cans.s3-us-west-2.amazonaws.com2019-2020/tax+… · web view(1887), 12 app. cas 575 (p.c.), which...

Taxation Law CANWinter 2019

TAXATION

Unit #1 – Introduction to Canadian Income Tax Law

A Brief Overview of the Constitutionality of Taxation

● Subsections 91(3) and 92(2) of the Constitution Act, 1867 set out the respective taxation powers of the Federal and Provincial governments.1

o Subsection 91(3) provides that the Federal Government can raise money by “any mode or system of taxation”

o Subsection 92(2) provides that provincial government can impose “direct tax[es] within the province in order to the raising of a revenue for provincial purposes”

● Sections 53 and 90 further require Federal and provincial governments to enact taxes through their legislative branches (subject to the clarification below).2

o This principle is often stated as “no taxation without representation” and has been said to be a component of our “rule of law”

● Question: does this constitutional (and rule of law) requirement mean that the Executive branch of government cannot create a tax?

o Answer: No – as long as the Legislative branch explicitly delegates its taxing power to the Executive branch and the Executive does not exceed its authority in exercising this delegated power.

o While it will be discussed in more detail in a subsequent Unit, section 221 is the primary section in the Act that delegates the ability to make tax regulations to the Governor in Council.

Definitions of a “Tax”, “Direct Tax” and an “Indirect Tax”

● Question: what is a “tax”?

o Answer: there is no definition of a “tax” in the Constitution Act, 1867 or the Income Tax Act.

o The Oxford English Dictionary defines a “tax” as “a contribution to State revenue, compulsorily levelled on people, businesses, property, income, commodities, transactions, etc.”▪ “Real Life Examples” of Canadian taxes include:

● Fed + provincial income taxes; federal “value added tax” (GST/HST); provincial sales taxes; property taxes; carbon; corporate; gift taxes; “sin” taxes; importation taxes/duties; transfer taxes (land); capital taxes (normally levied on corps)

o In Lawson v Interior Tree Fruit and Vegetable Committee of Direction, [1931] S.C.R. 357,3 the Supreme Court of Canada defined a tax as a charge that is:

1 As will be discussed in more detail below, municipalities derive their powers to tax (i.e. to levy property taxes) from the province (through a delegation of the provincial taxing power). 2 Note: there are several other provisions in the Constitution Act, 1867 regarding the Federal and provincial government’s ability to tax – however, these provisions are beyond the scope of the course.

© Sprysak 2019

TAXATION


▪ Enforceable by law,

▪ Imposed under the authority of the legislature by a public body, and

▪ Imposed for a public purpose.

● This requirement has generally been interpreted to mean that the charge is

intended to raise (general) revenue for the government

● Conversely, if the charge is designed to (within reason) only recover the costs of

providing a good/service, then courts have typically found that the charge is not a “tax” but rather a “fee” – and hence not subject to the constitutional requirements described above.4

● Question: what is a “direct tax” and is there such a thing as an “indirect tax”?

o Answer: According to the English legal philosopher, economist and politician John Stuart Mill in his book Principles of Political Economy (first published in 1848):

▪ A direct tax is one that is demanded from the very person who it is intended or desired should pay it; whereas

▪ An indirect tax is one that is demanded from one person in the expectation and with the intention that s/he shall indemnify herself/himself at the expense of another5

o Examples of direct taxes:

▪ Income taxes; property tax; etc.

▪ This includes value added taxes (GST) despite the fact that it might seem on its face like an indirect tax. The intent is that the cost is on the final consumer, the restaurant/store is just the collector.

o Examples of indirect taxes:

▪ Import taxes/duties

3 This definition has been confirmed/used many times by courts in subsequent decisions, including the Supreme Court of Canada in Eurig Estate, [1998] 2 S.C.R. 5654 While beyond the scope of this course, in addition to “fees”, the courts have exempted taxes that are an integral part of a regulatory regime from having to comply with the constitutional requirements of a tax – refer class to 620 Connaught Ltd. case as an example of this (not examinable).5 In Bank of Toronto v Lambe (1887), 12 App. Cas 575 (P.C.), which is commonly cited as the “foundational decision” regarding “indirect taxation”, Lord Hobhouse, for the Court, stated that to determine whether a tax is “direct” or “indirect”, the court will consider “the general tendencies of the tax and common understanding of men as to those tendencies”. He went on to state that if the tax was some sort of commodity or export tax where, “The producer or importer of a commodity is called upon to pay a tax on it, not with the intention to levy a peculiar contribution upon him, but to tax through him the consumers of the commodity, from whom it is supposed that he will recover the amount by means of an advance in price”, then that would indeed be an “indirect tax”

© Sprysak 2019

TAXATION


o Note: whether a tax is “direct” or “indirect” is only relevant when it is levied by a province, as the Federal government can generally enact any kind of tax it wishes.

Revenues from Taxation

● For 2018/19, the Federal government expects to collect approximately $323.4 billion in revenue.

● Of this amount, roughly:

o $161.4 billion comes from personal income tax (approximately 50% of the Federal government’s total revenues),

o $47.3 billion comes from corporate income tax (14.6%),o $37.7 billion comes from the Goods & Services Tax (GST) (11.7%), o $29.4 billion comes from “Other Revenues”,6 o $21.7 billion comes from Employment Insurance premiums (6.7%), ando $8.3 billion comes from the taxation of non-residents.

● In contrast, provinces and territories collectively receive approximately 25% of total revenues from income taxes – with a similar mix (as Federally) of 78% personal income taxes and 22% corporate income taxes

o They receive roughly an equal amount from “consumption” taxes – sales taxes and excise taxes on liquor, tobacco and fuel, etc.

▪ Of course, Alberta gets less from such taxes given we continue to be the last/only province without a sales tax

▪ Finally, they receive approximately 13% of total revenues from property taxes (which are generally levied by municipalities)

Sales Tax v Income Tax [From Julia’s Notes]● There are differing views on the best tax method to raise revenues for governments.

● IMF is a big advocate of generating revenue through sales tax as opposed to income tqx

o One view: people can choose what to be taxed on through their consumption habits

● Positives of GST: somewhat discretionary for some people at certain times

● Negatives of GST: disproportionally taxes lower income families who spend most of their income on necessities

o The government of Canada has recognized this and implemented some measures to relieve this issue: GST returns to low income families, tax exemptions on certain items (i.e. groceries)

● Income taxes are not as big of a revenue generator to provinces (except in AB where there is no PST)

● Municipalities generate revenue through property taxes

6 This includes revenues from Crown corporations and other non-taxation programs.

© Sprysak 2019

TAXATION


● The federal government relies heavily on income taxes

● Question: why do Parliament and the provincial legislatures impose a variety of different taxes?

Why not just pick one and make the rates such that the government gets all of its money? o Answer: Multiple forms of taxes make it harder for an individual to avoid participating in

paying their fair share

▪ Also diversifies risk

▪ E.g. people can avoid paying income taxes through estate planning, but the

government can still collect through GST, etc. A Brief History of Income Taxes in Canada

● There was no income tax before WWI

● The first income tax was intended to be a temporary war measure

o It was only temporary until 1948

● The government decided they liked the tax and made it a permanent tax

● In 1962, Prime Minister John Diefenbaker created the Royal Commission on Taxation, which was chaired by Kenneth Carter to review, analyze and make recommendations on all aspects of Canadian Federal taxation. In 1967, the Commission released a six-volume report which was viewed around the world as a great contribution to tax knowledge and analysis.

● After studying this report and issuing a White Paper suggesting possible changes, Parliament implemented several significant amendments to the Act effective January 1, 1972. It included the following three fundamental changes to Canadian income taxation:

o It broadened the tax base (i.e. what is subject to tax) - most notably, by making the gains (and losses) from the disposition of capital property taxable;

o It reduced the taxation rates and the number of tax brackets (both of which we will examine in more detail in a subsequent Unit); and

o It integrated the taxation of corporations and their shareholders (which we will also briefly discuss in a subsequent Unit)

● At this time, the highest combined Federal and provincial marginal tax rate was over 60%; the Budget proposed reductions to bring the highest combined rate down to 50%

● The next major tax reform occurred in 1987 - this time by a Conservative government. It introduced a White Paper, which contained the Federal government's intentions to:

o Lower personal tax rateso Broaden the tax base (primarily by increasing the inclusion rate for capital gains)o Convert many personal deductions into credits

© Sprysak 2019

TAXATION


o Enact a "general anti-avoidance rule" to prevent inappropriate/abusive tax planning, ando Introduce a new Goods and Service Tax (GST) to replace the existing Federal Sales Tax.

● The current method for calculating tax revenue is

o Tax revenue = tax base x tax rate

● Since the Carter system, tax reform has seen the more to broaden the base of taxes (create more taxes) and lower the tax rate

o One thought behind this is that is a good political strategy to say you are lowering taxeso Spryzak: change either the base or the rate has political implications, so this trend is not

really a strong agenda item for politicians

● Today: The CRA administers both the federal and provincial tax returns

o The provinces agreed to reply on the federal taxable income guidelines to allow thiso This is why the provincial Tax Acts are much smaller

▪ The federal act does all the heavy lifting

o Exceptions

▪ Quebec has its own corporate tax regime and its own administrators

▪ Alberta has its own corporate tax regime, act and administrators

● Why? AB was in disagreement with the National Energy Policy. In an act of defiance, the province set up its own corporate tax regime to separate ourselves

Evaluating Taxes and Tax Regimes

● General Question: Given the variety of ways governments can tax (i.e. income taxes, sales taxes, etc.) and infinite ways such taxes can be structured and administered, how do governments go about deciding how to tax and how can we evaluate such decisions?

● At a very high level, taxes are often evaluated on 3 grounds, namely:

o Its ability to generate revenue for the government imposing the tax;o How efficiently it generates the revenue; ando How fair/equitable it is.

▪ What is the goal? Is it meeting this goal?

▪ E.g. the sports tax disproportionally benefited higher income people who were going to put their kids into sports programs anyways. Further, it was not a widely known tax exemption

© Sprysak 2019

TAXATION


● Revenue Generation:

o Using the Revenue Generation test - a good tax (or tax regime) is one that generates the most net revenues (i.e. gross revenues less associated expenses) for the government

o Revenue = Tax Base x Tax Rate

▪ We will discuss “Tax Base” and “Tax Rates” in more detail in a subsequent Unit.

▪ Indeed, most of the Act addresses what is in the Tax Base

● Efficiency:

o Two key elements of efficiency (but by no means is this comprehensive) that we will briefly discuss in the course are:

▪ How the existing income tax provisions (and changes to the regime) affect taxpayer’s behaviour – the more it affects behaviour, the less efficient it is; and

▪ How costly our income tax regime is to administer – to either the taxpayer, the government or both (with more costly taxes being more inefficient)

o Focusing on the 1st measure, the less a tax influences a taxpayer’s behaviour, the more efficient the tax is and the happier economists generally are – this is commonly referred to as “tax neutrality”

▪

o With respect to the 2nd measure, generally speaking, a simple tax is a more efficient tax than a complicated tax (because it costs less for taxpayers to comply with and less for the government to verify compliance)

o Further, the more certain a tax is, the less costly it is to comply with (from the taxpayer’s perspective) and administer (from the government’s perspective).

▪ In contrast, the more uncertainty created by a tax regime, in addition to raising costs, it further affects/discourages positive economic behaviour.

o There are many other measures of “efficiency” – but this brief introduction is sufficient for our purposes

Julia’s Notes on Efficiency:● How do we measure efficiency?

o 1) The impact on tax payer’s behavior

▪ The more a tax effects a tax payers’ behaviour, the more it deviates from optimal allocation

▪ We want a free market

▪ The less impact, the better

▪ Economists call this “tax neutrality”

© Sprysak 2019

TAXATION


o 2) The cost of administration

▪ The more is costs, the less optimal

▪ Don’t want to waste government time on ensuring compliance

● In some cases, the government wants to discourage behaviours through taxes

o E.g. luxury taxes, sin taxes

● This can work in the opposite way as well: encourage behaviour

o E.g. charitable donation tax credits, tuition tax credits

● Question: Why do governments use a tax system that provides social benefit?

o They don’t have to administer the funds for these services o If we put the credit through the tax system, it encourages people to file their tax returns

● Fairness or Equity:

o Basic Principle: Canadians will more likely (“voluntarily”) comply with our tax legislation if they view it as being fair and equitable.

▪ Of course, what is fair/equitable is highly personal and contextual. Almost all of the great legal philosophers have their own theory of what is fair/equitable.

▪ Depending on which theory you identify with, you will prefer particular types of taxes which are consistent with that theory.

o Horizontal Equity: similarly situated taxpayers should be treated/taxed the “same”

▪ Example: Chris and John each make $100,000 of pre-tax income. They each pay $25,000 of taxes.

▪ Question: could this result ever be viewed as not being fair/equitable?

● Answer:

▪ In Canada, as we will discover during the term, our income tax regime only sometimes satisfies the principle of horizontal equity.

●

o Vertical Equity: higher income taxpayers should pay more tax than lower income taxpayers.

▪ Question: is this fair/equitable?

▪ Answer:

● While taxes (and tax regimes) can be evaluated on these – and other – measures, it is important to appreciate is that often, the values underlying these measures can conflict with one another and, as such, have to be ranked

© Sprysak 2019

TAXATION


Tax Expenditures

● In addition to raising revenues, countries (including Canada) typically use their income tax regime to provide benefits (in the form of credits, deductions or exemptions) to some (or all) of its constituents. These are commonly referred to as “tax expenditures”.

o They are called “tax expenditures” because they cost the government money, normally in forgone taxes, as opposed to raising money

● Generally speaking, these programs could be administered outside of the income tax regime

● Questions:

o What are some examples of tax expenditures in our Act?

▪ Answer:

o Why are they administered through the Act, rather than as a separate regime?

▪ Answer

o How do we evaluate tax expenditures?

▪ Answer: What is the goal? Is it being met?

● How must does it cost to administer and comply with?

● Are people aware of a certain tax credit? Is it being used?

● Each year, the government creates a Tax Expenditures Report which quantifies the cost (in terms of lost tax revenues) of all tax expenditures

Unit 1 Practice Questions● Both of these are more directed questions (compared to open ended hypotheticals)

● Assume that the client has no tax background

● Only provide background information to the extent that it’s relevant

o i.e., don’t dump irrelevant information

● Issue; rule; application; conclusion (IRAC)

o The conclusion is most often what is missing from an answer.

● No need to cite section numbers or case names.

Question 1

● State right away that they have a case.

● Grounds:

© Sprysak 2019

TAXATION


o 1) The tax may have been inappropriately enacted through regulation, not the full legislative process.

▪ There may have been an improper use of delegated power or there may not have been a delegation of the taxation power

▪ It is possible for the executive branch to enact a tax (i.e., through regulation) but this power must have been delegated to them

o 2) This is an indirect tax; therefore it is ultra vires the province’s powers.

▪ The province is only allowed to tax directly.

● Does the answer to one of these questions implicate/influence how I answer the next question?

o Not in this case, they are distinct grounds and neither needs to be answered first.

● Ground 1 Law:

o Constitutions and rule of law require governments to enact taxes through the legislative branches

o The legislative branch can delegate the power to enact a tax to a government body (in this case the executive branch). They must do so explicitly and the subordinate body has to exercise their powers within the scope of that delegation.

● Ground 1 Application:

o We don’t have all the facts – it is possible that this was validly enacted but this is dependent on whether we assume the power has been delegated.

o On the exam, say that you are going to follow up.

● Ground 2 Law:

o The province is only allowed to enact direct taxeso DEFINE YOUR TERMS – in this case, define what a direct tax is.o Direct tax: imposed on one person with the intent that that person will bear the burden.o Indirect tax: imposed on one person with the intent that the burden will eventually be

passed on to someone else.

● Ground 2 Application:

o It was definitely an indirect tax and therefore is unconstitutional.

Question 2

● Family tax cut is an inefficient provision because it is complicated and increases compliance costs and increases the difficulty for people to access the tax cut.

● Terms for eligibility are relatively clear – you either meet the criteria or you don’t

● The childcare benefit is arguably efficient because it applies to everyone with children

© Sprysak 2019

TAXATION


● Comparing the universal childcare benefits to the family tax cut, the family one only applies to a certain number of people – won’t apply to single parent families

© Sprysak 2019

TAXATION

Unit #2 – Sources of Income Tax LawThe Income Tax Act

● As we all know, the primary source of income tax law in Canada is the Income Tax Act, RSC 1985, c 1

(5th Supp) (Act), as amended

● While each commercial publication of the ITA is slightly different, they all generally contain the following:

o Table of Proposed Amendments (xv): shows the status of budgetary amendmentso Tax Reference Tables (xxvii): very useful for quick reference of tax rates, credits, etc.o Detailed Table of Sections (lxxix): this can be a useful research starting point o Legislative Provisions (page 1):

▪ While each publication differs slightly in form and in content, for each section of the Act, in addition to the actual provision, there will be a Related Provisions and Notes section.

o Index (page 2255) – along with the Detailed Table of Sections, this part of the ITA can be your best friend - often a starting point for research of the legislation - look for key terms and go from there...

▪ When researching, start in the index to find the area/issue

Income Tax Application Rules (ITARs)

● Background Information: while we will discuss this principle in more detail later in the course, generally speaking, there are two types of property for income tax purposes, namely:

o “Inventory” (or “business property”), which is any property acquired by a taxpayer for the purpose of selling it for a profit,7 and

o “Capital property”, which is – very loosely speaking – everything else.

▪ Generally speaking, “capital property” is any property that is acquired by a taxpayer for the purpose of using it either to earn income or personally,8

● Important Points:

o Characterization for property is taxpayer specific, not property specifico i.e., it’s tied to what the taxpayer was using it for, not the type of property (houses are not always

one or the other)

● Example: house

o If a taxpayer buys a house to flip it for a profit, then for that taxpayer, it will be inventory (business property)

o Conversely, if the taxpayer buys the property to use it, then for that taxpayer it will be capital property. Of course, the most common uses are:

7 Subsection 248(1) defines “inventory” as “a description of property, the cost or value which is relevant in computing a taxpayer’s income from a business for a taxation year…”8 Subsection 54 defines capital property as “any depreciable property of the taxpayer, and any property (other than depreciable property) any gain or loss from the disposition of which would, if the property were disposed of, be a capital gain or loss of the taxpayer…”© Sprysak 2019

TAXATION

Unit #2 – Sources of Income Tax Law

▪ To live in it (personal use property)

▪ To rent it out (income-earning capital property)

● As we will discuss later in the course, there are generally no taxes triggered when a taxpayer acquires property. However, when a taxpayer disposes of property, the Act will generally require the taxpayer to calculate the gain or loss, if any, on the disposition.9

o If the property is “capital property”, then the gain or loss on disposition will be a capital gain or loss

o Conversely, if the property is “inventory”, then the gain or loss will constitute business income (or a business loss)

● Prior to 1972, capital gains and losses were not taxable; they were outside the scope of the Act

o Conversely, business profits have always been taxable in Canadao So prior to 1972, where a taxpayer realized a gain from the disposition of property, the taxpayer

wanted the gain to be characterized as a capital gain – so that no taxes would be payable.

● Effective January 1, 1972, the government decided to make capital gains and losses taxable (on the recommendation of the Royal Commission on Taxation led by Kenneth Carter, which studied all aspects of Canadian taxation in the 1960s and made recommendations for reform)

● Example: Bert and Ernie bought a house in Belgravia in 1957 for $5,000. They sold it in 2019 for $500,000 (net of selling costs).

o Question: what is the economic gain on the sale of the house (excluding all of the maintenance costs over the years)?

▪ Answer: Not necessarily the tax gain. To calculate the economic gain, you take the proceeds of disposition ($500,000) and deduct the purchase price ($5000). Therefore, gain = $495,000.

▪ The full 100% of the gain is not always included in the taxable amount since much of the

gain is accounted for by inflation. o Question: how is that gain characterized for income tax purposes?

▪ Answer: to characterize the gain, you first have to characterize the property – capital property results in a capital gain; business property results in a business gain (business income)

▪ To properly characterize the property, we have to know what Bert and Ernie intended to do with the property (and what they actually did with the property) – factual analysis

▪ Note: we will revisit this topic in more detail later in the course

o Assuming that the property was properly characterized as capital property:

9 “Disposition” is a “recognition event” for tax purposes and is defined (in great detail) in subsection 248(1); for our purposes at this point in the course, a “disposition” is when a taxpayer sells or gives away property© Sprysak 2019

TAXATION


▪ Under the pre-1972 rules, the total economic gain would not have been taxable – Bert and Ernie could have pocketed the entire $500,000 proceeds without having to pay any income tax

▪ Under the post-1971 rules: the total economic gain would all be taxable since the recognition event occurred after capital gains/losses became taxable.

o Question: given the change in tax policy in 1972 to make capital gains taxable, is there anything wrong with Bert and Ernie having to report the entire gain on their tax returns (and pay income taxes on this gain)?

