit arises from a transaction (ss. 245(1) and 245(2)); the transaction is an avoidance transaction as defined in s. 245(3); and the transaction results in an abuse and misuse within the meaning of s. 245(4). The taxpayer bears the burden of proving that the first two of these criteria are not met, while the burden is on the minister to prove, on the balance of probabilities, that the avoidance transaction results in abuse and misuse within the meaning of s. 245(4). As this decision increases the power of the CRA to use the general anti-avoidance rule, sound tax planning has never been more necessary.