CANADIAN TAX HIGHLIGHTS Special Report November 23 1999 Editor Vivien Morgan LL B REVENUE CANADA AND FINANCE REVIEW 1999 ANNUAL TAX CONFERENCE Revenue Canada and Finance officials pa

							CANADIAN TAX HIGHLIGHTS

Special Report, November 23, 1999

Editor: Vivien Morgan, LL.B.

REVENUE CANADA AND FINANCE REVIEW
1999 ANNUAL TAX CONFERENCE

Revenue Canada and Finance officials participated in panel discussions at the 1999 annual tax conference. The
following report summarizes their comments on recent cases and on legislative and administrative matters.

CRB Logging. A newly incorporated Shellco borrowed to acquire shares of two other companies that owned the
target, CRB. CRB borrowed a similar amount and subscribed for shares in Shellco, which paid off its bank debt with
the proceeds. The TCC denied CRB’s interest expense: there was no reasonable expectation of dividend income
from Shellco, which had no income source independent of CRB’s business. The taxpayer has appealed. Revenue
says that this case does not represent a change in rulings policy. Revenue says that CRB’s true purpose in the use of
the loan was to enable Shellco to finance CRB’s acquisition, and the closed nature of the income flow made it
virtually impossible for CRB to receive dividends that did not arise from its own business activities; thus, the use of
the funds did not satisfy the direct use rule. Revenue does not intend to revise IT-315. In future rulings, Revenue
may look a bit more closely at the extent of the independent source of income, but will not engage in a detailed
analysis. In rulings given to date, another potential source of income existed to fund dividend payments.

Ludco. The taxpayers borrowed to acquire shares in an offshore investment designed to minimize income disbursed
and to enjoy capital gain treatment on the repatriation of accumulated income via redemption. The FCA denied
interest expense of $6 million: the true purpose of the borrowing was to produce not the $600,000 of dividend
income, but rather the $9. 2 million of capital gain. The taxpayer is seeking leave to appeal to the SCC. Revenue
says that it will not change its position on interest deductibility related to the usual share investment in either a
private or public company, which investment is fundamentally different from Ludco: that investment was structured
solely for tax purposes to transform deferred income into capital gains and was situated in a tax haven. As well, the
degree of certainty in the investment results in Ludco does not usually exist in arm’s-length investments in publicly
traded securities. Two of the three judges in the FCA stated that the income test in paragraph 20(1)(c) is a gross test;
Revenue says that these comments are obiter, and maintains that the test is one of net income.

Byram. The taxpayer made interest-free loans to a USco both when he owned shares directly and through a holdco.
When USco became insolvent, the taxpayer sold the debts for $1 and claimed a capital loss. Subparagraph
40(2)(g)(ii) denies such a loss unless the debt was acquired for the purpose of earning income; but a unanimous FCA
said that dividend income fulfilled that purpose. Revenue accepts the reasoning and intends to revise IT-239R2
when the appeal process is completed in Singleton, which suggests that the direct use of the funds determines the
purpose of the use. Revenue says that the SCC decision in Bronfman appeared to establish a “real purpose” test
followed in some other decisions, but not all. Revenue’s position on interest-free loans in IT-445 is that interest is
deductible only if funds are used to earn income by a Canco; the “real purpose” test could lead to a review
concerning the requirement that the funds be used by a Canco.

Singleton. The taxpayer withdrew funds from his partnership capital account and used them to pay for a home; on
the same day he borrowed a similar amount and topped up his capital account. Revenue has sought leave to appeal
the FCA’s decision, which viewed the transactions independently and found that the borrowed funds were used to
earn income. Revenue says that, per Bronfman, the true purpose is not just the immediate result, and Singleton has
created uncertainty as to the proper approach.

Oerlikon. Oerlikon received amounts described as advances from customers in the notes to the financial statements.
The amounts were included in income and deducted as a reserve under paragraph 20(1)(m). For LCT purposes,
advances are included in capital; reserves are also included unless they are deductible for income tax purposes. The
FCA included the advances in the LCT base; Oerlikon has filed for leave to appeal. Revenue says that from a policy
viewpoint LCT is levied on amounts available to and employed in the business, including advances. The exclusion
of deductible reserves, such as the allowance for doubtful debts, reflects an impairment of capital; the reserve for
advances does not represent such an impairment. Thus the fact that advances are not included qua reserves does not
create a policy issue. Revenue considers that the notes are an integral part of the financial statements and assist in
determining amounts reflected on the balance sheet. The nature of an amount reflected in the balance sheet is
determined with regard to legal principles; one must consider terms and meanings used for accounting or income tax
purposes, but it is necessary to look further to derive the meaning of some terms, such as “reserve. ” Revenue does
not consider Oerlikon to limit the meaning of reserves to the accounting or income tax usage: a reserve is an amount
set aside for any reason or purpose, independent of how it is labelled on the balance sheet. This view is consistent
with that of the TCC in Autobus Thomas.