▪ Answer: (arguably) yes – the change in tax law (and policy) has retroactive effect – it taxes gains that occurred prior to 1972 when capital gains/losses were not taxable

▪ Solution: the ITARs – a way of ensuring that the change in tax policy only applies prospectively (i.e. January 1, 1972 and onwards)

● How?

● The ITARs (page 1615) help taxpayers (and tax practitioners) deal with the introduction of capital gains/losses as a source of income as of January 1, 1972, by setting out rules on how to calculate the “tax cost” of capital assets which were acquired prior to 1972 in order to be able to calculate the asset’s post-1971 gains

● In the case of publicly-traded securities, this is very easy – the government recorded the ending trade values for all publicly-traded stock on December 22, 1971 – this is the “tax cost” for calculating post-1971 gains10

● In other cases (where the asset was not publicly valued on December 31, 1971), the ITARs set out how to calculate the January 1, 1972 “tax cost” – generally, as the amount that is neither the greatest nor the least of (a) the cost of the property to the taxpayer, (b) its fair market value on December 31, 1971, and (c) the taxpayer’s proceeds of disposition of the property.11

● Obviously, with the passage of time, the importance of ITARs have declined to most taxpayers (i.e. capital assets will be have been acquired after January 1, 1972 and hence this is not an issue)

o However, they continue to be relevant to property purchased prior to 1972 (and can also be relevant where property has been “rolled over” between generations

Income Tax Regulations

● As discussed in detail in the Administrative Law course, Parliament (and the provincial legislatures) has the

ability to delegate its ability to enact taxation (and other) law.

10 Paragraph 24(a) of the ITARs11 Subsection 26(3) of the ITARs.© Sprysak 2019

TAXATION

Unit #2 – Sources of Income Tax Lawo One of the primary benefits of delegating the law-making power, typically to the Executive Branch

of government, is its speed/efficiency – Regulations do not have to go through the full legislative process (that we will briefly discuss below)

o Of course, to be valid, any law created by the delegate – which is generally referred to as “subordinate legislation” or “regulation” – must be within the scope of the delegated authority

● Paragraph 221(1)(a) provides that the Governor in Council may make regulations “prescribing anything

that, by this Act, is to be prescribed or is to be determined or regulated by regulation”o Some of the more common/popular Regulations are those that specify the rates of depreciation for

certain capital assets for tax purposes

Tax Treaties

● As we will briefly discuss in a subsequent Unit, Canada levies income taxes on two bases:

o First, on persons who have a close connection to Canada – specifically, where such persons are “residents” of Canada

▪Where Canada taxes a Canadian resident, it taxes the resident’s worldwide income

o Second, on income that has its source within Canada

▪ Given Canada’s first basis of taxation (the taxation of Canadian residents’ worldwide

income), source taxation applies where the person earning the Canadian-sourced income is a non-resident of Canada

● Most countries levy income taxes based on similar connections (connections with the person and/or with the

person’s income).

● As a result, it is not uncommon for a person to be subject to “double tax” on some (or all) of his/her/its

income (i.e. subject to tax in Canada because the person is a Canadian resident; subject to tax in the United States since the income is earned there).

● To alleviate this double-tax problem, bi-lateral tax treaties were created.12 These treaties effectively

override a country’s domestic tax legislation in certain specified situations o Note: a person seeking treaty relief must be eligible for it and generally must elect for the treaty to

apply

Provincial Tax Legislation

● In addition to the Federal Income Tax Act, which applies across Canada, each province also has its own provincial income tax legislation.

12 This was the initial motivation for the creation of bi-lateral tax treaties. In addition to dealing with this issue, tax treaties are also used (especially more recently) (a) to assist in the mutual enforcement of each country’s tax legislation and (b) to share tax information.© Sprysak 2019

TAXATION

Unit #2 – Sources of Income Tax Lawo Generally speaking, these are (typically) very short pieces of legislation which basically refer to and

adopt the Federal Act’s calculations of “taxable income”.

Persons Involved in the Creation and Administration of Income Tax Law

● There are four key players involved in the creation and administration of income tax law in Canada:

o The Department of Finance: who makes key tax policy decisions (of course, with input from the Prime Minister’s Office and Cabinet) and drafts the associated tax legislation,

o The Department of National Revenue: who administers the Act through the Canada Revenue Agency (CRA),

o The Department of Justice: who represents the Minister of National Revenue/CRA in court.o The Court System: who interprets/applies the legislation as well as supplements such legislation

through its common law decisions

The Legislative Process

● Generally speaking, the enactment of new (federal) tax legislation typically begins with the Minister of Finance delivering the government’s Budget in the House of Commons

● Typically, Budget preparations are done outside of the public sphere such that, on Budget Day, there is some uncertainty (and excitement) as to what the government is proposing to do

o Why?o To prevent any changes in behaviour in anticipation of the new taxes that would frustrate the

purpose of the new regime.o If people know that there’s going to be a change then they might do something to minimize the

impact of the new taxes. This impacts the market in a way that taxes aim not to do.

● At the time the Budget is announced (or soon thereafter), the government releases a Notice of Ways and Means Motion to amend the Act, which is generally drafted using “ordinary language”, as well as a draft of the proposed legislative changes, accompanied by Explanatory or Technical Notes intended to explain the purpose of each amendment.

o Note: in practice, these Explanatory/Technical Notes are extremely valuable to taxpayers, tax practitioners and judges

● Following the delivery of the Budget, there is a debate (on it) in the House of Commons

● Sometime after the delivery of the Budget (and the associated debate), the government will introduce a Bill in the House of Commons to implement the proposals set out in the Notice of Ways and Means Motion.

o Like other federal bills, it will go through three readings in the House, be debated and refined and sent to Parliamentary subcommittees, and be similarly reviewed by the Senate, before receiving Royal Assent

© Sprysak 2019

TAXATION


● While the bill becomes law upon receiving Royal Assent, the general Canadian practice (unless an alternative implementation date is included in the draft legislation) is that at the time of Royal Assent, the legislative amendments become effective retroactive to the Budget date when they were first announced.

o Why?o For the same reason that the new tax plan is kept secret until the budget is announced. It prevents

people from changing their behaviour to take advantage, thus preventing market changes beyond what is intended.

● These legislative amendments are shown in the commercial publications of the Act by shading – and are generally followed as if they were law by taxpayers and tax practitioners.

● Question: What if there is a change in government between Budget day and Royal Assent? Could the change in government result in proposed legislative amendments not get passed (or at least not in their published form) – causing problems for taxpayers who followed them on the assumption (and general practice) that they would become law?

o Answer: To preserve the integrity of the tax system, in almost all cases, what is announced in a Budget will get passed, even if there is a change in government during the process.

▪ If the new government doesn’t like the current amendments, after allowing them to receive Royal Assent, they will then come out with a new Budget which makes whatever changes it feels necessary (from the Budget date forward).

Tax Cases

● The primary court of first instance for tax cases today is typically the Tax Court of Canada, which was created by the Tax Court of Canada Act (T-2) in 1983

o It has “exclusive original jurisdiction” to hear appeals with respect to various matters and statutes including, for our purposes, the Income Tax Act (section 12)

● Important Point: not all tax matters come before the Tax Court as the court of first instance (so you may have to look to decisions from other courts depending on the issue). For example:

o Criminal matters (such as tax evasion) will be heard either in Provincial Court or Court of Queen’s Bench (depending on the type of offence (summary conviction or indictment) and any available election

o Application for judicial review in respect of CRA decisions where the Act gives CRA discretionary decision-making powers (i.e. power to waive interest and penalties on outstanding assessments) - these must be done in Federal Court

o Applications in respect of the CRA’s use of its audit and investigatory powers under the ITA (i.e. search and seizures, requests for information by 3rd parties, etc.) - again, must be done in Federal Court or a superior court in the province

o Appeals from CRA decisions with respect to the registration and deregistration of charities, pension plans and other entities under the ITA - appeals must be initiated at the FCA (without first having a hearing before a trial judge)

© Sprysak 2019

TAXATION

Unit #2 – Sources of Income Tax Lawo Determinations of residency for provincial tax purposes are done in the Court of Queen’s Bench of

the relevant/seeking province unless the relevant provincial ITA specifically gives the Tax Court this power

● Section 20 provides that the Tax Court has the ability to make its own Rules of Court (which it has – so make sure you consult it as the rules might be different than the Rules of Court within the province)

● The Tax Court is a national court that hears cases throughout the country

● There are two types of hearings in the Tax Court - general and informal procedure cases

o General Procedure (GP) cases have all the trappings of a QB case including examinations for discovery/documents,13 expert witnesses, full precedential value, cost awards, appeal rights, etc.

▪ Note - only a lawyer or the taxpayer herself can run a GP case – section 17.1.

▪ There is no special “tax bar” – any lawyer is able to appear before the Tax Court – subsection 17.1(2)

o Informal Procedure (IP) cases are more stream-lined and intended to be faster, less costly and more accessible to the general public (intended to be analogous to Small Claims Court).

▪ These cases do not follow the full litigation procedure, strictly speaking, are not bound by the rules of evidence,14 do not have a general right of appeal (generally speaking, confined to “judicial review”), no full schedule of costs and, have no precedential value (section 18.28).

● Practically speaking, the decisions have precedential value

▪ For income tax cases, to qualify for informal procedure, amount of federal tax and penalties in dispute for each taxation year, excluding interest, must be $25,000 or less (increased from $12,000) – see section 18

▪ If more than $25,000, then can elect to dispute only $25,000 (give up on and pay the rest)

▪ Note: can have someone other than a lawyer or the taxpayer herself run the case (i.e. accountant, husband/wife, etc.)

● Appeals from the Tax Court are to the Federal Court of Appeal and then to the Supreme Court of Canada (by leave of the Court)

Canada Revenue Agency Publications

● To assist taxpayers (and tax practitioners) in complying with the Act, the CRA issues a variety of different publications. Some of the more common (and comprehensive) ones are:

13 Per subsection 17.3(1), the right to an oral examination for discovery may be restricted if the amount in issue is $50,000 or less14 That said, in every presentation that I have heard from a Tax Court Justice, they have stated (not surprisingly) that they will still be looking for evidential safeguards (particularly when evidence is being provided by a taxpayer or a taxpayer’s witness)© Sprysak 2019

TAXATION

Unit #2 – Sources of Income Tax Lawo Income Tax Folios: these publications are currently being issued to replace Interpretation

Bulletins. Both Folios and Interpretation Bulletins are intended to provide taxpayers (and tax practitioners) with summaries of the law and the CRA’s interpretation of the law (where the law is uncertain) on a subject-area basis.

▪ Important Point: neither the summaries nor the CRA’s interpretations (neither of which are labelled as such) are binding upon the CRA nor should they be blindly relied upon by taxpayers (and tax practitioners) as reflecting the current law (or even the CRA’s current administrative/interpretative policy)

● That said, where taxpayers have relied upon CRA advice, if it turns out the taxpayer has an outstanding tax liability (when the correct law is applied), the court will typically direct the CRA to waive any associated interest (and penalties), if assessed.

o Information Circulars: these publications generally provide information on how to comply with the Act (i.e. how to do a “fairness application”) rather than summaries and interpretations of substantive tax law.

o Advance Tax Rulings: are, as the name indicates, rulings given by the CRA (Income Tax Rulings Directorate) on a proposed (as opposed to completed) series of transactions as to what they believe the tax effects will be.

▪ The stated purpose of a ruling “is to promote voluntary compliance, uniformity and self-assessment by providing certainty with respect to the application of Canadian income tax law to proposed transactions”.15

▪ To obtain such a ruling, a taxpayer and her advisors must furnish the CRA with complete disclosure of the facts or transactions contemplated along with a cheque for services to be rendered – $100 for each of the first 10 hours and $155 for each subsequent hour or part hour spent on the ruling request

▪ The CRA states that it will abide by its advanced income tax ruling subject to any qualifications stated in the ruling.

● That said, technically, these Rulings may not binding on the CRA

▪ However, when there is a material omission or misrepresentation in the statement of relevant facts or the proposed transactions submitted by the taxpayer or the taxpayers authorized representative, the advanced income tax ruling will be considered invalid and the CRA will not be bound by it.

▪ To assist other taxpayers, they are published by commercial tax publishers such as Carswell and CCH (after taxpayer specific information is removed)

▪ Note: strictly speaking, the CRA is under no obligation to issue an advanced income tax ruling and can (and does) refuse to issue one if it doesn’t want to

15 CRA, Information Circular IC 70-6R8, “Advance Income Tax Rulings and Technical Interpretations” (1 November 2018) at para 12.© Sprysak 2019

TAXATION


● It has stated that it generally will not issue a ruling where the request concerns “primarily a factual or legal determination” (i.e. residence, income vs capital, or carrying on a business)16

● It has similarly stated that it generally will not issue a ruling “confirming the application of a provision that is conditional on the existence of facts (including an intention), especially where the facts or intentions have to be inferred from the circumstances”.17

▪ The CRA is also willing to do a “pre-ruling consultation” to discuss a particular (usually novel) tax issue to determine whether the taxpayer should submit a ruling request.18

o Technical Interpretations: these are similar to ATRs in that you are asking the CRA for their interpretation/position. However, these interpretations generally:

▪ are of a particular provision rather than to a proposed transaction

▪ are done on a “no-names” basis (as opposed to full disclosure)

● Put another way, they are “generic” in nature

▪ are not subject to any fees from the CRA, and

● the CRA is not bound by the Technical Interpretation (although they likely would follow it - it would also have value in defending against possible gross negligence penalties)

● Information concerning advanced tax rulings and technical interpretations (including how to request one) are contained in the recently released IC 70-6R8 “Advance Income Tax Rulings and Technical Interpretations” (1 November 2018).

16 Ibid at para 19(h).17 Ibid at para 19.1.18 Ibid at paras 30-40.© Sprysak 2019

TAXATION

Unit #3 – Who Is Subject to Tax?

Introduction

● Subsection 2(1) provides that “every person resident in Canada at any time in the year” will be

subject to Canadian income tax on their “taxable income”.

● Breaking this section down a bit, it means that for all of your taxable income to be subject to

Canadian income tax, you must:o 1st – be a “person”, ando 2nd – be “resident in Canada”

● Question: what if you are not a “person” for Canadian income tax purposes?

● Answer:

A Brief Overview of the Canadian Taxation of Non-Residents

● Question: what if you are a “person” for income tax purposes, but not “resident in Canada”?

o Answer: All of your taxable income will not be subject to Canadian income tax, but:o Pursuant to subsection 2(3) (supplemented by section 115) and section 212 (and subsequent

sections in Part XIII), certain income that can be sourced to Canada will be subject to Canadian income tax (unless eliminated by an applicable tax treaty). More specifically:

▪ Subsection 2(3) provides that where a person who is not taxable under subsection

2(1) (i.e. a non-resident of Canada):

● Was employed in Canada,

● Carried on business in Canada, or

● Disposed of a “taxable Canadian property”19

● then the income/gains from those activities, but only those activities, will be

subject to Canadian income tax (under Part I of the Act); and

▪ Section 212 lists several types of income (management fees, interest, rents,

royalties, pension benefits, dividends, etc.) that will be subject to a special “withholding tax” of 25% (under Part XII of the Act) (unless reduced/eliminated by tax treaty) on the gross amount paid to the non-resident

19 “Taxable Canadian property” is extensively defined in subsection 248(1) to include a variety of items including: real property situated in Canada, property used in carrying on a business in Canada, shares of a privately-held corporation (and interests in partnership or trust) where more than 50% of the value can be attributed to certain types of property located in Canada (i.e. real property), shares of a publicly-traded corporation (where certain similar characteristics are met), etc.

© Sprysak 2019

TAXATION


● Caution: while a detailed discussion of this issue is beyond the scope of this course,20 it is very

important to be alert for situations where a non-resident is involved – not only if you are acting for a non-resident (to ensure that the non-resident complies with his/her applicable Canadian tax responsibilities), but additionally if you (or your client) are dealing with a non-resident.

Example: Acquiring Canadian Real Estate from a Non Resident (Section 116)

● As noted above, pursuant to paragraph 2(3)(c), if a non-resident disposes of Canadian real estate

(which constitutes “taxable Canadian property” under subsection 248(1)21), then the non-resident may be taxable in Canada on the gain from the disposition (if any)

o “Disposition” is defined in significant detail in subsection 248 to include22 a variety of transactions, including:

▪ Any transaction or event entitling a taxpayer to proceeds of disposition (i.e. a “sale”),

and

▪ A gift

● To ensure that Canada will be able to collect its tax on a disposition of taxable Canadian property by

a non-resident person in a cost-effective manner, the Act contains section 116.23

● Among other things, section 116:

o 1st - gives the non-resident the opportunity to give the Minister advance notice of the disposition (pursuant to subsection 116(1)) and the ability to make a pre-payment/deposit with respect to the associated Canadian income tax (if any).

▪Where the non-resident (or his/her advisor) does this timely (i.e. prior to the transfer),

correctly, and accurately, then the CRA will issue to the non-resident a “certificate” (which can be provided to the purchaser) which allows the transfer to occur with no potentially detrimental tax consequences to the new owner (and no need for the new owner to take any steps to protect her/himself – as discussed below)

20 These topics may be addressed in detail in the International Taxation course offered by the Faculty. 21 In addition to “real or immovable property situated in Canada”, the definition of “taxable Canadian property” in subsection 248(1) includes such Canadian property as: property used in carrying on a business in Canada, the shares of a private Canadian corporation (i.e. not traded on a public stock exchange) where more than 50% of the fair market value (FMV) of the shares of the Canadian corporation can be attributable to taxable Canadian property (i.e. Canadian real estate, Canadian resource properties, etc.), and certain shares in publicly-traded Canadian corporations (which satisfy the specified requirements). 22 As an “inclusive” definition, it does not preclude the application of the ordinary dictionary meanings of “disposition”23 Note: there are similar provisions which in some cases put the responsibility on Canadian resident payors of the types of income listed in section 212 to withhold and remit an amount in respect of the non-resident’s Canadian taxes payable on their Canadian source income.

© Sprysak 2019

TAXATION


o 2nd – provides that where advance notice and prepayment do not occur in a timely, correct, and accurate manner prior to the transfer, then the new owner (as opposed to the seller/donor) may be liable to pay 25% of the purchase price (in the case of a sale24) to the Receiver General in respect of the non-resident owner’s Canadian tax liability pursuant to subsection 116(5)

▪ Subsection 116(5) does provide the new owner with somewhat of an escape from this

(harsh) consequence

▪ It provides that it will not apply if “after reasonable inquiry, the purchaser had no

reason to believe that the non-resident person was not resident in Canada”.25

▪ In Kau, the purchaser relied on the standard warranty/representation in the real estate

purchase agreement that the vendor was not a non-resident at the time of the transfer, despite the purchaser and his lawyer being aware of several other facts that suggested that the vendor was a non-resident

● In this particular factual circumstance, the Justice Russell held that the

purchaser had not satisfied the reasonable inquiry test – and hence was required to pay 25% of the purchase price to the Receiver General in respect of the (California) vendor’s Canadian tax liability

o Where subsection 116(5) applies and the CRA assesses the purchaser (or donee), the purchaser/donee can try to recover the additional payment from the non-resident vendor/donor.26

▪ Alternatively/additionally, the purchaser/donee appears to be able to sue his/her/its

legal advisor for not properly protecting the purchaser/donee – as was successfully done in Mao v Liu, 2017 BCSC 226.27

o Planning Point: to protect the new owner from having to pay 25% of the purchase price to the Receiver General after having paid 100% of the purchase price to the non-resident vendor

24 If the non-resident gifts the property, then the recipient may be liable to remit to the Receiver General 25% of the fair market value (FMV) of the property on the non-resident donor’s behalf.25 Subsection 116(5.01) provides some additional relief to the purchaser in respect of “treaty-protected property”.26 Of course, the challenge is that the non-resident (by definition) is outside Canada, so it may be difficult and costly to successfully recover the monies from the seller/donor (which is why Canada has enacted section 116)27 Mao v Liu involved the purchase of real estate in Vancouver for $5.56 million. The sale actually occurred with a creditor of the registered owners (CEIR) pursuant to a Court order. The purchasers (Mao) had hired a notary public (Tony Liu) to represent them in conveyancing the title of the property to them and had specifically detailed in their engagement letter that the notary “make inquiries as to the residency status” of the owners as required by the Act. While the notary did make inquiries about the owners’ residency status with the creditor’s legal counsel BLG LLP (which BLG never answered) as well as tried to get BLG to complete a statutory declaration that the owners were Canadian residents (which BLG refused to complete), the Court found that these steps were not sufficient to satisfy the “reasonable inquiry” safe harbour set out in subsection 116(5). As one of the owners was a non-resident of Canada, the CRA assessed the purchasers for $695,000 in respect of this transaction. In this case, Justice Affleck granted the purchasers’ application for summary judgment of $695,000 (plus costs) against the notary.

© Sprysak 2019

TAXATION


(and to protect the legal advisor from being sued for this amount), s/he should withhold 25% of the purchase price where s/he does not receive a certificate from the vendor prior to the sale closing and remit it to the Receiver General28

Who Is a “Person” for Income Tax Purposes?

● This is a statutory interpretation question

o Look at s 248(1), the general definitions sectiono Includes: any corporations, entities exempt due to 149(1), trusts, individuals, etc (non-

exhaustive list/inclusive definition)o Partnerships are not included in this – but each individual partner is taxable so it is generally

laid out in a partnership agreement how they will be taxed (if not, then it is generally equally split)

o Sole proprietorships are not either

What Does It Mean To Be a “Resident in Canada” for Canadian Income Tax Purposes?

● As we noted at the beginning of the Unit, subsection 2(1) provides that for your worldwide income

to be subject to Canadian income tax, you must (1) be a person and (2) be a Canadian resident

● Other than the definition of “ordinarily resident” in subsection 250(3),29 there is no general

definition of a “resident” in the Act.o What we do have, for certain persons, are statutory deeming rules – which provide that

such a person (where the requirements/circumstances are satisfied) will be “deemed” to be a resident

● Consequently, to determine whether a person is a resident for Canadian income tax purposes, we

have to consider:o The applicable common law definition/test, ando Any applicable statutory deeming rule.

● Practice Point: generally speaking, when a person’s residency for income tax purposes is in issue,

the person is usually hoping not to be a Canadian resident (as that will require him, her, or it to pay Canadian income taxes on their worldwide income)

o To be sure that a person is not a Canadian resident for Canadian income tax purposes, one must consider both the common law and statutory deeming rules.

28 While I believe that this should be clearly specified in the contract, regardless, subsection 227(1) provides that “[n]o action lies against any person for deducting or withholding any sum of money in compliance or intended compliance with this Act”.29 Subsection 250(3) provides: “In this Act, a reference to a person resident in Canada includes a person who was at the relevant time ordinarily resident in Canada”. As we will discuss further, this definition allows a person to be “resident in Canada” in an “extraordinary” year if he/she/it was ordinarily resident.

© Sprysak 2019

TAXATION


● To assist (potential) taxpayers and tax practitioners in answering this very important issue, the CRA

has issued Income Tax Folio S5-F1-C1: Determining an Individual’s Residence Status30 o Remember that folios are not the law, they are simply the CRA’s interpretation of the law

Residence of an Individual – Common Law Test

● The leading case on when an individual will be a Canadian resident for purposes of the Act

continues to be Thomson v Minister of National Revenue, [1946] C.T.C. 51 (S.C.C.).31 o As set out in Justice Rand’s decision, which is the decision most commonly quoted in

subsequent case law (particularly paras 48-50), residence is:

▪ Chiefly a matter of the degree to which a person in mind and fact

settles into or maintains or centralizes his ordinary mode of living with its accessories of social relations, interests or conveniences at or in the place in question32

▪ Do a comprehensive analysis of all of the facts relating the individual

in question to Canadao In defining when an individual will be resident for income tax purposes, the Supreme Court

in Thomson (as well as other judges in other cases) also referred to the dictionary definition of “residence”, namely:

▪ [t]o dwell permanently or for a considerable time, to have one’s

settled or usual abode, to live, in or at a particular place.o To assist in understanding this concept of residency for income tax purposes, Justice Rand

also distinguished “ordinarily resident” from “occasional, casual or deviatory” residence, which as we will discuss later in this Unit, is essentially the common law definition of “sojourning”.

▪ “Ordinarily resident” was defined by Justice Estey in a concurring decision in

Thomson as “the place where in the settled routine of his life, he regularly normally or customarily lives”

30 As we discussed earlier in the course, while not binding (to the extent that they reflect the CRA’s administrative position or interpretation of the law), CRA publications can be very helpful. In my opinion, this Folio (which has been revised several times since being issued a couple of years ago) is extremely thorough and helpful, and, as such, I strongly encourage you to read it carefully. Where applicable, I have made reference to it in our notes.31 Mr. Thomson was born in Saint John, New Brunswick and spent the next 50 years living and working in Canada. After retiring from his business activities and getting into a property tax dispute, he decided to cease being a Canadian resident and move to Bermuda. While he rented a home in Bermuda and obtained a Bermuda passport, he did not actually spend much time there. Instead, he spent most of his time in North Carolina and New Brunswick, first in rented homes and then in homes that either he or his corporation owned. He was very careful not to stay more than 183 days in Canada per calendar year to avoid the application of the “sojourner rule”. For the 1940 taxation year, he was assessed as a Canadian resident and hence subject to Canadian income tax on his worldwide income. Mr. Thomson disputed this assessment. 32 This quote from Justice Rand’s decision is also set out (and has been adopted by the CRA) in para 1.5 of Folio S5-F1-C1.

© Sprysak 2019

TAXATION


▪ Given subsection 250(3), an individual who is “ordinarily resident” in Canada will

generally be a Canadian resident in an “extraordinary year”

▪ Conversely, if an individual is only “occasionally resident” in Canada in a particular

year, then generally speaking he/she will not be found to be a resident under this common law test (but may be deemed to be a Canadian resident if he/she is resident for a significant period of the year under the sojourner rule).

o Practice point: “ordinarily resident” is an important concept/distinction in Canadian income tax law. Residence for tax purposes inherently requires a level of normalcy, regularity, etc. – a person won’t generally be found to be a resident under the common law solely by physically being present in a particular jurisdiction at a moment in time.

● To ascertain if an individual is resident in Canada, one must conduct a comprehensive factual

analysis to see if Justice Rand’s definition of residence for tax purposes is satisfied.o A case that I like to refer to which outlines many of the indicia that a court can and does

consider in its comprehensive factual analysis is Lee v Minister of National Revenue, [1990] 1 CTC 2082 (TCC)33

● Under this analysis, the most important/determinative factor is the residential ties of the

individual under consideration, his/her spouse or common law partner and any dependents.o As noted in para 1.10 of Folio S5-F1-C1, “while the residence status of an individual can

only be determined on a case by case basis after taking into consideration all of the relevant facts, generally, unless an individual severs all significant residential ties with Canada upon leaving Canada, the individual will continue to be a factual resident of Canada and subject to Canadian tax on his or her worldwide income. [Emphasis added.]

● Starting Point: where is the individual and his/her spouse/partner/immediate family currently

residing?o 1st Scenario: If the individual is residing in Canada (and this is not extraordinary/unusual),

then this is a compelling factor in favour of a finding that the individual is a Canadian resident for tax purposes.

o 2nd Scenario: If the individual is residing outside of Canada, but his/her spouse/partner and/or minor children are residing in Canada, then this is (similarly) a compelling factor in favour of a finding that the individual is a Canadian resident.

▪ Question: Why would this be the case? Why should someone else’s residency

situation be relevant?

▪ Answer:

33 For those with access to Krishna’s text, you can alternatively/additionally refer to his list of factors on pages 73-74.

© Sprysak 2019

TAXATION


▪ The assumption is that this is a temporary/extraordinary/unusual situation – it

presumes that the individual residing abroad will return

▪ This is rebuttable but it is presumed to start.

▪ This does not go beyond the immediate nuclear family

o 3rd Scenario: If the individual and his/her spouse/partner/immediate family are currently living outside of Canada, but they have a dwelling place in Canada available for their use either immediately or in the very short term, then this will usually be a significant fact in favour of finding the individual to be a Canadian resident.

▪ Question: why is having a Canadian residence available immediately or in the short-

term important in establishing the residency of the owner(s)?

▪ Answer: Why would someone keep their residence if they do not intend on returning

to Canada?

▪ Tax Planning Tip: Sever as many connections as you can to avoid becoming a

Canadian resident – this can be done by renting out the residence on one-year leases.

▪ The fact that you haven’t sold a Canadian residence isn’t sufficient to make a

determination of residency, but it’s one of the biggest parts of the comprehensive factual analysis.

● While the residential ties of the individual (and his/her spouse/partner and dependent children) is the

most important indicia, as noted above, the CRA/courts will collectively consider all relevant facts including the following “secondary residential ties”:34

o Personal property located in Canada (i.e. furniture, clothing, automobiles, etc.),o Social ties within Canada (i.e. memberships in Canadian professional, recreational, and

religious organizations, etc.),o Economic ties with Canada (i.e. employed with Canadian employer, involvement in a

Canadian business, Canadian bank accounts, etc.),35

o Landed immigrant status or appropriate work permits in Canada,o Canadian hospitalization and medical insurance coverage,o Canadian driver’s licence,o Canadian seasonal dwelling place or leased dwelling place,o Canadian passport, landed immigrant status, etc.

34 Note – this is not an exhaustive list.35 Collectively, I like to refer to these three indicia as the “Secondary Big Three” (after considering the residential ties of the taxpayer and his/her spouse/partner/family)

© Sprysak 2019

TAXATION


● These “secondary residential ties”, particularly once you get beyond what I call “the Big 3” taken

alone, are typically given limited weight – but as they accumulate, they can become more influential in the overall residency determination.

● 128.1 Right before you cease to become a Canadian resident, you are deemed to dispose of and

reacquire all of your capital property – this way Canada gets all of the capital gains taxes.o This also goes the other way, immediately prior to becoming a Canadian residence, you are

deemed to dispose of and reacquire all of your capital property at fair market value. This prevents new residents from having to pay capital gains tax when they come to Canada.

● Question: assuming that an individual has properly been characterized as a Canadian resident under

the common law, then can that individual change his/her status to a non-resident by remaining outside of Canada for a certain period of time?

o Answer:

▪ It used to be that if you are away for more than 2 years, the CRA would assume that

you were now a non-resident status.

▪ This hard amount of time is no longer the case, as evidenced by para 1.17 of the folio

(see below)o In para 1.17 of Folio S5-F1-C1, it states,

▪ Although length of stay abroad is one factor to be considered in making this

determination [of Canadian residency]… the Courts have indicated that there is no particular length of stay abroad that necessarily results in an individual becoming a non-resident. Generally, if there is evidence that an individual’s return to Canada was foreseen at the time of his or her departure, the CRA will attach more significance to the individual’s remaining residential ties with Canada in determining whether the individual continued to be a factual resident of Canada subsequent to his or her departure… [Emphasis added]

● In paras 1.18 and 1.19 of Folio S5-F1-C1, the CRA states that another factor that it will consider in

determining whether an individual intended to (and did) sever its residential ties with Canada is whether he/she complied with the relevant income tax provisions engaged when a person ceases to be a Canadian resident.

o For example, under subsection 128.1(4), when a taxpayer ceases to be a Canadian resident, then (among many things), the Act deems the taxpayer to have disposed and reacquired at fair market value (FMV) generally speaking all property except “taxable Canadian property”

▪ To the extent that such property has increased in value from when it was acquired,

then this deemed disposition and reacquisition will trigger gains for which Canadian

© Sprysak 2019

TAXATION


taxes will likely have to be paid (or adequate security posted) – commonly referred to as an “Exit Tax”

● Other points concerning the common law residency test (see Folio S5-F1-C5 for further details):

o Every person has at least one residence for tax purposes at all times.

▪ Put another way, it is impossible to not be a resident of a country for tax purposes

▪ In Folio S5-F1-C5 at para 1.21, the CRA seems to take this a little further (although

this position is not new or controversial – at least in my opinion) – by stating that if a Canadian resident purports to sever his/her residency but does not appear to acquire a new residence, then the individual’s remaining ties to Canada “may take on greater significance and the individual may continue to be resident in Canada”

▪ This means you can’t just buy a yacht and live free of all taxes.

o A person may be a resident in more than one country at the same time.

▪ Strong connections to another country (to prove residency there) does not take

away from the evidence supporting Canadian residency

▪Make sure to detract from the evidence supporting Canadian residence instead of

proving residence in another countryo Residence is primarily a question of fact. So too is the date of acquiring or severing a

residence – which can sometimes be very important (see para 1.22 of Folio S5-F1-C5 for more information)

o While a taxpayer’s intention to reside in a particular jurisdiction may be relevant to the determination of residence (see Justice Rand’s definition above), this intention is not determinative, but “must always be viewed objectively against all the surrounding facts”

▪Where intention has been considered by the courts, it has most often been an

“objective manifestation of intention” (intention derived from the facts in the case) as opposed to a subjective manifestation by the taxpayer

▪ Further, there have been cases where courts have said that intention is irrelevant (i.e.

where a foreigner is incarcerated in Canada)o Generally speaking, being resident in another jurisdiction is of little importance in

determining if an individual is a Canadian resident.

▪ As already noted, it is possible for a person to have more than one residence at a

particular time.

▪ It is an examination of the residential ties to Canada which will govern the result for

Canadian tax purposes.

© Sprysak 2019

TAXATION


▪ Practice Point: Sever all possible ties to Canada if you wish to not be a resident.

o Appellant courts have repeatedly stated that the standard of review (at the Federal Court of Appeal and Supreme Court of Canada) in a residency case is “reasonableness” / must be a “palpable and overriding error” to find unreasonableness

● Given the uncertainty that always exists with using a factual analysis to answer a legal question, the

CRA will provide a ruling on an individual’s Canadian residency status if the individual submits a completed Form NR-73 (if leaving Canada) or NR-74 (if entering Canada)

Provincial Residency for Individuals

● Once it is determined that an individual is resident in Canada using the common law indicia, then the

next step is to determine where the individual is resident for provincial tax purposes.o This can be a significant given the differences in provincial tax rates (both for low and high

income earners) as we will discuss in a subsequent Unit.36

● Just as for determining Canadian residency under the common law, the same basic test is used for

determining provincial residency (comprehensive factual analysis to identify significant residential ties) with one important modification.

o For provincial tax purposes, generally speaking, the test is applied on December 31 of the year and the results of that test determine the individual’s residency for the entire taxation year (which as we will discuss in a subsequent Unit, is generally January 1 to December 31 for individual taxpayers).

▪Where an individual ceases to be a Canadian resident before the end of the year, then

the test is applied as of the last day the person was a Canadian resident (and then applies for that taxation year up to the point in time that the individual ceased to be a Canadian resident.

● Further, where an individual has residential ties in two (or more) provinces on December 31, then

Regulation 2607 provides that you “break the tie” by selecting that province which may reasonably be regarded as the person’s “principal place of residence”37

o In other words, you take the province with the stronger/closer ties; you can’t be resident in two Canadian provinces/territories in the same year.

36 As we will discuss in a subsequent Unit, to do a proper analysis, one must not only consider provincial tax rates, but also provincial tax credits.37 Of course, as a matter of tax policy, this is different than in the case of determining a person’s country of residence for tax purposes (for which the policy/principle is that a person can be resident of more than one country at the same time).

© Sprysak 2019

TAXATION


Case Example - R. v. Smale 2009 CarswellSask 243 (Sask. Q.B.)

● Facts: Mr Smale was born, raised and educated in Saskatchewan. Up until February 2005, he lived

(with his wife and two children) and worked in Saskatoon as a chartered accountant; his wife also worked outside of the home in Saskatoon. The family home was jointly owned by Mr. and Mrs. Smale.

● In February 2005, he was fired from his job and given 12 months of severance pay. After several

months of looking for a new job in Saskatoon without success, Mr. Smale broadened his job search and towards the end of November 2005, found a new permanent job in Calgary.

● While he moved to Calgary in November 2005 to begin work, he left his wife and kids behind; the

“plan” was that they would join him in Calgary sometime towards the end of June 2006 after their younger daughter finished Grade 11 (in Saskatoon). The family’s plan to join Mr. Smale in Calgary was pushed back to June 2007 at the daughter’s insistence to allow her to finish Grade 12 in Saskatoon with her friends.

● For the first week (or so), Mr. Smale lived in a Calgary hotel; very soon, he found an apartment,

brought a carload of personal items from his home in Saskatoon and purchased roughly $3,000 of furniture. He also (quickly) changed the address for his credit cards, bank statements, to the accounting profession to his new Calgary address. In February 2006, he obtained an Alberta drivers licence and registered his car with Alberta registries. In November 2006, he applied for Alberta health care coverage, which he obtained.

o Note: the “rule” for obtaining Alberta Health Care coverage was that he couldn’t apply until his Saskatchewan coverage (which lasted 12 months after he left the province) expired.

● Every 6 weeks (or so), Mr. Smale drove back to Saskatoon (presumably on the weekends) to spend

time with his family.38

● On his 2005 income tax return (and presumably in subsequent years), Mr. Smale filed as an Alberta

resident subject to Alberta, rather than Saskatchewan provincial tax rates.

● The CRA reassessed his 2005 return on the basis that he was primarily a Saskatchewan resident in

2005 (and hence subject to the higher Saskatchewan rates)

● In roughly March 2007, Mr. and Mrs. Smale decided to separate (possibly due to the strains of living

apart since November 2005?). Mrs. Smale stayed in Saskatoon; Mr. Smale stayed in Calgary.

● Issue – where was Mr. Smale resident for provincial tax purposes for his 2005 taxation year?

o Notes: as we will discuss in more detail in a subsequent Unit:

38 It is unclear from the decision when (and for how long) these visits back to Saskatoon occurred.

© Sprysak 2019

TAXATION


▪ The Minister’s assessment is presumed to be correct (as well as valid and binding)

pursuant to subsection 152(8). Consequently, the initial legal burden is on the taxpayer to disprove the Minister`s assessment (in this case, that Mr. Smale was a Saskatchewan resident)

▪ Assuming that the taxpayer overcomes the initial legal burden, then it shifts to the

Minister to bring sufficient evidence and make sufficient arguments to support its assessment (which, if successful, shifts the burden back to the taxpayer, etc.)

▪ Even though Mr. Smale moved to Calgary in November 2005 (meaning that, at most,

he resided for only 2 out 12 months in Alberta, residing the 1st 10 months in Saskatchewan), assuming that he indeed acquired Alberta residency (and severed his Saskatchewan residency) then, he was entitled to report and pay tax on his entire 2005’s income using Alberta rather than Saskatchewan provincial income tax rates (since he would have been an Alberta resident on December 31, 2005).

▪ As we noted in the previous Unit, while generally speaking, the Tax Court of Canada

has exclusive original jurisdiction over tax cases, there are several exceptions. This type of case is one – because it deals with provincial, as opposed to Canadian residency. This is why this case was heard and decided by the Saskatchewan Court of Queen’s Bench rather than the Tax Court.

▪ There are a few other minor issues discussed in this case which we will not be

covering (and for which you will not be responsible for exam purposes) – for instance discussion/conclusion about how to name the Respondent (in practice, this issue does not have a clear or unanimous answer)

● There are multiple after-the-date facts that probably influenced the judge’s decision (AB driver’s

license was acquired in 2006, separation in 2007). Even though the date in question is Dec 31, 2005, these facts likely had some bearing. In this case, passage of time was probably helpful to Mr Smale.

Statutory Deeming Rules

● In addition to the common law rules for establishing residency, there are also statutory rules which

deem an individual to be a Canadian resident for Canadian income tax purposes.o Note: these rules are separate and apart from the common law test described above. o Put another way, an individual may be found not to be a Canadian resident using the

common law test but will still be a Canadian resident by virtue of the statutory deeming rules

● These deeming rules are contained in section 250 and can be broken down into two categories (with

regards to individuals):

© Sprysak 2019

TAXATION


o Sojourner Rule - paragraph 250(1)(a)o Special Individuals39 rules - paragraph 250(1)(b) - (g)

Statutory Deeming Rule #1: “Special Individuals”

● Paragraph 250(1)(b) – (g) identifies several groups of individuals who typically (or regularly) work

for or on behalf of the Canadian government abroad, namely:o Members of the Canadian forceso Government officers/servants (loosely defined - quite a broad category)o Children (and certain spouses) of the above

● Because these individuals (and their families) are living and working abroad, it is unlikely that they

will be found to be Canadian residents under the common law test. o However, subsection 250(1) deems them to be Canadian residents and taxed in Canada on

their worldwide income.o Note: to prevent such individuals from being “double taxed” on their income (since they will

likely be resident in the foreign country in which they are living and working), the foreign country will typically either deem them to be a non-resident for that country’s tax purposes or non-taxable

▪ Canada follows the latter approach with respect to foreign diplomats, military, etc.

living and working in Canada – see paragraphs 149(1)(a) and (b)

Statutory Deeming Rule #2 – Sojourner Rule

● The Sojourner Rule in paragraph 250(1)(a) deems an individual to be a resident in Canada for the

entire year if that individual “sojourned” in Canada for 183 days or more

● Rationale: If you are living here for more than half the year, you are likely utilizing tax-funded

services and therefore you should pay taxes for those services.

● Question: What does it mean to “sojourn” for income tax purposes?

o Answer: As “sojourn” is not defined in subsection 248(1), the courts have relied on the dictionary definition, which is “to stay temporarily in a foreign land as opposed to ordinary residence; to make a temporary stay in a place; to remain or reside for a time; a place where one unusually, casually or intermittently visits or stays”.

▪ This is also the approach the CRA takes in Folio S5-F1-C1 para 1.33, which states

that sojourning “means to make a temporary stay in the sense of establishing a temporary residence, although the stay may be of a very short duration”

39 This is my terminology as opposed to the Act’s.

© Sprysak 2019

TAXATION


o Note: these definitions do not refer to (or generally care about) the purpose of the visit. As a general rule, it does not matter if the person is in Canada for work, for play, stopover on a flight, or jail, etc.