Dudney. A US independent contractor worked temporarily at his customer’s offices in Canada. The TCC said that
he had no fixed base—a term that has a meaning similar to that of “permanent establishment” (PE) as described in
the OECD commentary— because the premises were not controlled by or identified with him. Revenue agrees that
the PE and fixed-base articles rest on the same principles, but thinks that Mr. Dudney had a fixed base in accordance
with the use-of-space concept in the OECD PE commentary—the taxpayer need not own or rent the premises—even
though Mr. Dudney changed offices on the premises. There are few cases in this area. Mats Johansson and Scanwell
AB v. Stavanger Municipality, a case decided under the Norway-Sweden treaty, found a PE where the sole employee
was given non-exclusive use of space on an oil-drilling platform to supervise work there; in fact, the company’s
entire business was performed there. In Alphawell Ltd and Richard M. Pegrum v. Stavanger Rommune, decided
under the UK-Norway treaty, the place of work was Norway and England. The taxpayer was hired by Statoil to
provide advice and interpret seismic and geological data, and its sole employee used a number of different Statoil
offices at more than one location. The court found that the UK company’s business was not established at a distinct
place with a degree of permanence. The Norwegian fisc did not argue that any particular place was a fixed place or
that all the Statoil offices were a fixed place of business in the spatial delimitation approach.

Cudd Pressure. The US taxpayer operated a Canadian branch using unique equipment owned by the taxpayer.
Article III of the 1942 Canada-US treaty required the determination of the branch’s profit as if it were a separate
enterprise. The FCA denied a notional deduction for rent related to the equipment. The dissent said that notional rent
may be allowed in certain circumstances. Revenue disagrees because expenses were not defined in the treaty, and
the Income Tax Conventions Interpretation Act states that a term in a convention that is not defined has the meaning
it has for the purposes of the Income Tax Act. Because a notional amount is not incurred, it is not an expense and
cannot be deducted in computing the branch’s profit. The OECD commentary supports this view: paragraph 7(3)
says that actual expenses are taken into account, and the separate enterprise rule in paragraph 7(2) on the facts leads
to depreciation only. The situation is different from interest payments made by a banking PE to its head office. In
National Westminster Bank PLC v. US, the branches and head office borrowed from each other and third parties.
The bank’s US return claimed interest expense and reported income on such loans, relying on article 7 of the
UK-US treaty, which contained a separate enterprise rule. The US court followed the 1963 OECD commentary,
which gives special consideration for intracorporate advances of a financial intermediary, and rejected the general
rule that notional expenses are not deductible; the Code rules that provide a formula to determine deductible interest
were said to be inconsistent with treating the branch as a separate entity. Revenue says that revisions to the OECD
commentary on article 7 may contain some relevant material.

Transfer of stock options. Revenue announced a reversal of its position that GAAR applies to an employee who
transfers stock options to a non-arm’s-length taxpayer to avoid the rules in subsections 7(1. 3) and 47(1). Under
those rules, the ACBs of identical shares are averaged, but shares acquired under employees’ options are deemed
sold in the order acquired. Thus, if equal amounts of shares were acquired under options granted first when a
company was a CCPC and later when it went public, the sale of one-half of the shares triggers the reporting of the
entire and previously deferred taxable benefit on shares related to CCPC options. Now Revenue intends to treat
stock options in the same manner as other securities when it comes to the avoidance of the administrative provisions
of subsection 47(1). A taxpayer may hold an employer’s shares directly and also cause a trust or a corporation
controlled by him to acquire new shares, allowing the taxpayer to isolate the shares sold, avoid the realization of the
benefit on the deemed sale of the CCPC shares, and control the capital gain or loss realized. Revenue gave an
example of an employee who in year 1 acquires shares under options received from the employer CCPC at FMV.
The market rises steadily throughout the period, and on January 1, year 2, the employer goes public. A second and
equal number of share options are awarded to the employee in year 2 and exercised immediately, and the shares are
sold. In such an example, the deferred benefit on the CCPC options is realized in year 2 when the shares are sold, as
is the benefit on the Publico options and the capital gain. In this situation Revenue would not seek to apply GAAR if
the employee transferred the options to buy the public company shares to a non-arm’s-length trust that exercised the
options and sold the shares.

New civil penalties. The impetus behind the new civil penalties began in 1994, when Revenue closely examined 40
tax preparers; 20 were prosecuted and thousands of reassessments were issued. In 1996, the auditor general
recommended civil penalties for promoters of abusive tax shelters and other arrangements. In 1997, the House of
Commons Standing Committee on Public Accounts instructed Revenue and Finance to introduce such penalties.
Finance asked the Mintz committee to consider the issues; the committee recommended civil penalties for those who
knowingly or in circumstances amounting to gross negligence make false statements or omissions related to
another’s tax matters. The civil penalty was needed in cases where a criminal proceeding was not warranted in
monetary terms or in terms of the resulting harm to the reputation of the tax preparer. Criticism of the gross
negligence test by the joint committee led to Finance’s shifting to a “culpable conduct” standard; that phrase was
defined in accordance with Finance’s understanding of gross negligence with the knowledge of professional
associations representing tax practitioners, and was intended to alleviate the concern that judicial interpretation in
non-tax cases might erode what Finance considered to be a very high standard.