▪ The one exception to this statement that has been recognized by the courts is where

an individual comes into Canada for the day to work and then leaves Canada once she is finished for the day.

● In at least one case,40 the court held that this did not constitute “sojourning”

for Canadian income tax purposes.

● In Folio S5-F1-C1 para 1.33, the CRA describes this situation as

“commuting” rather than “sojourning”.

▪ Note: the CRA’s position is that if the individual does not return home after working

that day but instead stays overnight in Canada, this exception will not apply and the individual will be held to be “sojourning” under the Act.

▪ This exception allows a person living in, say, Seattle, USA to work in Vancouver,

Canada without having her worldwide income subject to tax in Canada on the basis of being a deemed Canadian resident.41

● Question: what constitutes a “day” for purposes of the sojourner rule?

o Answer: this is somewhat of an unresolved question; it is not defined/specified in the Act.

▪ Folio S5-F1-C1 para 1.33 states that as a general rule, the CRA considers any part of

a day to be a “day” for the purpose of determining the number of days that an individual has sojourned in Canada in a calendar year.

● That said, para 1.33 goes on to state that the nature of each stay must be

examined separately to determine whether the individual is sojourning or not (which it describes as a question of fact).

▪ This position is not unanimously accepted by the courts. In fact, different judges

have made different interpretations of “day” for purposes of the sojourner rule.

● Generally speaking, the courts have rejected the notion that day requires

continuous “24 hours”

40 The case is R&L Food Distributors Ltd v MNR, [1977] C.T.C. 2579 (T.R.B). “TRB” stands for “Tax Review Board”, which was a predecessor to the Tax Court of Canada.41 Of course, as briefly discussed at the beginning of this Unit, the non-resident would be subject to Canadian tax on her Canadian source employment income pursuant to subsection 2(3) and section 115 unless alleviated by the Canada-US Tax Treaty.

© Sprysak 2019

TAXATION


● Some agree with the CRA’s interpretation/position that any part of a day

counts as one day

● Others have stated that you do not count the day you enter Canada but you do

count the day you leave Canada (where you are in Canada over 2 days)

▪ Tax Tip: Be careful of your non-resident clients inadvertently triggering the

sojourner rule – assume all portions of each day in the country count and keep track when you might be coming close to the 183 day threshold!

● Note: the sojourner rule is applied on a calendar year basis, with each calendar year treated

separately/distinctly

● As confirmed by paras 1.30 and 1.32 of Folio S5-F1-C1, the sojourner rule does not apply to factual

residents under the common law test (which, by implication, sets out the ordering in application of the 2 tests – common law test first, sojourner rule second)

o Example: Afshaan is a common law resident of Canada for the first 5 months of 2018 (assume 150 days). She then severs all of her Canadian residential ties and establishes new residential ties in Palm Springs, USA, where she continues to reside to today. However, during the remaining 7 months of 2018, she spends 60 days in Canada visiting her Canadian friends.

▪ Question: how is Afshaan’s 2018 taxation year treated for Canadian tax purposes?

▪ Answer: She is not a sojourner because she was only sojourning for 60 days, for the

first 150 days she still had sufficient ties to Canada to be a resident under the common law test.

▪ Her worldwide income is reported for the first 150 days. For the remaining 215 days,

you only report the income that would otherwise be subject to Canadian taxes for a non-resident.

● Where an individual is resident in Canada for part of a taxation year and a non-

resident for the other part, section 114 applies to tax the individual’s worldwide income for that period of time that the individual is a Canadian resident and tax the individual’s Canadian source income for the remaining period that she was a non-resident. 42

42 Section 114 is required to mitigate the potential harshness of subsection 2(1), which provides that if a person is resident in Canada “at any time in the year”, that person’s worldwide income for the entire year is taxable in Canada.

© Sprysak 2019

TAXATION


● Note: while you are deemed to be a Canadian resident for the entire year, the sojourner rule does

not deem the individual to be a resident of a particular province.43

o To “fill the gap”, subsection 120(1) imposes a federal surtax (in lieu of the provincial/territorial income tax that a Canadian resident would pay).

A Brief Overview of Corporations

● As you are most likely aware, under corporate law,44 a corporation is a legal entity that is distinct

from its owners (i.e. shareholders), its employees, and anyone with whom it deals.45 o Further, the governing legislation will set out how the corporation is brought into legal

existence (through incorporation), its capacities and powers (i.e. to enter into contracts, carry on a business, own property, etc.), how it can raise funds using equity and/or debt, the rights and responsibilities of its directors, officers, shareholders, etc.

● As we learned earlier in this Unit, consistent with corporate law, a corporation is a person for tax

purposes, meaning that pursuant to subsection 2(1), if resident in Canada, it is required to calculate its worldwide taxable income for its taxation year and pay Canadian corporate income taxes.46

o Once such taxes have been paid, the corporation is free to distribute its after-tax corporate income to its shareholders as dividends.

o Whether and how such dividends are taxed to the shareholder(s) will depend on (a) who the shareholder receiving the dividend is (i.e. corporation, individual, trust, non-taxable entity) and (b) how the income was taxed in the corporation.

● While there are usually two levels of taxation with respect to corporate income that is distributed to

an individual shareholder (i.e. the corporation and individual shareholder levels),47 Canada’s tax system has been designed to try to ensure that the total taxes levied on such income is equal to the amount of tax that the individual shareholder would pay if she earned the income personally.

o This is referred to as the principle of integration as is often accomplished using the “dividend gross up and tax credit mechanism”.

o Theoretically, the total amount of tax paid on income should be the same, regardless of whether a sole proprietor is earning directly and is taxed on that income or if someone is making money through a corporation and is then being paid dividends from the corporation.

43 As noted in Folio S5-F1-C1 para 1.30, the deemed Canadian resident will not be entitled to any provincial tax credits or benefits.44 For instance, the Business Corporations Act, RSA 2000, c B-9 and Canada Business Corporations Act, RSC 1985, c C-44.45 This is an important point – particularly for individuals who own all of the shares of a private corporation. In my experience, it is not uncommon for such individuals to think that because s/he owns all of the shares of the corporation, the assets belong to him/her as opposed a separate and distinct legal entity. This line of thinking (and behaviour consistent with this line of thinking) often results in “tax trouble”.46 For those students interested in carrying on a corporate/commercial practice after graduation, I strongly suggest you consider taking the Corporate Tax course offered by the Faculty.47 This is sometimes referred to as “double taxation”

© Sprysak 2019

TAXATION


o This follows the principle of neutrality.

● Example: Assume there is a Canadian resident who is carrying on a business that generates $1000

of pre-tax income per year. The applicable tax rates for (1) individuals = 40% and (2) corporations = 25%

o Scenario 1: Individual carries on business personally.

▪ Business income = $1000; personal tax (40%) = <$400>; after tax personal income =

$600o Scenario 2: Individual carries on business through corporation.

▪ Corp business income = $1000; corporate tax (25%) = <$250>; after tax corp income

= $750

▪ Individual dividend income = $750; notional gross up by $250 via dividend tax credit

= $1000; personal tax (40%) = <$400> + DTC = $250; net personal tax = <$150>. Dividend income = $750 <150> = $600.

▪ < x > = -x

o The tax benefit of a corporation is that if you don’t pay out the full after corporate tax income as a dividend, you have more money (less taxed) to reinvest into the business compared to an individual who will be taxed more.

Residence of a Corporation

● Just as is the case for determining the residency of an individual, there is a common law test and

statutory deeming rules for determining the residence of a corporation for Canadian income tax purposes.

o Consequently, just like for determining whether an individual is a Canadian resident, one must consider both before being able to come to a correct conclusion.

o Note: unlike the case for determining the residency of an individual (for which you start with the common law test before proceeding to the sojourner rule), there is no implicit ordering in determining the residence of a corporation

● Beginning with the statutory deeming rules (which are generally the easier of the two to apply), the

most common rule is contained in paragraph 250(4)(a), which provides that if a corporation is incorporated in Canada after April 26, 1965, then from that point forward (unless continued into another country or another rule applies), it will be a Canadian resident corporation.

o This covers the vast majority of Canadian-incorporated corporations in existence and any incorporated today (and in the future).

© Sprysak 2019

TAXATION


▪ 250(4)(c) If the corporation was incorporated before this date, it will have to have

carried on business in Canada to be deemed a Canadian residento If a corporation is incorporated in Canada (say September 1) and then is continued into (say)

the U.S. on September 30, then for tax purposes (pursuant to subsection 250(5.1)), it is treated from the point of continuation to have been incorporated in the U.S. (and not ever have been incorporated in Canada)

▪ Conversely, if a corporation is incorporated in the U.S. and then continued into

Canada, subsection 250(5.1) will deem that corporation to have been incorporated in Canada as of the date of continuance (so be careful if doing this corporate law procedure)

▪ There will likely be some tax consequences of doing this, however, since once you

cease to be a resident you are deemed to have disposed of and reacquired all of your capital property.

● The common law test for corporate residency is based upon a quote from Lord Loreburn’s

decision in De Beers Consolidated Mines Ltd. v. Howe, [1906] A.C. 455 at 458, where he said:

▪ In applying the conception of residence to a company, we ought, I think, to proceed as nearly as

we can upon the analogy of an individual. A corporation cannot eat or sleep, but it can keep house and do business. We ought, therefore, to see where it really keeps house and does business… A company resides for purposes of income tax where its real business is carried on… I regard that as the true rule, and the real business is carried on where the central management and control actually abides. [Emphasis added.]

o Not surprising, this test has become known as the “central management and control” test and, like the Thomson test for individuals, is primarily a question of fact (but practically speaking, not as difficult to apply and uncertain in result as the factual test for determining whether an individual is resident in Canada)

o To determine where a corporation’s “central management and control” is exercised, courts will typically look to where the corporation’s Board of Directors meet and make decisions.

▪ Generally speaking (unless the Board is the shareholders’ “puppet”), the residence

status of the corporation’s shareholders is irrelevant in determining the corporation’s residence for Canadian income tax purposes.

▪ However, where one or more shareholders are effectively controlling the corporation

(i.e. the Board is the shareholders’ “puppet”), then central management and control will be found to be exercised where the shareholder(s) reside(s).

▪ This was the factual situation in the Landbouwbedriff Backx B.V. case.

© Sprysak 2019

TAXATION


● The Backxes (Michiel and Marian) were the initial directors (and shareholders

of their corporation) until they decided to immigrate to Canada. At this time, they resigned as directors and appointed (as shareholder) Marian’s sister Anna Van Gorp to be the sole director.

o Justice Smith agreed with the Minister that Anna was not acting as a true director (but only an “administrator48) – but only implementing the instructions of the Backxes – that the Backxes were the de facto directors – and hence where they lived and made decisions regarding the corporation 9constituted the place where central management and control was being exercised

o As these decisions were made in Canada, the corporation was resident in Canada and hence liable to Canadian income taxes on its worldwide income

o In so doing, he confirmed (at para 42) that “cogent evidence is required to displace the well-established notion that de jure directors hold primary responsibility for the management and control of a company. Such evidence must clearly establish that the “outsider” has ‘effective’ or ‘independent’ management and control.”49

● Practice Points:

o In deciding in which jurisdiction to incorporate and who will be the directors, consideration should be given to the implications to the corporation’s residency status for income tax purposes.

▪More specifically, if you want a corporation resident only in Canada, then should

incorporate it in a Canadian jurisdiction and make sure the Directors are Canadian residents who meet and make fundamental corporate decisions in Canada!

o While generally not relevant for residency purposes, consideration should also be given to the residency status of the shareholders – particularly if dealing with a “private” corporation (i.e. a corporation not traded on a public stock exchange)

▪ “Canadian controlled private corporations” as defined in subsection 125(7) are

subject to several benefits under the Act (including potential access to the “small business deduction”, which we will briefly discuss later in the course)

▪ To preserve this benefit (and others), you want to ensure that no controlling

shareholder (or group of shareholders) are non-residents of Canada.

48 Justice Smith went on to note that Anna had no relevant business or directorial experience that she could have used to act as a “true director”. He then concluded (at para 46) that Anna was “a mere nominee who carried out clerical and administrative functions on behalf of the Backxes”.49 Case reference omitted.

© Sprysak 2019

TAXATION


A Brief Overview of Trusts

● Very generally, a “trust” is (a) a relationship, (b) with respect to property, (c) whereby there is a

separation of legal and equitable interests, such that the legal owner of the property (the trustee) holds such legal ownership for the benefit of the equitable owner (the beneficiary) in such a manner that the law finds the trustee to have a fiduciary duty to the beneficiary.

o To be clear, under the general law, a trust is not recognized as a separate legal entity like a corporation is; the law recognizes the trustee as the legal owner and the beneficiary(s) as the equitable owner(s).

o HOWEVER, under tax law, a trust is deemed to be a person (i.e., must file a tax return)

● In order for a trust to come into existence, three certainties must be present, namely:

o Certainty of intention: to create a trust (as opposed to, say, make an outright gift, bailment, lease, licence, etc.);

o Certainty of subject matter: which is comprised of two main features, namely, (1) certainty of the property that is subject to the trust and (2) certainty of the respective shares/interests each beneficiary has in such trust property; and

o Certainty of object: which usually refers to the beneficiaries that the trust is created for, but could also refer to the purpose/use of the trust (and trust property)

● Note: it is not uncommon for a court to find that a trust hasn’t been created because it hasn’t

satisfied all of the requirements to be a trust.

● If a settlor creates a trust when s/he is alive, then it is an inter vivos trust; alternatively, if the trust is

created as a consequence of the settlor’s death, then it is generally called a testamentary trust.o For our purposes, an “estate” can be defined as “the real and personal property that a person

possesses at the time of death and that passes to the heirs or testamentary beneficiaries”.50

● While the law generally does not recognize a trust as a distinct legal entity, as we have learned

earlier in this Unit, Canadian tax law does recognize a trust (and an estate) as a “person” separate and distinct from the settlor, trustee and beneficiary(s) pursuant to subsection 248(1).

o As such, just like a corporation, a trust, if resident in Canada, must calculate and report its taxable income and taxes on a trust tax return (T3 Tax Return).

● In this regard, it is important to note that generally speaking:

o Subsection 104(1) provides that trusts and estates are generally treated the same for tax purposes, and

50 Black’s Law Dictionary, 9th ed, sub verbo “decedent’s estate”

© Sprysak 2019

TAXATION


o Subsection 104(2) generally provides that a trust/estate is treated as if it was an individual taxpayer – unless there is a specific provision in the Act which provides special tax treatment for trusts (of which there are many)

● Some of the exceptions to these general rules include:

o Subsection 122(1), which generally provides that all of trust’s income (other than income from a “graduated rate estate” – discussed below) is taxable at the highest marginal rate for individuals (as opposed to all of the marginal rates/brackets applicable to individuals)

▪ Effective January 1, 2016, subsection 248(1) was amended to create a “graduated

rate estate” (GRE).

▪ For our purposes, a GRE is: (a) the deceased estate for up to 36 months after the

deceased’s death,51 (b) that has been designated as the deceased individual’s GRE for income tax purposes.

▪ Unlike inter vivos and testamentary trusts, a GRE is entitled to all of the marginal tax

brackets and rates as if the trust was an individual taxpayer – but only while a GRE.52 o Subsection 122(1.1), which provides that trusts cannot claim personal tax credits (which

individual taxpayers may be eligible to claim)

● In some respects, the relationship between a trust and its beneficiaries is analogous to the

relationship between a corporation and its shareholders for tax purposes. More specifically:o Corporations and trusts are persons for income tax purposes distinct from their respective

shareholders and beneficiaries;o To the extent that corporations and trusts earn income, they may be required to complete a

tax return (T2 for corporations, T3 for trusts) and pay taxes;o Similarly, to the extent that shareholders and beneficiaries receive distributions from their

corporation or trust, the shareholders and beneficiaries may have to report such distributions on their tax returns and pay taxes;

o Canada has structured its income tax regime to generally avoid such distributions being “double-taxed” – although the way the Act accomplishes this in the context of trusts and beneficiaries is different than for corporations and their shareholders.

o That said, there are also significant differences in the tax treatment of (and the common tax strategies associated with) corporations and trusts

Example:

● Assumptions:

51 After the 36 month period expires, if the estate is still in existence (i.e. all of the property has not been distributed to the beneficiaries), the estate loses its special status as a GRE and is taxed as a testamentary trust – meaning all of its income is taxed at the highest marginal rate.52 In effect, this is an special exception to the general exception to subsection 104(2) contained in subsection 122(1)

© Sprysak 2019

TAXATION


o Inter vivos trust subject to tax at the highest marginal rate (50%)o Trust earns $1000 of investment income annuallyo Trust has one Canadian resident beneficiary who is taxable at 25% for her first $45,000

of taxable income

● Scenario 1A: Trust earns income and retains it (2018)

o Trust makes $1000; tax rate 50% = <$500>; after-tax trust income (AKA “trust capital”) = $500

o Beneficiary does not report income because the trust retains it; therefore the beneficiary pays no taxes

● Scenario 1B: Trust pays beneficiary $500 and designates it as a trust capital distribution the year

after the income is earned (2019)o This is assumed to come out of the trust income unless it is designated as coming out of

the trust capital (which it is here)o In this case, the beneficiary does not have to report taxes on this incomeo General Rule: If a trust earns income and pays tax on that income at the trust level, then

the beneficiary can receive the trust capital and does not have to pay double tax on that income

● Scenario 2: Trust earns and distributes income in the same year (2018)

o Trust: Investment income = $1000; income distribution within the year = <$1000>; net income = 0; tax (50%) = 0.

o Beneficiary: Trust distribution = $1000; tax (25%) = <$250>; after-tax personal income = $750

o Once again there is only one instance of tax despite there being two entities.o *This is the better scenario – the trust is basically being disregarded and only the

beneficiary is taxed (flow-through treatment of trust income)o Note: there are ways to get this scenario without necessarily paying out all of the income

to the beneficiary (e.g., if the beneficiary is a minor)

● So if scenario 2 is better, why would anyone ever use scenario 1?

o If a beneficiary resides in a province where they are taxed the highest marginal rate, then if the trust is set up in a province where the trust’s highest marginal rate is lower than the beneficiary’s province, then scenario 1 will be preferred.

Determining the Residence of a Trust

© Sprysak 2019

TAXATION


● While we have noted that for both individuals and corporations, there are both common law tests and

statutory deeming rules, in the case of trusts, there are no general statutory deeming rules,53 only a common law test, which was more recently updated by the Supreme Court of Canada in Garron Family Trust (Trustee of) v. R.54

● There used to be a case that was poorly interpreted by practitioners as standing for the proposition

that the trust is resident where the trustee is resident – if you read the headnote, this is what you’d get out of it.

o Gibson J never said it was just the residence of the trustee, but this is how it was interpretedo For a long time in Canada, this was the prevailing knowledgeo The CRA challenged this presumption and they went all the way up through the courts to fix

this misconception

● In the Supreme Court of Canada’s decision (which largely upheld the decisions of the Tax Court and

Federal Court of Appeal55), the Court, after acknowledging the similarities between a corporation and a trust,56 adopted the common law test for determining the residency of a corporation – namely, the “central management and control” test.

o At para 15, the Court stated, “[a]s with corporations, residence of a trust should be determined by the principle that a trust resides for the purposes of the Act where ‘its real business is carried on’, which is where the central management and control of the trust takes place” [emphasis added]

▪While this will normally be where the named trustee(s) resides and exercises power

over the trust assets,57 it does not have to be.

▪More specifically, if someone other than the named trustee(s) is exercising central

management and control over the trust (and perhaps the named trustee is only providing “administrative services”), then the residence and place that the other

53 The closest the Act has is some provisions (i.e. subsection 94(3)) which deem an otherwise factually non-resident trust to be a Canadian resident for certain purposes. These deeming rules are beyond the scope of this course.54 [2012] 1 S.C.R. 520. Very briefly, this case involved a trust with a trustee (corporation) resident in Barbados and Canadian resident beneficiaries. When the trust sold its shares in Ontario corporations for a very sizable capital gain, the trust sought a treaty exemption from Canadian tax on the basis that the trust was resident in Barbados. The Minister of National Revenue took the contrary position that the trust was resident in Canada and hence Canadian taxes applied to the gain.55 The Supreme Court explicitly noted that it was not addressing some of the other arguments made by the Minister involving other provisions of the Act and that its decision should not be interpreted as endorsing the Federal Court of Appeal’s reasons on those alternative arguments/provisions.56 At para 14, the Court notes that: (1) both hold assets that are required to be managed; (2) both involve the acquisition and disposition of assets; (3) both may require the management of a business; (4) both require banking and financial arrangements; (5) both may require the instruction or advice of lawyers, accountants and other advisors; and (6) both may distribute income.57 In para 15, the Court states, “[t]he residence of the trustee will also be the residence of the trust where the trustee carries out the central management and control of the trust, and these duties are performed where the trustee is resident”.

© Sprysak 2019

TAXATION


person is exercising central management and control over the trust will determine the residence of the trust58

● The Supreme Court’s decision in Garron Family Trust is reflected in Folio S6-F1-C1: Residence of

a Trust or Estate (25 November 2015)

● Practice Points:

o Just like for corporations, the current law for determining the residency of a trust for tax purposes focuses on the where the “central management and control” of the trust is exercised – which requires a full factual analysis

▪ Reliance on the trust indenture and the residence of the named trustee(s) is no longer

sufficient.o In my opinion, the key issue under this new test, which was not discussed by the Supreme

Court, is what functions (and the level of such functions) will constitute “central management and control”, particularly where the argument is (by the CRA) that these functions are being exercised by someone other than the trustee?

o Question: so what (objective) evidence might indicate that the named trustee is in fact exercising “central management and control” over the trust property – as opposed to say, the beneficiaries?

▪ Answer:

● A record of advice relied on and how they came to their final decisions

● Trustees should get independent advice from someone other than the

beneficiaries, a record of this would be evidence that the trustee is in charge

58 In Garron, the Tax Court found as a fact that the Canadian resident beneficiaries, as opposed to the Barbados trustee, were exercising central management and control over the trust – and this finding was upheld by both the Federal Court of Appeal and the Supreme Court of Canada.

© Sprysak 2019

TAXATION

Unit #4 – The Administration of Income Tax Law

Step #1 –Taxpayer

● General Rule: Typically, the starting point in any discussion regarding the administration of federal

income tax law is subsection 150(1), which provides that a taxpayer generally must prepare and file an income tax return for each taxation year.

o For individuals,59 the general rule is contained in paragraph 150(1)(d), which requires individuals to file their return for the preceding “taxation year” (i.e. calendar year) by April 3060

o In the case of deceased individuals, the general rule stated in paragraph 150(1)(d) applies unless the individual passed away after October, in which case the deceased’s legal representative gets at least 6 months after the deceased’s death in which to file his/her final tax return (paragraph 150(1)(b)).

● Note: where April 30 (or any other applicable deadline) falls on a weekend or statutory holiday, then the

deadline is extended until 11:59 p.m. of the next business day.

● Exception to the General Rule: The general requirement to file a yearly tax return in subsection

150(1) is then modified by subsections 150(1.1) and (2) as follows:o Subsection 150(1.1) generally provides that an individual does not have to file a tax return if

s/he (a) does not have a tax liability, (b) has not disposed of capital property, and (c) does not have a positive balance in a Home Buyers Plan or Lifelong Learning Plan, but

o Subsection 150(2) provides that an individual must file a tax return if furnished with a demand to do so by the Minister (even if the individual fits within the exceptions contained in subsection 150(1.1) – “exception to the exception”)

● Practice Point: while an individual might not technically be required to file a tax return by virtue of an

“exception” contained in subsection 150(1.1), there are advantages to filing a yearly tax return, including:

o Receiving the GST (refundable) credit and certain government child support benefits, o Being able to transfer tuition tax credits to a spouse, common-law partner or parent, o Acquiring the ability to contribute to a Registered Retirement Savings Plan (RRSP), ando Perhaps most importantly, starting the statutory limitation period running (which we will discuss

in more detail below)

Step #2 – The CRA

59 From this point forward, we will focus primarily on individual taxpayers in this course. Those who are interested in the tax treatment of corporations should consider taking Corporate Taxation. 60 Individual taxpayers have until June 15 where the individual (or his/her cohabiting spouse or common law partner) is carrying on a business per subparagraph 150(1)(d)(ii), although interest on any outstanding balance starts accruing after April 30. © Sprysak 2019

TAXATION


● Once the CRA receives an individual’s income tax return,61 then subsection 152(1) requires it to review

it and assess the taxpayer’s tax, interest, penalties, tax refund, losses, etc. (as applicable) for the year “with all due dispatch”.

o This is reflected in a Notice of Assessment (subsection 152(2)), which is sent to the taxpayer.

● Important Points:

o The CRA does not have to wait for the taxpayer’s return to issue a Notice of Assessment nor is it bound by the information contained in the taxpayer’s return.

▪ Indeed, the CRA can issue a Notice of Assessment even if the taxpayer has not submitted

a return pursuant to subsection 152(7) – explain when this is typically doneo The issuance of this assessment is important for a variety of reasons, including that it generally

starts the statutory limitation period during which the CRA can go back, audit, and reassess a taxpayer.

▪ For individuals, subsection 152(4), in conjunction with subsection 152(3.1) generally

provides that this statutory limitation period is 3 years after the date the initial assessment is sent.62

▪ Consequently, if no return is submitted and no assessment is issued, the statutory

limitation period does not start – which taxpayers who don’t file a tax return don’t appreciate – they are continuously at risk!

▪ As further set out in subsection 152(4), there are several cases where the CRA will have

a longer period in which to reassess a taxpayer.

▪ The situation that I want to bring to your attention is set out in subparagraph 152(4)(a)

(i) – where a taxpayer has “made any misrepresentation that is attributable to neglect, carelessness or wilful default, or has committed any fraud in filing the return or in supplying any information under the Act”, then the CRA has an unlimited time period in which to audit/reassess (as confirmed by subsection 152(4.01)!

● Note: the Crown has the burden of proving the taxpayer’s neglect, carelessness,

wilful default, and/or fraud

● This initial assessment is commonly referred to as the “original assessment” (or “desk assessment”)

because it is the first assessment typically done at the CRA’s offices without any information being provided by the taxpayer other than his/her completed return.

61 The CRA receives approximately 56 million income tax and GST returns each year from individuals, corporations, and trusts.62 Subsections 244(14) and (15) collectively (and rebuttably) presume that the date the assessment is made is the date on the assessment.© Sprysak 2019

TAXATION


o Note: this does not mean that the CRA doesn’t already have other information in its possession (i.e. tax information slips)

o There may be a variety of other steps that the CRA takes as part of its desk assessment (that it doesn’t disclose to the general public)

o For most taxpayers, unless there are obvious/mechanical errors on the face of the tax return or the taxpayer has failed to include the information on one (or more) tax information slip, they will receive this Notice of Assessment, typically within a month of filing it, and it will match what the taxpayer filed in his/her return.

● Important Point: pursuant to subsection 152(8), an assessment (or reassessment) is “deemed to be

valid and binding notwithstanding any error, defect, or omission” in ito As we will discuss shortly, this puts the initial legal burden on the taxpayer to disprove an

assessment/reassessment – and applies to any assessment/reassessment issued by the Minister

Step #3 – The CRA

● As noted above, while the CRA is tasked with issuing a Notice of Assessment in response to receiving

the taxpayer’s tax return, this does not end the administration of that tax return. o For the next 3 years (and possibly longer in certain situations), the CRA has the ability to audit

pursuant to section 231.1 and, if necessary, reassess the taxpayer’s tax return.

● Question: what could cause the CRA to audit a taxpayer (and his/her return(s))?

o Answer: a variety of reasons, including:

▪ The taxpayer may have had an error(s) in his/her returns in prior years that does not seem

to be a “inadvertent mistake”;

▪ The taxpayer may be involved in an activity (i.e. cash businesses, construction, etc.)

where there is typically more attempts to commit tax evasion;

▪ Random selection – keeps everyone honest.

● There are several forms that an “audit” can take, including:

o A request for specific information (i.e. receipts for union/professional dues, moving expenses, etc.),

o A request for all supporting documentation for a particular tax return, o A request for supporting documentation for three years of tax returns, ando A site visit by a CRA auditor.

● Important Point: if the CRA decides to audit a taxpayer to see if his/her return complies with the Act,

paragraph 231.1(1)(d) (along with other sections – i.e. subsection 231.5(2)) imposes a positive duty on the taxpayer to assist the CRA in its audit.

© Sprysak 2019

TAXATION


o However, if the CRA is investigating whether the taxpayer may have committed tax evasion pursuant to section 239 (or 238), which is a criminal offence, this duty to assist disappears and all of the Charter protections (i.e. freedom from unreasonable searches and seizures, presumption of innocence, etc.) kick in

● At the end of the audit procedures, the CRA will decide whether a Reassessment is necessary

o Typically, prior to issuing a Reassessment, the CRA will issue a “proposal” (referred to in the Sherman text as a “30 day”) letter outlining the details of its proposed assessment and giving the taxpayer (or perhaps his/her tax advisor) 30 days to respond

Step #4 - Taxpayer

● Assuming that the taxpayer has been audited and that the CRA has issued a Notice of Reassessment

that increases the taxpayer’s tax liability from what s/he reported on his/her return,63 the taxpayer has two possible courses of action:

o S/he can agree with the Notice of Reassessment and pay the additional taxes and interest (and depending on the circumstances, penalties), or

o S/he can dispute the Reassessment

● To dispute a Notice of Reassessment, the taxpayer must file a timely Notice of Objection pursuant to

subsection 165(1), which must set out the relevant facts and the reasons for disputing the Notice of Reassessment

o General Rule: The Notice of Objection must be submitted within 90 days after the date the CRA mailed the Notice of Assessment (as opposed to the date the taxpayer received it, opened it, etc.)64

● Generally speaking, there is no official form/document that has to be completed to object to a Notice of

Assessment - but CRA has created Form T400A Objection - Income Tax Act which you can use.o Essentially, your objection should include the facts surrounding the controversial item and the

reasons why you are objecting (i.e. contrary to the case law, facts don’t support the results, etc.)o Note: the reasons for disputing the Reassessment must be based in the law or on the facts (or the

application of the law to the facts) – this is not a “fairness” or “economic hardship” type appeal (discuss these briefly)

● While (of course) a taxpayer can (and often does) prepare and file the Notice of Objection, there are

benefits to having it done by a tax lawyer, including:o Potential better utilization of the administrative appeal process (as discussed below), ando Privilege on any communications between the lawyer and taxpayer

63 Of course, an audit could result in a Reassessment that reduces a taxpayer’s taxable income and/or taxes payable.64 The date of mailing is assumed to be the date on the Notice of Assessment/Reassessment.© Sprysak 2019

TAXATION


Step #5 – CRA

● Once the taxpayer’s Notice of Objection is received by the CRA, it and the auditor’s files on the

taxpayer then go to an Appeals officer within the Appeals Division of the CRA65

● The Appeals Division is still part of CRA, but separate from the Audit Division (internal administrative

appeal).

● As part of the administrative appeal process, you are able to get CRA documents supporting the

Assessment/Reassessment (i.e. reports prepared by the CRA auditor (unless privileged), CRA auditor working papers, copies of court decisions and the relevant sections of legislation relied on by the CRA auditor, appraisal/valuation reports relied on, and information obtained from 3rd parties to support the Assessment, etc.)

o The appeals officer is supposed to give all the non-privileged information in the file to the taxpayer

▪ Practice point: this doesn’t always happen, so you often have to ask for it. The story told

by the taxpayer vs the story told by the auditor’s working papers are not always the same.

● Once the taxpayer (and his/her tax advisors) obtain this information (or even without it in cases where

the taxpayer/advisor is fully aware of the basis for the Assessment/Reassessment), the taxpayer/advisor will try to provide further information/evidence and/or make legal arguments to try to:

o Resolve matters completely (and hence alleviate the need and cost to take the matter to court)o Reduce the number of issues under dispute and clarify exactly what is being disputed (i.e. is it an

evidentiary issue or a question of law)

● After reviewing the matter and considering any further submissions from the taxpayer and his/her

representatives, the Appeals Officer will either confirm the Reassessment (Notice of Confirmation) or issue a new Notice of Reassessment

● Note: In his 2016 Fall Reports, the Auditor General expressed some serious concerns with the CRA’s

administrative appeal process. One of his office’s key findings was that, generally speaking, the CRA was taking too long to process income tax objections, which resulted in an increasing backlog and an ever-increasing demand for more personnel.

Step #6 - Taxpayer

● If the taxpayer is still not happy with the current status of his/her tax return, then the next step is to file a

Notice of Appeal to the Tax Court of Canada in a timely fashion pursuant to subsection 169(1).o Note: as set out in subsection 169(1), before a taxpayer can appeal to the Tax Court, s/he must

first file a Notice of Objection (i.e. can’t go directly to Tax Court from assessment)65 In the Auditor General’s 2016 Fall Report on Objections, his office noted that it could take over 3 months for a “low complexity” appeal just to be assigned to an Appeals Officer.© Sprysak 2019

TAXATION


▪ That said, if the taxpayer is not happy with how the Administrative Appeal is

progressing, the taxpayer is able to file a Notice of Appeal after the Administrative Appeal has been ongoing for 90 days

o General Rule: taxpayer has 90 days after the CRA mails a Notice of Reassessment or Notice of Confirmation to file his/her Notice of Appeal

● Timing of all these documents is critical. Failure to comply with a deadline could eliminate your

client’s appeal rights and result in a professional negligence claim against you and your legal insurer.

Miscellaneous Points about the Tax Dispute Resolution Process

● Roughly 90% of all Notices of Objection filed are settled/discontinued at the administrative appeal level.

o Of the remaining 10%, only approximately one third are actually heard by a court (typically the Tax Court).

● Of the roughly 400 tax cases the TCC hears each year, more than half are decided in favour of the

taxpayer. Less than 10% of TCC decisions are appealed to the FCA; less than 10% of FCA decisions are granted leave to appeal to the SCC.

● Like virtually all areas of the law, there is an access to justice issue in taxation cases (even despite the

informal procedure rules). o Pytel v. R., [2010] 2 C.T.C. 2429 (TCC – IP) is an example of an informal procedure case

conducted by the taxpayer (in which the taxpayer experienced much frustration and difficulty with the process – which culminated with him storming out of the courtroom at one point).

o While that is typically fatal to an appeal, in finding for the taxpayer, Chief Justice Rip (as he then was) acknowledged the difficulties a layperson has trying to run his own tax appeal – even using the informal procedure rules – and made a plea for legal aid, pro bono, and student run tax litigation services (paras 42-45).

● Generally speaking, the costs incurred in disputing a Reassessment are deductible under paragraph

60(o).

Disputes and Interest

● Filing a Notice of Objection has two important functions:

o 1st – it preserves/activates a taxpayer’s appeal rights – no Notice of Objection (and administrative appeal), no ability to file a Notice of Appeal to the Tax Court;66 and

o 2nd – it (generally) puts the CRA’s collection activities on hold

66 As noted above, subsection 152(8) deems an Assessment/Reassessment to be valid and binding.© Sprysak 2019

TAXATION


● However, filing a Notice of Objection (and Notice of Appeal) does not stop the “interest clock” on any

outstanding tax liability (that is considered to be outstanding from the date the tax return was required to be filed and taxes paid)

● Pursuant to section 161, interest is compounded daily at a prescribed rate that changes quarterly (6%

for the last 3 quarters of 2018 and the first quarter of 2019)

● Consequently, to protect a taxpayer from having to pay additional interest (beyond what has already

been assessed) if unsuccessful in his/her administrative/judicial appeal, the taxpayer should consider paying the outstanding liability and including a letter, which states that the payment is solely for purposes of stopping interest from accruing and not as an admission or acceptance of the additional liability. This way:

o If the taxpayer wins the appeal, the payment will be returned (along with interest67);o If the taxpayer loses the appeal, no additional interest charges will apply.

The Burden of Proof in Tax Appeals

● As we know, generally speaking:

o In civil trials, the person initiating the Statement of Claim has the initial legal burden of proof (on a balance of probabilities); and

o In a criminal trial, the Crown has the burden of proof (beyond a reasonable doubt)

● At this high level, tax cases are the same:

o Where only the taxpayer’s compliance with Act is in issue, the relevant burden of proof is the civil burden (balance of probabilities), and

o Where the Minister is alleging that taxpayer has committed a criminal offence (i.e. tax evasion), then the relevant burden of proof is the criminal burden (beyond a reasonable doubt).68

● However, somewhat unlike civil cases, the taxpayer bears the initial burden of disproving the Minister’s

assessment/reassessment.69 More specifically, as was described in Northland Properties Corporation v British Columbia 2010 BCCA 177, based largely upon the Supreme Court of Canada’s decision in Hickman Motors Ltd. v R, [1997] 2 S.C.R. 336:

o Because the Minister’s assessment/reassessment is presumed to be “valid and binding” by virtue of subsection 152(8), the taxpayer has the initial legal burden of proof to “demolish the Minister’s assumptions in the assessment”.70

67 Like the financial institutions, the rate of interest that the CRA pays on overpayments (3%) is substantially less than the interest it charges on outstanding debts (6%).68 Further, for criminal tax evasion cases, the Minister bears this initial legal burden of proving the actus reus and mens rea components of the offence beyond a reasonable doubt.69 This was first confirmed by the Supreme Court of Canada in Johnston v Minister of National Revenue, [1948] C.T.C. 195 at paras 7 and 19 (among others).70 Hickman Motors Ltd. at para 91.© Sprysak 2019

TAXATION


▪ Put more simply, if the taxpayer does not successfully challenge the Assessment, the

Assessment is considered correct and valid at law and the taxpayer is responsible for the tax liability as set out in the Assessment

o The taxpayer can accomplish this in one of three ways, namely:

▪ 1st – by challenging that the Minister in fact relied upon the stated assumptions in coming

to the assessment

● If the Reassessment is not based on the stated assumptions (i.e. the Minister

pulled the Reassessment out of the air), then the Reassessment is invalid

● The tax principle here, like the general legal principle, is that the taxpayer has the

right to know the case before her

● As you might imagine, this basis of appeal is rarely applicable and just as rarely

successful

▪ 2nd – by “demolishing” one or more of the Minister’s assumptions on which the

assessment is based – which can be done by bringing credible evidence that is contrary to the assumption,71 or

● This is accomplished by the taxpayer making (at least) a prima facie case by

providing sufficient evidence.72

● Note: in House v R, 2011 FCA 234, Justice Nadon (for the Court) noted

(beginning at para 55), based upon Hickman Motors, that (a) unless the Act requires supporting documentation, or (b) the taxpayer’s credibility is in question, “credible oral evidence from a taxpayer is sufficient [to demolish the Minister’s assumptions] notwithstanding the absence of records”.

▪ 3rd – by contending that, even if the assumptions were justified, they do not of themselves

support the assessment (i.e. improper application of the law to the facts).o If the taxpayer is successful in this regard (on any or a combination of these 3 bases), then the

taxpayer will win the tax appeal (and have the tax liability as set out in his tax return restored) unless the Minister is able to show (again on a balance of probabilities) that the Assessment is otherwise valid (by providing evidence/legal argument supporting this conclusion)

▪ Put another way, once the taxpayer satisfies its initial legal burden, the burden shifts to

Minister.

71 See e.g. Hickman Motors Ltd. at paras 92-93.72 In Hickman Motors, Justice L’Heureux-Dube (for the majority) at para 93 noted that “unchallenged and uncontradicted evidence ‘demolishes” the Minister’s assumptions”.© Sprysak 2019

TAXATION


▪ If the Minister overcomes this tactical burden, then the taxpayer (again) has a “tactical

burden” to successfully challenge the new evidence in support of the Minister’s Assessment

● Question: why does the taxpayer bear the initial legal burden?

o Answer: as a matter of practical efficiency, the taxpayer is the best person to know and provide the necessary information and evidence to calculate his/her tax liability – see e.g. Johnston v The Minister of National Revenue, [1948] C.T.C. 195 (S.C.C.)

▪ Note: this approach is only taken in respect of assessing the taxpayer’s tax liability –

“civil compliance” with the Act. If the Minister is alleging tax fraud or other criminal offences, then like all criminal cases, the legal burden is on the Minister (at the criminal standard)

Settlements

● In ordinary civil litigation, parties will typically consider the costs and risks of litigation and may, to

minimize them, decide to settle their case before trial.

● Question: is this also the case in tax litigation?

o Answer: “yes” – but not to the same extent as in general litigationo Technically speaking, both the CRA and Justice are under a statutory obligation to assess tax in

accordance with the facts and the current law. This is commonly referred to as a “principled settlement” (or the “principled approach” to settling tax disputes)

● Unlike other litigation, it is not possible settle on a “risks of litigation” or other basis that doesn’t reflect

and apply the relevant current tax law to the facts

© Sprysak 2019

TAXATION

Unit #5 – The Mechanics of Income Taxation

Overview

● As we discussed in Unit #3, the starting point for the taxation of Canadian residents is subsection 2(1), which states that “an income tax shall be paid, as required by the Act, on the taxable income for each taxation year of every person resident in Canada at any time in the year”.

o In Unit #3, we addressed two of the key components of this important section, namely, (1) who is a person for Canadian income tax purposes, and (2) when is that person resident in Canada?

o In this Unit, we will discuss (1) what is “taxable income”, (2) how Canada taxes such income when earned by an individual,73 and (3) when does that taxable income have to be calculated and reported.

What Is Taxable Income?

● Subsection 2(2) defines “taxable income” as “the taxpayer’s income for the year plus the additions and

minus the deductions permitted by Division C”.74

● Subsection 248(1) further provides that “taxable income” cannot be less than nil

Step #1 – Calculation of Net Income for Tax Purposes

● The starting point for calculating a Canadian resident individual’s tax liability is to calculate his/her Net

Income for Tax Purposes as specified in Division B of the Act.75

● As referred to in section 3, there are four main sources of income, namely, employment, business,

property, and capital gains/losses.o There are also other miscellaneous income inclusions and deductions that are distinct from the

other four sources – which collectively are often referred to as income from the “other” source – so five sources in total.

o Source based approach – i.e., if it doesn’t fit into any of the five sources, it’s generally not taxable.