A Finance official said that although not all relevant professional bodies have been canvassed, it appears that
professional standards of conduct are more stringent than the culpable-conduct standard; therefore, practitioners who
abide by the rules of professional conduct should not be offside the income tax test. Finance considers that the
exception for good faith reliance is folded into the culpable-conduct concept, which is tantamount to intentional
acting, indifference to whether the law is complied with, or wilful, reckless, or wanton disregard for the law. The
lack of a “reliance in good faith” exception for planning or valuation scenarios is intended to prevent individuals
from escaping liability by pointing a finger at others; for example, a promoter may say that the valuator gave him the
value and the valuator may claim that the promoter supplied the assumptions. Finance has not yet established the
range of acceptable deviations in a valuation before the special reverse onus is triggered. Finance agreed that the
ultimate penalty on a single filing could be a multiple of 50 percent of the tax. For example, a partnership may
engage in the practice of attracting clients by padding clients’ expenses or inflating charitable donations, and
individual partners may direct employees to engage in the same behaviour; in that case, the partnership, partners,
and employees may suffer a penalty. The concern that some auditors may use the threat of the penalty as a
negotiating tool has been addressed by Revenue’s promise not to assess such penalties until a head office review is
completed. Revenue has said that procedural details—such as whether the auditor informs the tax professional
before or after he goes to head office—will be developed in consultation with the private sector. Finance confirmed
that the new penalty may apply to a company’s internal tax adviser.

Status of legislation and treaties. Comments made by Finance concerning legislation that may or may not fall into
the budget bill are summarized in Canadian Tax Highlights, “Legislative Update,” November 23, 1999.

On the treaty front, protocols with Indonesia, Vietnam, France, and the Netherlands have entered into force this
year. Canada recently signed treaties with Algeria, Bulgaria, Jordan, Lebanon, Luxembourg, Portugal, and
Uzbekistan and protocols with Austria and Japan. The 1995 commitment to review the Canada-US protocol within
three years is in process. Final agreement on most of the provisions in the Canada-UK protocol has been reached
after four years of negotiations; it is hoped that that protocol, and a new treaty with Germany, will be signed next
year. A new treaty may soon be signed with Belgium. Negotiations recently began with Ireland. It is hoped that a
new Canada-Italy treaty will be signed early next year; negotiations were completed last May. Australia now wishes
to recommence treaty negotiations that were suspended for another round of tax reform there. It is hoped that Chile
will soon ratify the treaty ratified here in 1998, to take effect in 2000. Negotiations have also been completed with
the Czech Republic, Egypt, Gabon, Senegal, the Slovak Republic, and the United Arab Emirates.

The rulings process. Revenue intends to reduce the turnaround time for processing a ruling. Early next year
additional resources will be dedicated to the rulings function, including the hiring of more rulings officers, with a
view to reducing to 60 days the average time spent on a file. It is anticipated that faster processing will increase the
number of ruling requests. The cost-recovery fees related to rulings will be raised to help fund the new resources.
Currently a ruling is completed in an average of 122 days; about 20 of those days are under the control of the
taxpayer and relate to missing information, etc. About 55 percent of rulings are issued within 90 days of receipt;
two-thirds are issued after 60 days. The main causes of delays are incomplete submissions due to missing facts or
inadequate discussion of technical issues; the complexity of files; the need to consider significant policy issues; time
for reworking the business transaction to solve a technical issue or as part of the due diligence or negotiation
process; and, perhaps most important, excess demand for Revenue’s resources. A complete submission is critical for
timeliness, and should include full descriptions of the transactions to assist in the understanding of the commercial
aspects and supporting technical analysis and research. A person requesting a priority ruling should contact the
section chief early on to determine whether significant issues have already been addressed; Revenue will entertain a
discussion of a new technical issue before the formal ruling is submitted. Each item for which a ruling is requested
must include a description of why that issue gives rise to uncertainty and an analysis in support of the ruling request.

Revenue will look into preparing a model submission for general use. Revenue has no intention of releasing its
officers’ internal analyses of rulings requests (the issue sheets), which do not necessarily represent the department’s
views; the key elements of a ruling letter are summarized in the header information that precedes a severed ruling
letter. If the rulings staff believes the input of the GAAR committee is necessary, it may refer a ruling with a
recommendation that will be confirmed or overturned. Revenue has no plans to allow taxpayers to attend committee
meetings. The taxpayer may prepare a separate written submission for the committee, although Revenue again
emphasizes the importance of the written submission with the original ruling request. The new Canada Customs and
Revenue Agency will have no direct impact on the rulings process, although Revenue envisions that there will be
more operational flexibility and a much faster hiring process.

Revenue does provide some rulings on questions of fact and will consider becoming more flexible on this point. In
response to a request for compliance rulings related to completed transactions for which a filing position has not
been taken, Revenue said that these are effectively available as real-time audits. Revenue is willing to study the
issue of valuations rulings, although valuations are currently an Audit responsibility and that is where the expertise
resides. The executive interchange program was successful; however, there were certain concerns about
confidentiality of taxpayer information, the ability to integrate permanent staff with interchange members, and
continuity of work.

Vivien Morgan
Canadian Tax Foundation, Toronto