● To calculate Net Income for Tax Purposes, a taxpayer:

o 1st – pursuant to paragraph 3(a), calculates his/her income from employment, business, property, and the other sources, as applicable, using the relevant rules for each applicable source – and then total the positive amounts.

▪ These calculations are done distinctly for each source/activity (section 4). Put another

way, a taxpayer cannot use a deductible business expense to reduce his/her employment income – at least not at this stage of the calculations.

73 Of course, we consider the “why” of taxation throughout the course (tax policy question). 74 As noted in Krishna’s text on page 100, technically and strictly speaking, the Act does not define what “income” is, but instead sets out what is included in or excluded from income for income tax purposes. 75 Technically, section 3 refers to “income” rather than “net income” – but the calculation of “income” under the Act is a net calculation. The CRA refers to “net income” rather than “income” in its publications.

TAXATION


▪ This is a “net” calculation – “taxable revenues” less “deductible expenses”.76

▪ Capital gains/losses are not included in this first step

▪ Only positive net amounts are aggregated at this step of the calculation; negative net

amounts are not included in the aggregation in this step, but may be included in a later step – or in another taxation year.

▪ In the case of the other source, only income inclusions are considered in this step

▪ After completion of this step, the taxpayer will either have a positive or nil income

balance.o 2nd – pursuant to paragraph 3(b), a taxpayer then calculates the amount by which his/her

taxable capital gains exceed allowable capital losses, as well as the taxpayer’s net listed personal property gains

▪While we will discuss capital gains/losses (and listed personal property) in a

subsequent Unit in more detail, as we have already discussed:

● A capital gain/loss arises from the (actual or deemed) disposition of capital

property, and

● Generally speaking, only 50% of capital gains are taxable and only 50% of

capital losses are deductible for income tax purposes – with the other 50% being outside the scope of the Act

● When the inclusion rate is applied to a capital gain/loss, it is referred to as a

“taxable capital gain” and “allowable capital loss”77

▪ Analogous to the first step, if the net amount(s) is negative (i.e. the taxpayer’s allowable

capital losses exceed the taxable capital gains, and/or there is a net loss from listed personal property dispositions), a nil amount is reported for this step

o 3rd – pursuant to paragraph 3(c), the positive amounts calculated in the first two steps are aggregated and then any applicable deductions contained in the other source (i.e. moving and childcare expenses, RRSP contributions, etc.) are claimed

76 These are my terms for ease of reference/understanding.77 As discussed below, an “allowable capital loss” that cannot be used in the year incurred can be carried back or carried forward to offset a taxable capital gain in a prior or subsequent year. When an allowable capital loss is carried back/forward, it is referred to in the Act as a “net capital loss”.© Sprysak 2019

TAXATION


o 4th – pursuant to paragraph 3(d), any employment, business, property, and allowable business investment losses (ABILs)78 (but not allowable capital losses79) that were calculated, but not reported earlier in this process, are deducted, but only to bring the taxpayer’s Net Income balance to nil.

▪ As we will discuss later,

● To the extent that there are additional current year losses from employment,

business, and/or property (including ABILs), these losses, collectively referred to non-capital losses, can generally be carried back up to 3 taxation years or carried forward up to 20 taxation years and applied against any type of positive income in the carry over year.

● To the extent that the taxpayer has an allowable capital loss, this loss can be

carried back up to 3 taxation years or carried forward until the taxpayer either is able to use it or dies

● Example:

o George’s predominant source of income is from his employment with the City of St. Albert, where he works as a Senior Manager. For 2018, he earned a $150,000 salary (pre-tax) and his only deductible employment expense is Union Dues of $2,000;

o In addition to being an excellent administrator, George is also an incredible handyman. Up until 2018, he only did work on his own home and for friends as favours (and at no charge) to them. However, in 2018, he decided to start a small home repair/renovation business – which he thought he would like to carry on once he retired from the City in 2020. To get the “word out”, he hired an IT programmer to develop a webpage and purchased advertising on benches at bus stops in St. Albert. He also rented a small workshop close to his house and purchased several tools and equipment. His total deductible business expenses for 2018 are $40,000; the associated taxable revenues are $10,000;

o In 2018, George earned $25,000 of taxable investment (property) income; he incurred $5,000 of deductible interest expense associated with his income;

o In 2018, George sold his shares in Apple and Petro Canada; he realized a taxable capital gain of $10,000 on the former and an allowable capital loss of $15,000 on the latter; and

o In 2018, he received taxable spousal support from his ex-wife of $12,000 and made a deductible Registered Retirement Savings Plan (RRSP) of $20,000. (Both of these amounts are part of the Other source of income).

● Answer:

78 A “business investment loss” is defined in paragraph 39(1)(c) as generally the loss from the disposition of shares of a “small business corporation” or from debt issued by the small business corporation that has become uncollectible. The details of an ABIL is beyond the scope of this course.79 This is due to the fact that allowable capital losses can only offset taxable capital gains© Sprysak 2019

TAXATION


o (1) Calculate positive net income from employment, business, property, and other.

▪ Employment = salary (150,000) + expenses <2000> = 148,000

▪ Business = revenue (10,000) + expenses <40,000> = <30,000>

▪ Property = income (25,000) + expenses <5,000> = 20,000

▪ Other = spousal support (12,000)

▪ Add up positive income (employment, property, other in this case)

▪ Total net income = 180,000

o (2) Calculate the net taxable capital gains, if any (i.e., 50% of total capital gains)

▪ Taxable capital gain = 10,000

▪ Allowable capital loss = <15,000>

▪ “Net allowable capital loss” = <5000>

● Note: this can only be offset against taxable capital gains, either going back 3

years or going forward until we die.

● If we can’t use it in this year, it is referred to in the Act as a net capital loss.

o (3) Aggregate the positive amounts from the first two steps and claim any other deductions (from the other source)

▪ Net income (180,000) + net taxable capital gains (0) + RRSP contribution <20,000>

▪ Total = 160,000

o (4) Deduct any non-capital losses (to the extent that it brings it down to zero)

▪ Non-capital loss includes anything other than net capital losses

▪ Step 3 net income (160,000) + business loss <30,000>

▪ Total net income for tax purposes = 130,000

o Note: we claim deductions at two different stages. Each source has its own legislation and caselaw determining how and why we deduct.

▪ Unless the expense is specifically listed in section 8, you don’t get a deduction.

© Sprysak 2019

TAXATION


▪ This creates a preference for someone who is deemed a “business person” as opposed to

an employee.

▪ If you carry on a business, as long as it is incurred for the purpose of that business, then

those expenses are deductible.

Step #2 – Calculation of Taxable Income

● To calculate an individual’s Taxable Income, section 110 requires the taxpayer to take his/her Net

Income for Tax Purposes calculated in Step #1 and reduce it, as applicable, by the amounts contained in Division C, which includes:80

o An amount in respect of employee stock options (pursuant to paragraph 110(1)(d), (d.01) and (d.1)),

o An amount for “payments” – most commonly, workers compensation and social assistance payments,

o Any lifetime capital gains deductions claimed under section 110.6, ando Any loss carry overs from prior or future years

▪While we will discuss this in more detail later in this Unit, non-capital losses from up to

the three immediately preceding years can be used to reduce the current year’s Net Income – but only to bring this amount to nil; and

▪ Net capital losses from up to the three immediately preceding years can be used to

reduce the current year’s net taxable capital gains – but only to bring net taxable capital gains to nil

Step #3 – Calculation of Taxes Payable

● Once Taxable Income has been calculated, then the next step is to calculate Taxes Payable. This is

generally accomplished by multiplying Taxable Income by the appropriate Tax Rate(s), and then reducing that amount by any applicable tax credits.

Taxation Rate Regimes

● There are essentially 3 different taxation rate regimes that a government can adopt, namely: proportional, progressive and regressive

● Proportional Taxation - a proportionate tax regime is one where the rate of taxation does not change as income changes. Because of this defining feature, it is often referred to as a “flat tax”.

o Alberta used to have this type of regime (excluding the application of tax credits) – by levying a 10% provincial tax on taxable income (as calculated under the Act)

80 Note: this list is not comprehensive, but contains the more common deductions in calculating taxable income.© Sprysak 2019

TAXATION


● Progressive Taxation - a progressive tax regime is one where the taxpayer’s tax rate increases with his/her income.

o Our Federal tax regime has always been progressive – and since October 1, 2015, Alberta’s provincial tax regime has become progressive

o In the case of individuals, progressivity is accomplished by first allocating the taxpayer’s Taxable Income into the various Federal (and provincial/territorial) brackets and applying the applicable rate to each bracket of income.

o For 2018, the Federal brackets and rates (which are adjusted annually for inflation) are as follows:

Income Rate$0 - $46,605 15%$46,606 - $93,208 20.5%$93,209 - $144,489 26%$144,490 - $205,842 29%$205,843 + 33%

● For 2018, the Alberta brackets and rates (which are currently adjusted annually for inflation) are as

follows:Income Rate$0 - $128,145 10%$128,146 - $153,773 12%$153,774 - $205,031 13%$205,032 - $307,547 14%$307,548 + 15%

● Combining the Federal brackets and rates with the Alberta brackets and rates,81 in order to calculate the

combined tax liability of an Alberta resident (excluding the application of applicable tax credits) – and rounding the brackets for ease of use – results in the following rate schedule (which is provided in the General Information tab on TWEN and which will be provided to you for examination purposes):

Income Federal Rate Alberta Rate Combined Rate$0 - $45,000 15% 10% 25%$45,001 - $90,000 20.5% 10% 30.5%$90,001 - $130,000 26% 10% 36%$130,001 - $150,000 26% 12% 38%$150,001 - $200,000 29% 13% 42%$200,001 - $300,000 33% 14% 47%$300,001+ 33% 15% 48%

81 Note: in practice, a Canadian resident will file two income tax returns – a Federal and provincial/territorial return – using the rate regime applicable to each return. For our purposes at this point in the Course, I have combined the rates to determine an Alberta resident’s total tax liability (excluding the application of applicable tax credits)© Sprysak 2019

TAXATION


o Question: what would George’s combined (Federal and Alberta) tax liability be (before applying relevant tax credits)?

▪ Answer: If he makes $130,000, the first $45,000 is multiplied by the combined 25%

(11,250); the next $45,000 * 30.5% (13,725); the last $40,000 * 36% (14,400); all added up = $39,375 in tax liability

o Question: if the government wished to generate the same amount of tax revenue from George using a proportionate tax regime, what would the rate have to be?

▪ Answer: 39,375 / 130,000 = 30.29%

▪ Note: this is also the average tax rate

o Terminology:

▪ Marginal Tax Rate: the rate at which incremental income will be taxed.

▪ Average Tax Rate: this is calculated by taking total taxes payable and dividing it by total taxable income.

▪ Effective Tax Rate: this is calculated by taking total taxes payable and dividing it by total net income

● Regressive Taxation – a regressive taxation regime is one whether taxpayers pay tax at a lower rate as

their income increases.o Example: the first $50,000 of income is taxable at a rate of 25%; any taxable income in excess

of $50,000 will be taxed at a rate of 10%

● Question: Why might a particular government/country choose one regime over another?

o Proportionate: Doesn’t discriminate against higher income earners (“more equitable”); does perform some redistributive function; does not discourage increased economic activity + risk taking (like progressive might); simple and easy to administer

o Progressive: Allows for redistribution or equalization of wealth; better matches with a taxpayer’s ability to pay taxes; allows lower income taxpayers to be taxed at a lower rate

o Regressive: Attracts high income earners to the jurisdiction; encourage increased economic activity

● Question: are horizontal and vertical equity achieved by any of these regimes?

o Answer: Yes, both are achieved in all regimes.

Step #4 – Calculation/Application of Tax Credits

● Think of tax credits as gift cards. It reduces the amount you pay. Tax credits are also different than

prepayments or withholdings.

● The final step in calculating an individual taxpayer’s net tax liability is:© Sprysak 2019

TAXATION


o 1st – to determine what tax credit(s) the individual qualifies for,

▪ The “personal” tax credits are contained in subsection 118(1)

o 2nd – multiply the base amount(s) of the tax credit(s) by the applicable tax rate (which is typically the lowest marginal rate82), and

▪ In the case of personal credits, the disability tax credit, and tax credits transferred from a

spouse or person supported by a taxpayer, section 118.91 further requires that they be pro-rated where an individual is resident in Canada for only part of the year.

o 3rd – take this calculated amount and use it to reduce the individual’s tax liability as calculated in Step #3

▪ Note: strictly speaking, Federal tax credits can only be used to reduce an individual’s

Federal tax liability – and similarly, Alberta tax credits can only be used to reduce an individual’s Alberta tax liability

● Some of the more common Federal tax credits are:

o For all the credits listed, there is a federal credit and a corresponding provincial credit. The federal credit has to be applied against the federal tax liability, same goes for the provincial.

o Basic Personal Credit (paragraph 118(1)(c)) – which can be claimed by a single person and has a base amount for 2018 of 11,809,83

▪ This effectively means that the 1st $11,809 of every Canadian resident taxpayer’s income

(regardless of his/her total taxable income) is free from federal income tax

▪ Of course, the actual tax savings is calculated as $11,809 * 15% = $1,771.35

▪ Note: all of the provinces/territories have their own Basic Personal Credit - which can be

used to reduce the amount of provincial/territorial taxes payable

▪ In Alberta, this provincial Basic Personal Credit for 2018 is $18,915 – which (again)

means that the 1st $18,915 of every Alberta resident taxpayer’s income (regardless of his/her total taxable income) is free from Alberta provincial income tax.

▪ Another way of quantifying this benefit is to take $18,915 * 10% = $1,891.50 – this is the

reduction in an Alberta taxpayer’s provincial tax liability (or tax savings)o Spousal/Common Law Partnership Credit (paragraph 118(1)(a)) – which provides that

where an individual taxpayer is married or in a common law relationship, in addition to claiming

82 Note: for Federal tax credits, this is 15% and for Alberta tax credits, this is 10% under our current regimes.83 Note: this tax credit (and many others) is indexed for inflation by virtue of section 117.1. Consequently, while the Act refers to $10,320 as being the amount of the tax credit (before being multiplied by the “appropriate percentage for the year”), the actual amount for 2018 (after applying the inflation factor) is 11,809 (see Tax Reference Tables at the front of the Act)© Sprysak 2019

TAXATION


the Basic Personal Credit for himself/herself, he/she can claim a credit for his/her spouse/CL partner

▪ The base amount of the Spousal Credit is generally the same as the Basic Personal

Credit,84 but is reduced by the spouse’s/CL partner’s net income – hence once the spouse/partner has $11,809 of Net Income, the Spousal Credit is no longer available.

▪ Notes:

● The spouse/CL partner is entitled to his/her own Basic Personal Credit

● Only one person in the marriage/partnership can claim the Spousal Credit

o Wholly Dependent Person Credit (paragraph 118(1)(b)) – which is available to a single person who is not claiming the Spousal Credit who supports a wholly dependent person who lives with the taxpayer, is related to the taxpayer, and who is wholly dependent on the taxpayer (i.e. a minor child)

▪ Like the Spousal Credit, the base amount of the Wholly Dependent Person credit is the

same as the Basic Personal Credit (unless the dependent person is dependent because of a physical or mental infirmity – in which case the base amount is higher) but is reduced by the dependent person’s net income

o Age Tax Credit (subsection 118(2)) – which is available for individuals who turn 65 years of age before the end of the taxation year.

▪ For 2018, the base amount of the credit is $7,333, but is reduced by the individual’s net

income over a specified thresholdo Canada Employment Tax Credit (subsection 118(10)) – which is available for all individuals

who have employment income.

▪ The base amount is $1,195 (unless the individual’s employment income is less than this

amount, in which case it is the individual’s employment income)o Charitable Donation Tax Credit (section 118.1):

▪ This credit is unique in at least three respects

▪ First, while the first $200 of charitable donations that are claimed in the year are

multiplied by the lowest marginal rate to determine the tax savings, any donations in excess of $200 are multiplied by the 29% Federal rate (unless the individual claiming the donation has income taxed at the 33% rate, in which that rate may be applicable).

● Alberta has a somewhat similar regime – the first $200 claimed is multiplied by

10%, but any amount claimed over $200 is multiplied by 21%.84 If the spouse/partner is dependent on the taxpayer due to a physical or mental infirmity, the amount of the credit is higher© Sprysak 2019

TAXATION


● This means that the combined Federal and Alberta tax relief for charitable

donations claimed in excess of $200 is 50% of the donation!

● Example 1: make and claim $100 donation [the ITA specifies that you have the

valid charitable donation tax receipt] – 100 x 15% = 15 of tax credit amount federally; for Alberta 100 x 10% = 10 of provincial tax credit. For making and claiming a 100 donation we get $25 of tax credits.

● Example 2: Make and claim $1,000 donation. First 200 follows the general rule in

example one. 200 x 15% = 30 and 200 x 10% = 20 for a total of $50 tax credit.o For the remaining $800, Federally: 800 x 29% = $232; in Alberta: 800 x

21% = $168. The total tax credit on the $800 is $400. So on the $1000, you get a total tax credit, provincially and federally, is $450.

o The 21% in Alberta was around even when the flat tax existed.

▪ Second, it is possible for charitable donations to be carried forward for up to 5 years

before being claimed85

● If a 200 donation is made every year for 5 years and claimed then you get 50 of

tax relief combine per year. 250 over the 5 years. But if you waited until the 5th year to claim the donations, there is a 1000 of donations, and the total tax relief over the 5 years is 450 (see example 2 for calculation).

● Is there a benefit of waiting to claim if the income is increasing over the 5 year

period? No – because tax credits it does not matter what the persons income is. The rates are set for how to calculate the charitable donation tax credit regardless of the income. The only exception is where the income of the taxpayer claiming puts them at the 33% federal rate.

● Are there any ethical concerns with this deferring behaviour? No not really, it is

explicitly provided for in the law. It may encourage people to give to charity.

▪ Third, it is possible for couples to pool their donations and claim them on one return

● This is a CRA administrative position so it’s not law and can be taken away at any

time. You can pool and defer them for 5 years. You would do this because you want to maximize the amount that is eligible for the high rate of tax relief (29% or 33% federally, 21% provincially).

▪ Generally speaking, the limit on the amount of donations that can be claimed on a

particular tax return (other than in the year of death) is 75% of the taxpayer’s net income

85 In the case of ecological gifts, the carry forward period is 10 years.© Sprysak 2019

TAXATION


o Medical Expense Tax Credit (section 118.2) – which allows individuals to claim a credit for qualifying medical expenses over a specified threshold that have not been reimbursed by a health plan (unless the reimbursement must be included in the individual’s income)

▪ For this and the disability tax credit, people with medical and disability issues often have

less income and have less ability to bear the tax burden, so they receive extra tax relief. It has to be borne by the tax payer not reimbursed by Blue Cross for example.

▪ Generally speaking, because it’s based on expenses greater than a threshold that is

partially based on income; because you can pool the expenses, you want the lower income person to claim the expenses because their income is less and the threshold would therefore be less.

▪ This is an exception to the general rule that income doesn’t matter when you claim tax

credits.

▪ Also it can be based on any 12 month period that ends in the taxation year. So you would

want to claim the highest 12 month period that ends in the taxation year.o Disability Tax Credit (section 118.3) – which allows a person with a physical and/or mental

disability that satisfies all of the requirements in the Act (including certification by a listed medical practitioner) to claim a credit

o Tuition Tax Credit (section 118.5) – which allows students who incur eligible tuition fees to claim a credit generally equal to 15% of those fees

▪ Like the Charitable Donation Tax Credit, there is the possibility of carrying forward this

credit (section 118.61) when the student does not have sufficient income in the year the tuition fees are claimed to fully claim the tax benefit of the tax credit (although there is no maximum carry forward period).

▪ Alternatively/additionally, where the student cannot fully utilize the tax credit, it is

possible to transfer a portion of the credit to a spouse/CL partner (section 118.8) and/or a parent/grandparent (section 118.9)

Tax Deductions vs Tax Credits

● As we have briefly discussed, “net income” (or “profit”) can generally be defined as “revenues” less

“expenses” (or more generally, “net receipts”).o While often attention is focused on the revenue/receipt side of this equation, equally important is

the expense/cost side. o Very generally, “deductions” are expenses that are recognized/allowed for income tax purposes.o They offset revenues/receipts and hence reduce a taxpayer’s income (and taxes payable).

© Sprysak 2019

TAXATION


● As noted above, some deductions are “source-specific” – meaning that they can only be deducted in the

calculation of one source of income (i.e. the employment expenses listed in section 8 can only be deducted against employment salary, wages and other remuneration as described in sections 5-6)

o Other deductions are non-source specific, meaning they can be deducted against any source of income (i.e. RRSP contributions)

● Important Point: as tax deductions reduce the income of a taxpayer, the benefit of a deduction is

taxpayer specific

● Example: let’s assume that we have 2 taxpayers who each contribute $10,000 to his or her RRSP and as

a result can claim a tax deduction for this contribution. o The first taxpayer has $40,000 of taxable income before taking into account his RRSP

contribution; the second taxpayer has $400,000 of taxable income before taking into account her RRSP contribution.

o Question: What is the value of that tax deduction to each taxpayer (i.e. how much tax does the taxpayer save or, if tax has already been deducted as source, how much of a tax refund does the taxpayer receive)?

o Answer:

▪ Pre-tax Income * Tax Rate = Taxes Payable

▪ Taxes Payable without Deduction – Taxes Payable with Deduction = Tax

Savings/Benefito Taxpayer 1: $40,000 taxable income, $10,000 RRSP

▪ 40,000 * 25% = 10,000

▪ Taxes payable with deduction = (40,000 – 10,000) * 25% = $7500

● 10,000 – 7500 = 2500 = Tax savings

● 10,000 = RRSP contribution

● 7500 = net cash cost

▪ Shortcut: Tax deduction * marginal rate = tax savings/benefit

● 10,000 RRSP contribution * 25% = $2500 tax savings

o Taxpayer 2: $400,000 taxable income, $10,000 RRSP

▪ The $10,000 comes out of the top bracket of income (48%), so using the shortcut, we do

$10,000 * 48% = $4800.

© Sprysak 2019

TAXATION


o Taxpayer 3 (class example): $49,000 taxable income, $10,000 RRSP contribution, taxable income now = $39,000. What is the tax savings to that taxpayer?

▪ (4000 * 30.5%) + (6000 * 25%) = 1220 + 1500 = $2720

▪ Everything above $45,000 is taxable at 30.5%, everything under is taxable at 25%

o Exam: You can use either the longform or the shortcut, but the longform will take longer

● Tax credits also constitute a tax benefit to taxpayers, but they provide that benefit to taxpayers in a

different way than tax deductions.o As noted above, tax deductions reduce a taxpayer’s taxable income, which in turn reduces the

taxpayer’s tax liability (which is calculated by multiplying taxable income by the appropriate tax rates).

o In contrast, tax credits do not affect a taxpayer’s taxable income. Instead, they are calculated separately from the calculation of taxable income (and taxes payable).

● Important Point: Because tax credits do not alter a taxpayer’s income (and are generally calculated at

the same rate for all taxpayers), tax credits are not, like tax deductions, taxpayer specific; assuming that two taxpayers both qualify for the credit, they will receive the same “tax benefit” regardless of their income.

Utilizing Tax Deductions and Tax Credits

● If tax deductions exceed taxable revenues to create a net loss in respect of a particular source of income

(or activity), then that loss:o In cases involving income from any source other than capital gains, the net loss may be used to

offset net income from another source (or activity) in the current tax year (if any), ando If the net loss cannot be used in the current year’s return, it can be carried back up to 3 taxation

years or carried forward to offset taxable income in those tax returns (see section 111).

▪More specifically, if the loss is not a loss from the disposition of a capital asset, referred

to as a “non-capital loss”, then it can be carried back up to 3 years and forward generally up to 20 years and offset against any other source of income in those years (paragraph 111(1)(a));

▪ However, if the loss is a loss from the disposition of a capital asset, referred to as a “net

capital loss”, then the loss can still be carried back up to 3 taxation years and can be carried forward indefinitely (i.e. until the taxpayer dies), but can only be used to offset net taxable capital gains in those years (paragraph 111(1)(b)).

o Given this feature, the tax benefit of a deduction will generally be realized – either in the year that it is claimed or in a prior or subsequent year.

© Sprysak 2019

TAXATION


● In contrast, for the majority of tax credits, if they cannot be used in the current year to reduce an existing

tax liability (including a tax liability that has been covered by source withholdings or instalment payments during the taxation year), then they are of no use for that taxation year (and are not applicable against future or prior taxation years)

o Put more simply, the benefit is lost (forever) o For this reason, tax credits are generally described as being “non-refundable”o That said, there are some exceptions where tax credits can be used by someone other than the

taxpayer (i.e. tuition tax credits) or carried forward to a subsequent year (i.e. student loan interest).

● A few tax credits are also “refundable”, meaning they can result in a tax benefit even if the taxpayer is

not taxable (i.e. the GST credit).

When Does Taxable Income Have to be Calculated and Reported?

● Sections 249 and 249.1 collectively define the “taxation year” for each of the three “persons”

recognized by the Act.o For an individual, generally speaking, the taxation year is the calendar year (January 1 to

December 31);86

▪ As trusts are generally treated and taxed as if they are “individuals” pursuant to

subsection 104(2), the default rule for trusts is that, like individuals, they will have a calendar year taxation year.

▪ In the case of a graduated rate estate (GRE), the current rule is that the taxation year

cannot end more than 12 months after the testator’s death and can be off-calendar, but only for 36 months, at which point it will be forced to have a calendar year taxation year

o For a corporation, the taxation year is its “fiscal period”, which generally cannot end more than 53 weeks from when the period began.

▪ Effectively, this allows a corporation to choose whatever 365 day period as its “fiscal

period” – although once it selects this period, then generally speaking it is “stuck” with it unless it has a “good reason” to change it (i.e. amalgamated with another corporation)

▪ Notes:

● In the corporation’s first year of existence, it can have a fiscal period that is less

than 365 days (which is typically the case to allow the corporation to select its fiscal year end)

86 As noted in paragraph 249(1)(c), the calendar year is the default taxation year for anyone other than a corporation and a graduated rate estate.© Sprysak 2019

TAXATION


● This can be an important issue (for both tax and non-tax purposes) that should be

addressed with the corporation’s management, accountants and tax advisors (and perhaps creditors) to determine the best year end.

▪ Primary consideration for businesses with highs and lows would be to end the year after a

high and during a low time

▪Might also want to consider the cycles of the accounting firms

Case Study: Sprinkling Income 87

● Assumptions:

o Two marginal tax brackets for individuals:

▪ $0 – 50,000: 25% tax rate

▪ $50,001+: 50% tax rate

o Corporate tax rate on the 1st $500,000 of active business income earned by a Canadian-controlled private corporation (CCPC): 10%

o No personal tax creditso Two households, each containing two persons in an intimate, economically interdependent

relationship.o In the 1st Household, Ellen works as an elementary school teacher and earns $100,000 of

employment income. Her common-law partner Portia does not work outside of the home. She looks after all of the household matters and otherwise supports Ellen in her creative teaching endeavours.

o In the 2nd Household, Kanye runs a “Dollar Store” through his corporation Cheepyz Inc. (Cheepyz). His wife Kim looks after all of the household matters and supports Kanye’s creative and business efforts. Kayne owns 100% of the Class A voting shares in Cheepyz; Kim owns 100% of the Class B non-voting shares in Cheepyz. Both classes of shares are entitled to dividends (at the Board of Director’s discretion) and the corporation’s articles allow dividends to be paid on one class of shares without paying dividends on the other (again, at the Board’s discretion). For the last few years, Cheepyz has generated $100,000 of pre-tax corporate income. With this income, it has paid Kayne a $50,000 salary (taxable as employment income) and has paid whatever is left in the corporation to Kim as dividends on her Class B shares.

● Ellen:

o First 50,000 is taxed at 25%, tax liability = 12,500o Next 50,000 is taxed at 50%, tax liability = 25,000o Total tax liability (for 100,000) = 37,500

87 This was one of the three issues raised by the Federal government in Budget 2017 and the July 18, 2017 Small Business Tax Proposals.© Sprysak 2019

TAXATION


o After tax income = 62,500o Shortcut: Pre-tax income * (1 – tax rate) = after tax income

● Kanye and Kim

o Cheepyz

▪ Business income = 100,000

▪ Salary expense = <50,000>

▪ Taxable (and net) income = 50,000

▪ Corporate tax (10%) = <5000>

▪ After tax corporate income = 45,000

o Kanye

▪ Employment income = 50,000

▪ Personal tax (25%) = <12,500>

▪ Kanye’s after tax income = 37,500

o Kim

▪ Dividend received = 45,000

▪ Grossed up dividend = 50,000

▪ Kim’s personal tax (25%) = <12,500>

▪ Dividend tax credit (to reflect the corp tax already paid on this income) = 5000

▪ Net personal tax = <7,500>

▪ Net after-tax income = 37,500

o Kim + Kanye

▪ 37,500 + 37,500 = 75,000

▪ Compared to Ellen and Portia, Kim and Kanye earn more

© Sprysak 2019

TAXATION

Unit #6 – Employment Income

Overview of the Taxation of Employment Income

● The taxation of employment income is very important for two primary reasons:

o 1st – more tax revenue is derived from the taxation of employment income than any other source taxed by the ITA; and

o 2nd – each individual who earns employment income also typically has a vote – so the government has to be very careful in how it taxes employment income as this could impact its ability to stay in power.

● That said, there are only 4 main sections that cover employment income – sections 5-8

Characterizing the Relationship between a Service Provider and Service Recipient for Income Tax Purposes

● When an individual provides services to another person and generating revenues and/or incurring

expenses, for tax purposes, it is important to first consider the capacity in which the person is providing those services.

o This will determine how the person’s income from providing those services will be taxed under the Act, if at all

o This can also have non-tax implications (i.e. vicarious liability, need to comply with employment legislation (or not), etc.)

● Practically speaking, there are three possible relationships that can exist between a service provider

and a service recipient, namely: a personal relationship, an employment relationship, or a business relationship

o For our purposes, a “personal relationship” (my term) is one that done with no intention for profit (i.e. shovelling my neighbour’s sidewalk after shovelling my own)

o In this context, when a business relationship is found to exist, the service provider is commonly described as an independent contractor

● Unfortunately, the Act doesn’t contain very helpful definitions which could be used to distinguish

between employment and business relationships. Looking in subsection 248(1): o Employed “means performing the duties of an office or employment”;o Employee “includes officer”;o Employer “in relation to an officer, means the person from whom the officer receives the

officer’s remuneration”;o Employment “ means the position of an individual in the service of some other person… and

“servant” and “employee” mean a person holding such position”; o Office “means the position of an individual entitling the individual to a fixed or ascertainable

stipend or remuneration and includes a judicial office, the office of a minister of the Crown, the office of a member of the Senate or House of Commons of Canada… and also includes the position of a corporate director, and officer means a person holding such office”; and

© Sprysak 2019

TAXATION


o Business is defined as “includ[ing] a profession, calling, trade, manufacture or undertaking of any kind whatever and… an adventure in the nature of trade, but does not include an office or employment”

▪ Note: an activity will either constitute employment or business for tax purposes; these

characterizations are mutually-exclusive

Overview of the Tax and Non-Tax Implications of being Characterized as an Employee or an Independent Contractor

● Commitment to Service Costs: while depending on the terms of the contract, generally speaking,

business relationships are entered into at the service recipient’s discretion and for the amount of time the recipient requires the service. In contrast, in most employment relationships, the employer is committed to long-term ongoing costs in respect of its employees

● Scope of Deductions: This is a key reason why this characterization is important for income tax

purposes. o As we will discuss later, an employee is very limited in the deductions that s/he can claim -

confined to those set out in section 8. o In contrast, if an individual is running a business, then s/he has a very broad spectrum of

expenses that s/he can claim – general rule in paragraph 18(1)(a) is that if the expense was incurred for the purpose of earning business income, it will be deductible for tax purposes (unless another specific section denies the deduction).

● Employment Insurance (EI):

o If there is an employment relationship, then both the employee and employer will generally be subject to employment insurance premiums (or possibly the employer will pay both) – see generally sections 5, 67 and 68 of the Employment Insurance Act, SC 1996, c 23.

o However, if the service provider is an independent contractor, then the service recipient will not have to pay EI premiums in respect of the service provider (so a benefit to the service recipient – reduces service costs).

▪ However, if the service provider is an independent contractor and s/he loses/ends her/his

contract with the service recipient, then the independent contractor will not receive EI while s/he looks for new work (while an employee will often, but not always, be entitled to some EI support).

▪ This is how many of these cases come before the CRA (and the courts) – the service

provider loses her/his work with the service recipient, then goes looking for EI coverage.

● Canada Pension Plan (CPP):

© Sprysak 2019

TAXATION


o Similar to EI legislation, if there is an employment relationship, then generally speaking both the employer and the employee will have to pay CPP premiums – see generally sections 6, 8 and 9 of the Canada Pension Plan RSC 1985, c C-8

● Vicarious Liability: the basic rule/principle under tort law is that an employer may be vicariously liable

for the acts of its employees but will not be vicariously liable for the acts of independent contractors

● Payment and Withholding of tax: not a huge issue to most employers as it is more of an administrative

function and/or matter of timing/cash flow, rather than an addition cost or savings.

o For employment income, the employer has the responsibility of withholding and remitting source deductions from employment income (paragraph 153(1)(a)).

▪Many provinces (but not currently Alberta) also levy payroll taxes against employee

remuneration. o In contrast, generally speaking, there are no withholding requirements associated with business

income (although the service provider, like all businesses, might be required to make instalment payments)

● Basis of Measurement: as we will discuss in more detail later, subsection 5(1) requires employment

income to be reported by employees on a cash received basis. In contrast, business income is generally calculated on an accrual basis.

● Participation in Employer Plans/Benefits: while employees (after passing their probationary period)

are generally entitled to supplementary health care benefits and participation in the employer’s pension plan (if such benefits/plans exist), independent contractors are not.

Determining the Characterization of a Service Provider for Income Tax Purposes

● The key case continues to be Wiebe Door Services Ltd. v. Minister of National Revenue, [1986] 2

C.T.C. 200 (F.C.A.) – which was approved by the Supreme Court in 671122 Ontario Ltd. v Sagaz Industries Canada Inc., [2001] 2 S.C.R. 983

o Facts: Wiebe Door Services Ltd. (WDS) was in the business of installing and repairing doors (primarily garage doors) in Calgary. Rather than having a large staff of installers (which of course would be costly – particularly when WDS didn’t have work for them), WDS had contracts with a number of door installers and repairers, each of whom had the understanding that they would be running their own business with all of its implications (i.e. no unemployment insurance, responsible for WCB premiums, taxes, etc.)

o Issue: were these door installers and repair persons employees or independent contractors for tax purposes?

© Sprysak 2019

TAXATION


o Analysis: basic test/rule - you look at the whole relationship of the parties to determine if the service provider is in business for himself/herself or a servant of the service recipient88

▪ Another way of asking the question often used by the courts - is there a contract of

service (i.e. an employment relationship) or a contract for services (i.e. a business relationship)?

o To answer this question, one must do a comprehensive factual analysis which considers all aspects of the parties’ relationship.

o In the course of performing this comprehensive analysis, one should consider the following four tests (but of course, not limit oneself to solely these tests), namely, the control test, the ownership of tools test, the chance of profit and risk of loss test (sometimes referred to as the entrepreneurial test) and the integration test.

▪ Note: some subsequent courts have broken up the entrepreneurial test into 2 tests – (1)

chance of profit, and (2) risk of loss – and/or have ignored the integration test o Of course, while you address the four sub-tests in your analysis, in the end, these tests must be

considered together (along with any other relevant facts) to determine the essence of the relationship

o As noted by Justice MacGuigan, speaking for the FCA, at para 15 (and quoting from Professor Atiyah’s text Vicarious Liability in the Law of Torts):

▪ What must always remain of the essence is the search for the total relationship of the parties… It is

exceedingly doubtful whether the search for a formula in the nature of a single test for identifying a contract of service any longer serves a useful purpose… The most that can profitably be done is to examine all the possible factors which have been referred to in these cases as bearing on the nature of the relationship between the parties concerned. Clearly not all of these factors will be relevant in all cases, or have the same weight in all cases. Equally clearly no magic formula can be propounded for determining which factors should, in any given case, be treated as the determining ones [Emphasis added]

▪ Practical Tip: in applying these tests (or formulating arguments/positions in respect of

each test), I find it helpful to have particular business and employment relationships in mind and then test your argument/position against these undisputed relationships

o Control Test – as a general rule, if the payor controls only what is to be done, then this is more indicative of a business relationship.89 However, if the payor not only controls what is to be done but also how it is to be done, then this is more indicative of an employment relationship90

▪ One of the indicia that some judges have found helpful in applying this test (but of

course, not the only) is whether the service providor must do the work herself/himself or whether s/he can subcontract/delegate it to another person

88 In the Sagaz Industries case, Justice Major, on behalf of the Supreme Court, states the question (at para 47) in this way, “The central question is whether the person has been engaged to perform the services is performing them as a person in business on his own account”. 89 Example: a client retains a lawyer to implement a real estate conveyance – business relationship.90 Example: an in-house corporate counsel lawyer.© Sprysak 2019

TAXATION


● If the service provider can hire helpers or someone else to do the job, then the

courts have often found this fact to make the relationship look more like a business one

● That said, just because someone must perform the services does not mean that

service provider is an employee of the service recipient

▪ Another factor that courts sometimes consider is whether the services are more

“indefinite” in nature (i.e. ongoing) as compared to accomplishing a “specific result” – with the former generally (but not always) more indicative of an employment relationship and the latter sometimes more indicative of an employment relationship

▪ Other factors that courts have considered under this test include: mode and timing of

payment, mandatory attendance at staff meetings, workers having to follow company policies, etc.

o Ownership of Tools Test - if the taxpayer owns all of the tools required to provide the contracted services, then this is typically viewed as more indicative of a business relationship

▪ The least important indicia – e.g., when you go the dentist, they have all the tools, so this

would be characterized as a business relationship.

▪ For employment relationships, tools are provided by employer. Employee only provides

time and skills.

▪ This breaks down in certain cases, though.

o Chance of Profit/Risk of Loss Test (sometimes referred to as the Entrepreneurial Test) – as the title indicates, this test explores whether the taxpayer has the opportunity to profit and the risk of loss – which are generally thought to be two of the hallmarks of a business

▪ This breaks down as well – you could be a stock broker or salesperson where your

income depends entirely on performance, but you’ll still be deemed to be an employee

● Integration Test - this test is to be applied from the service provider’s standpoint (rather than the

service recipient’s standpoint) and asks whether the service recipient is so integral to the provider’s business that the activity would likely end/fail if the recipient ceased to be a customer/client

o If the existence of the recipient is not critical to the provider’s business (or can be described as somewhat ancillary to it), then this will be an indicia supporting characterization as a business relationship

o This is sometimes described as the “economic dependence” testo While there is some debate in the jurisprudence, the majority view appears to be that the Wiebe

Door approach is also applicable in Quebec (explain – Code mentions only “control”)

© Sprysak 2019

TAXATION


The Role of the Parties’ Intention in Characterizing their Relationship

● Question: Do the parties’ (mutual) intention to create an employment or business relationship, as set out

in a jointly-signed written contract, play any role in the characterization of a service relationship?o Answer: In Wiebe Door (at para 2), the FCA stated that the parties’ intention that the installers

“would be running their own businesses … was not determinative of the relationship between the parties and a court must carefully examine the facts in order to come to its own conclusion”.

▪ Some judges/practitioners have interpreted this statement to mean that the parties’

intention is irrelevant in the analysis.91

o However, the Federal Court of Appeal in 1392644 Ontario Inc. v Minister of National Revenue, 2013 FCA 85 (Connor Homes) (among other recent decisions) has taken a different view of the role of the parties’ intention. More specifically, it (at least arguably) expands the analysis set out in Wiebe Door (and Sagaz Industries) as follows:

o Step #1 - consider “whether there is a mutual understanding or common intention between the parties regarding their relationship” (Step #1),92 and

▪ As noted at para 39, this can be ascertained “either by the written contractual relationship

the parties have entered into or by the actual behaviour of each party, such as invoices for services rendered, registration for GST purposes and income tax filings as an independent contractor”.

o Step #2 – where such a mutual intent (typically to have a business relationship) exists, consider “the relevant factors in light of that mutual intent for the purpose of determining if, on balance, the relevant facts support and are consistent with the common intent”.93

▪ Important Point: The parties’ mutual intention is not legally determinative. If present,

then their mutual intention only creates a “prism”94 through which the Wiebe Door analysis is to be undertaken

▪ Relevant question: is the particular component of the relationship being considered

inconsistent with the parties’ mutual intention (as identified/verified in Step #1)

▪ If not, then the parties’ relationship (and the service provider’s income) for tax purposes

should be characterized in accordance with their mutual intention

Incorporated Employees

91 Judges taking this approach often state that the proper characterization of a service provider for tax (or other) purposes is a legal question. As such, only/ultimately a judge can make that determination (as opposed to the parties doing so themselves through their mutual intention).92 Connor Homes, para 30.93 Connor Homes, para 33.94 Connor Homes, para 42. © Sprysak 2019

TAXATION


● Question: assuming that after performing a Wiebe Door analysis, as supplemented by Connor Homes,

your professional opinion/conclusion is that an employment relationship has been created by the parties, is it possible to change this characterization by having the service provider incorporate a company, who will then contract with and provide services to the service recipient?

o Note: In the Act, the individual actually providing the services, now as an employee of his/her corporation is referred to as an “incorporated employee”

o Answer: No – it doesn’t work for tax purposes!o To combat this (inappropriate) form of tax planning, in 1981, the federal government created the

definition of a “personal services business” in subsection 125(7), which is:

▪ A service business carried on by a corporation where,

▪ The individual who provides the services on behalf of the corporation (the “incorporated

employee”) or anyone related to the individual is a “specified shareholder” of the corporation, AND

● “Specified shareholder” is defined in subsection 248(1) very generally as a

person who owns “not less than 10% of the issued shares of any class of the capital stock of the corporation”

▪ The incorporated employee would reasonably be considered an employee of the service

recipient but for the existence of the corporation, UNLESS

● The corporation employs in its business throughout the year more than 5 fulltime

employees and those employees are necessary to maintain the business (or one other exception beyond the scope of this course)

o Very briefly, if a corporation is found to be carrying on a “personal services business”, then the 2 most significant (and taxpayer unfriendly) consequences are:

▪ The income from such business is not eligible for the small business deduction (and

other rate reductions) – meaning that it is taxed at full corporate rates (because income from a personal services business is not “active business income” as defined in subsection 125(7)) which are similar to personal rates,95 and

▪ By virtue of paragraph 18(1)(p), the corporation is severely restricted in what expenses

it can deduct for tax purposes in calculating its personal services business income (to essentially what an employee could deduct under section 8)

● There is also a surcharge added on

o Put more simply, there are no tax advantages to incorporating a corporation to carry on a “personal services business”; indeed, there are additional costs, including the potential for double

95 Indeed, an additional 5% corporate tax is levied on personal services business income by section 123.5.© Sprysak 2019

TAXATION


tax (once the income is distributed to the shareholder/employee) compared to simply earning the income personally and non-tax costs of creating and maintaining another legal entity.96

What is Included in Employment Income?

● The starting point for determining what is to be included in employment income for income tax purposes is

section 5. o While a very short section, it answers 2 important questions, namely:

▪What is to be included in employment income for tax purposes (tax base question)?

▪When such income is to be calculated/included (timing question)?

o With respect to the 1st question, subsection 5(1) generally provides that a taxpayer’s income from an office or employment is the salary, wages, and other remuneration, including gratuities, received by the taxpayer during the year.97

▪ Gratuities are a little weird to include since they don’t come from your employer

▪ Easiest to assume that it is taxable employment income if its connected to the employment

relationship, then work backwards to see if you can justify it not being taxable

▪ Generally speaking, this does not seem surprising (at least not to me) – although when we get

to paragraph 6(1)(a), we see just how broad the combination of these two provisions are in including things in employment income for tax purposes.

▪ See also subsections 6(3) and (3.1), which supplement section 5 by deeming certain

payments to fall within the scope of section 5 (i.e. an inducement payment or signing bonus to become an employee)98

o With respect to the 2nd question, subsection 5(1) provides that the recognition event for tax purposes is receipt during the year.

▪ Not surprisingly, this is commonly referred to as the “cash basis” of income recognition –

you report your employment income in the taxation year in which it is received, as opposed to when the work is done (which is the general basis for recognizing business revenue).

Taxable Benefits – Section 6

96 See Gomez Consulting Ltd v The Queen, 2013 TCC 135 for a case involving an IT worker whose corporation was found to be carrying on a personal services business (with the CRA as a client)97 As noted in Folio S2-F3-C2 “Benefits & Allowances”, para 2.6, the courts have relied on the ordinary dictionary definitions of “salary, wages, and other remuneration” and have generally held an amount paid for services performed by an employee to fall within the meaning of these terms.98 See also, Folio S2-F3-C1, “Payments from Employer to Employee” (26 November 2015), paras 1.4-1.6© Sprysak 2019

TAXATION


● Section 6 clarifies (or arguably expands) what is taxable under section 5 by explicitly providing that

benefits connected to the employment relationship are also generally taxable as employment income. o The primary provision in section 6 is paragraph 6(1)(a), which requires an employee to include

in his/her employment income “the value of board, lodging and other benefits of any kind whatever received or enjoyed by the taxpayer or by a person who does not deal at arm’s length with the taxpayer, in the year in respect of, in the course of, or by virtue of the taxpayer’s office or employment” [emphasis added].

o Typically, this provision is applied to catch “non-cash benefits” (as cash benefits would likely be caught by section 5) – although nothing in its wording prevents it from being applied to cash benefits

o Paragraph 6(1)(b) supplements 6(1)(a) by generally providing that any allowances received for personal or living expenses are also taxable as employment income (with some legislative exceptions)

● Very generally, for paragraph 6(1)(a) to be engaged, the employee must (1) receive or enjoy a

“benefit”, (2) “in respect of, in the course of, or by virtue of the taxpayer’s office or employment” (collectively – an “employment benefit”) that is not excluded by (a) the Act, or (b) the jurisprudence

● Question: what is an “employment benefit” for tax purposes?

o Answer: Professor Krishna has defined it (and this definition has been accepted by the courts) “as an economic advantage or material acquisition, measured in monetary terms, that one confers on an employee in his capacity as an employee”.99

o Supplied uniforms are non-taxable (e.g., Walmart vests, barristers robes)

● Question: When is a benefit “in respect of, in the course of, or by virtue of” employment?

o Answer: The leading case concerning the relationship between a benefit and an individual’s employment continues to be R. v Savage, [1983] 2 S.C.R. 428, in which case the Court referred to its decision in Nowegijick v The Queen, [1983] 1 S.C.R. 29 at para 30 where it stated that:

● The words “in respect of” are, in my opinion, words of the widest possible scope. They import

such meanings as “in relation to”, “with reference to” or “in connection with”. The phrase “in respect of” [is] probably the widest of any expression intended to convey some connection between two related subject matters. [Emphasis added.]

o As a result of this interpretation, generally speaking, courts don’t have difficulty finding the necessary relationship between the benefit and the employment relationship

▪ That said, where the facts have supported it, sometimes judges have found that a benefit

was provided to an employee in another capacity (rather than because he/she was an employee), in which case the benefit was not taxable to him/her as employment income (but may be taxable as a shareholder benefit, or perhaps not taxable at all)

99 Krishna at page 214© Sprysak 2019

TAXATION


A Brief Overview of Selected Statutory Taxable Benefits

● Imputed Interest Benefit: where an employer makes a loan to an employee, then the general rule under

sections 6(9) and 80.4 is that the employee has to report a taxable benefit equal to the amount of the loan multiplied by the excess of the prescribed rate over the rate charged by the employer, less any payments made by the employee to the employer in respect of the loan in the year or within 30 days of the following year

o Note: pursuant to section 80.5, the employee is deemed to have paid the imputed interest. As such, if the borrowed funds can be traced into an income-producing asset or use, then the employee should be able to deduct the imputed interest pursuant to paragraph 20(1)(c)

o If the employer forgives the loan, then subsection 6(15) deems the amount of the forgiven loan to be a taxable benefit in the year forgiven

● Automobile Benefits:

o Subsection 6(2) and paragraph 6(1)(k) describe the standby100 and operating101 benefits that an employee may have to report on his/her tax return when an employer provides the employee with a vehicle that the employee uses for personal purposes.

o Personal trips have generally been defined by the courts as home to work, work to home, and any personal travel that has no connection to work (i.e. going to the movies).

▪ Going from home to work is a personal trip, but stopping along the way to do work may

be construed as a work trip.

▪ It is possible to create a mileage log after the fact

o Note: where an employee uses the company vehicle solely for work trips, there is no taxable benefit to the employee.

▪ Further, to the extent that the employee pays the employer for the personal use of the

vehicle in the year or within the first 45 days of the following year, this will reduce/eliminate the taxable employment benefit

o Where the employee uses his/her own vehicle for work (as well as personal purposes) and his/her employer pays all of the operating costs, then paragraph 6(1)(l) requires a taxable benefit to be reported (i.e. personal kms divided by total kms driven multiplied by total costs paid by the employer)

100 This benefit relates to simply having access to the company vehicle and is based on the value of the vehicle and the number of complete months that the vehicle is available to the employee101 This benefit relates to the operating costs incurred by the employer in respect of the employee’s personal travel and is generally calculated by multiplying the number of personal use kilometres by a prescribed rate. If the employee pays all of the operating costs, then there will not be a taxable operating benefit to the employee© Sprysak 2019

TAXATION


o Finally, where an employee use his/her own vehicle for work purposes, then the employer can pay the employee a “reasonable allowance” (i.e. solely based on work kms) that will not constitute a taxable employment benefit.

▪ For 2018, the per km rates are 55 cents on the 1st 5,000 work kms and 49 cents thereafter.

▪ Sprysak says that this is the best option for tax purposes.

● Allowances: subject to a list of exceptions contained in the provision,102 paragraph 6(1)(b) generally

provides that an employee has to report any allowances received from his/her employer as a taxable benefit

o Note: in some cases, an employee can mitigate this result by deducting the associated expense (if allowed by section 8)

o An “allowance” has generally been defined by the courts as an amount that the employee is paid, for which s/he does not have to substantiate how it was spent

▪ Because there is no accountability, the potential exists for the employee to pocket the

money and/or use it for personal purposes and enjoy an “employment benefit” (i.e. net worth has increased)

▪ E.g., a $500 work boot allowance – taxable because there is no way to know whether you

actually spent $500 on boots.o In contrast, if an employer reimburses an employee for a work expense,103 then that

reimbursement will generally not constitute a taxable benefit since the employee is not better off.

▪ However, if an employer reimburses an employee for a personal expense, then the

employee has to report the amount as a taxable benefit since s/he is better off o Practice Point: where commercially feasible/practicable, it is better (for tax purposes) to

structure a system whereby employees are reimbursed for work expenses (rather than providing them with an allowance).

Statutory Exceptions

● As one might well expect (given the existence of paragraph 6(1)(a)), there are not many benefits that

an employer can provide to its employees that will not be taxable as a result of a statutory exclusion.o Rule of Thumb: Assume any amount or benefit that can be connected to the employment

relationship is taxable as employment income unless you can find a provision, relevant case law, or an administrative exception to the contrary

102 These non-taxable exceptions include “reasonable” allowance for travel (particularly where the employee sells property or negotiates contracts for his/her employer) and the use of the employee’s motor vehicle (discussed above)103 In contrast to an “allowance”, a “reimbursement” is where the employee has to account to his/her employer before getting paid (i.e. provide receipts of work expenditures). Folio S2-F2-C2 para 2.16, defines a “reimbursement” as “a payment made to repay an amount an employee spent on a specific expense and for which detailed receipts are provided”. © Sprysak 2019

TAXATION


● That said, there are a limited number of cases contained in section 6 where an employment benefit will

not be taxable to the employee. Some of the more common statutory non-taxable benefits contained in paragraph 6(1)(a) include:

o A group sickness or accident insurance plan and a private health services plan (subparagraph 6(1)(a)(i)),

o Benefits from counselling services in respect of the mental or physical health of the taxpayer (or an individual related to the taxpayer) or the re-employment or retirement of the taxpayer (subparagraph 6(1)(a)(iv), and

o Education assistance to someone other than the taxpayer (i.e. a child) if it is reasonable to conclude that the benefit is not a substitute for salary, wages, or other remuneration of the taxpayer

Common Law Exceptions

● In addition to statutory exceptions, the courts have developed a common law test called “the primary

beneficiary” test to determine whether an employee has received or enjoyed a taxable employment benefit.104 This two-part test is applied as follows:

o 1st – Did the item under review provide the employee with “an economic advantage that is measurable in monetary terms”?

▪ If the answer is yes, then you go to the second question; if the answer is no, then the

employee does not have a taxable benefit and the analysis is over.o 2nd – if an advantage was provided, who was the primary beneficiary – the employer or the

employee?

▪ The FCA has described this as an “all or nothing test”105

▪ If the answer is that the employer is the primary beneficiary, then the employee will

not have to report a taxable benefit (even if the employee did benefit somewhat).

▪ Conversely, if the answer is that the employee is the primary beneficiary, then the

employee will have to report the full value of the item as a taxable benefit (even though the employer might also benefit)

● Examples:

o Parking: if the employer provides free parking to an employee (for which there is otherwise a charge), then the employee will generally be considered to be the primary beneficiary (and will

104 See e.g. Lowe v Canada, [1996] 2 C.T.C. 33 (F.C.A.)105 To a certain extent, I agree with this characterization, but where a trip has distinct business and personal components (i.e. like a personal/holiday extension after the programmed events have concluded), judges have not hesitated to partition the trips into 2 components, with the second component being found primarily for the benefit of the employee (and hence fully taxable) © Sprysak 2019

TAXATION


have to report a taxable benefit) unless the employee is regularly required as part of his/her job to use his/her car (in which case it will be a non-taxable benefit)

o Fitness memberships: despite all of the health and productivity benefits to employees who exercise regularly, the courts have generally held that unless the employee’s job has minimum physical requirements (i.e. a police officer, fire fighter, etc.), the employee is the primary beneficiary of an employer-provided fitness membership

o Continuing Education: if the employer pays for the cost of an employee taking a course that is related to the employee’s job responsibilities, then the courts have generally found the employer to be the primary beneficiary and, as such, the course is a non-taxable benefit to the employee. Conversely, if the course is unrelated to the employee’s work (i.e. course on learning how to golf), then the courts have found the employee to be the primary beneficiary and hence a taxable benefit.

● Practice Point: while the “primary beneficiary test” may seem quite straightforward in theory, its

application can result in various outcomes depending upon the particular facts in issue (and the particular judge deciding the appeal)

o Some judges (and commentators) take the view that the primary beneficiary test is to be applied more “objectively” or “generically” – you consider the facts to determine generally who is the primary beneficiary of the expenditure

o Other judges, particularly in more recent years, take the view that in addition to applying the test generically, you also consider whether the particular taxpayer in the case “subjectively” enjoyed a benefit

● Rachfalowski v R, [2009] 1 C.T.C. 2073 (TCC)

o Ratio: Look to the particular taxpayer circumstances to determine if there is a benefit.o Facts: Mr. Rachfalowski was a VP (Investment Department) for Canada Life. As part of the

employment package for a VP, he was entitled to a membership, fully paid by Canada Life, at a private golf club of his choice provided it offered year-round dining privileges.

o Canada Life wanted him (like all other VPs) to have this “perk” because: (a) it would allow him to take important clients out golfing and for dinner, (b) it was a status symbol for the rest of the company (i.e. work hard, climb the ladder, become a VP, get a fully paid golf membership – among other benefits), and (c) it was a status symbol to the public (i.e. Canada Life is doing so well, its VPs get fully-paid golf memberships)

o Question: What was the problem with this?

▪ Answer: Very simply, Rachfalowski hated golf!

o He initially refused the membership; Canada Life insisted. He asked to get a membership at a curling club instead; Canada Life refused. He asked to receive the “cash equivalent” of the membership fees; Canada Life said “no”. He reluctantly took the membership (what other choice did he have?) but rarely used it (took his wife out for dinner a few times and went golfing with clients once or twice).

© Sprysak 2019

TAXATION


o In short, he didn’t enjoy it at all and barely used it!

o Issue: should R have to include the value of the employer-provided golf membership in his income for tax purposes?

▪ CRA said “yes” and reassessed Rachfalowski’s return (as he did not include the amount

when filing) o Analysis: Chief Justice Bowman (as he then was) agreed with Rachfalowski - no taxable benefit

– for 2 reasons.

▪ 1st – Chief Justice Bowman found that the primary benefit of the expenditure was Canada

Life (the employer) – it enhanced company’s image and provided a place to entertain company clients

▪ 2nd – Chief Justice Bowman ALSO said you must, as part of the analysis, look at the issue

in the taxpayer’s particular factual circumstances - and doing so in this case, it was clear that Rachfalowski derived no personal benefit from the membership

Administrative Exceptions

● The CRA has had a longstanding practice of taking positions (and publishing – unfortunately, in a

variety of different forms) what it feels to be non-taxable benefits outside of what has been pronounced by the courts in specific cases.

● For the longest time, the CRA had an Interpretation Bulletin IT-470R – Employee Fringe Benefits,

which contained many of its administrative exceptions (as well as taxable employment benefitso This was replaced by Folio S2-F3-C2, “Benefits and Allowances Received from

Employment” (7 July 2016) – although the CRA “pulled” this Folio after a controversy arose from a change in its position regarding the treatment of staff discounts

▪ To date, it still has not re-released this Folio, opting instead to rely on its Employers’

Guide: Taxable Benefits and Allowances (T4130)

● Valuation

● After determining that an employee has received or enjoyed a taxable employment benefit, the next step

is to value that benefit to determine the income inclusion.o Practice Point: generally speaking, the Act does not specify how to do this, which has resulted

in some uncertainty and diversity in the case law.

● Example: in lieu of paying faculty and support staff “cost of living” increases, suppose that the

University offers (and all staff accept) to provide free educational services (i.e. tuition) for any children of current employees.

© Sprysak 2019

TAXATION


o Question: assuming that the primary beneficiaries of this program are this the University staff members, how might you value it?

o Answer: What’s the cost to the school? What’s the incremental cost of putting another student in a seat? It benefits the school to have their professors’ children going to that school. This reasoning is used in private school cases (where teachers are contractually obligated to send their children to that school)

Stock Options

● Stock options can be offered to (key) employees as a way of motivating them by aligning their interests

with the company’s interests (i.e. as the company does well and appreciates in value, so too does the employee’s options)

o Under an option contract, an employee is given the legal right to purchase a certain quantity of company shares at a pre-determined fixed price.

▪Where the option price is more than the current trading price (value) for the shares, the

options are essentially worthless to the employee at that point in time (“out of the money”); the employee is better off purchasing the shares (if s/he can) at the current value on the open market.

▪ However, where the option price is less than the current trading price (value), then the

employee gets an instant (and generally risk-free) return if s/he exercises the options and purchases shares at the option price (i.e. gets the shares “on sale”; option is “in the money”)

● There are three time periods that are important in assessing the income tax consequences of employment

stock options, namely: the Option Grant Date, the Option Exercise Date, and the Selling Date

● It is also necessary to know whether:

o The employer corporation granting the options is a public corporation or a Canadian-controlled private corporation (CCPC);

o The employer corporation and the employee are acting at “arm’s length”;106 ando The option is “in the money” when granted (i.e. less than the FMV for the shares).

● Options Issued by a Public Company:

o Option Grant Date: no tax implications to the employee o Option Exercise Date: the employee has to report a taxable employment benefit equal to the

amount the FMV of the shares exceed the option price, multiplied by the number of shares

106 Section 251 describes when persons will not be acting at arm’s length for tax purposes. More specifically, paragraph 251(1)(a) provides that “related persons” shall be deemed not to act at arm’s length with each other (and subsection 251(2) defines who “related persons” are – including a person who controls a corporation). Finally, paragraph 251(1)(c) provides that it is a question of fact whether persons not related to each other are acting at arm’s length. © Sprysak 2019

TAXATION


purchased under the option contract in the year the options are exercised and the shares are purchased

▪ If the options were not “in the money” when granted to the employee, then the employee

can claim a paragraph 110(1)(d) deduction equal to ½ of the employment income inclusion (but this is a deduction in the calculation of taxable income, rather than employment income)

▪ In contrast, if the options were “in the money” when granted, then the employee does not

get the paragraph 110(1)(d) deduction and has to report and pay tax on the full employment gain

o Selling Date: the employee will report a capital gain (or loss) equal to the difference between the selling price and the exercise price (i.e. the FMV of the shares at the time the options are exercised) in the year the shares are sold

▪ This way if you bought “in the money,” then you’re not paying tax (again) on the

disparity between the FMV at the time of purchase and the option price.

▪ There is a tax benefit by claiming the para 110(1)(d) deduction, so you only have to pay

tax on half of the taxable employment benefit (difference between FMV and option price).

▪ Note: claiming the paragraph 110(1)(d) deduction does not affect the ACB of the shares

acquired for purposes of calculating the capital gain or loss on disposition.

● In the year of sale, the adjusted cost base (ACB) is the FMV at the time of

purchase.

● Options Issued by a CCPC:

o Option Grant Date: no tax implications to the employee o Option Exercise Date:

▪ In the case of options issued by a CCPC, the employee still calculates a taxable

employment benefit equal to the amount the FMV of the shares exceed the option price, multiplied by the number of shares purchased under the option contract;

▪ However, the benefit does not have to be reported until the year the employee sells the

shares if the employee and the CCPC are acting at arm’s length

▪ Like for public company options, if the options were not “in the money” when granted to

the employee, then the employee can claim a paragraph 110(1)(d) deduction equal to ½ of the employment income inclusion

● Note: this deduction is recognized in the same year that the employment gain© Sprysak 2019

TAXATION


▪ Alternatively, if the options were “in the money” when granted, but the employee holds

the shares for at least 24 months, then the employee can claim a paragraph 110(1)(d.1) deduction equal to ½ of the employment income inclusion

o Selling Date:

▪ Like in the case of public company options, the employee will report a capital gain (or

loss) equal to the difference between the selling price and the exercise price (i.e. the FMV of the shares at the time the options are exercised) in the year the shares are sold

▪ However, in addition, the employee will report a taxable employment benefit in the year

the shares are sold.

Employment Deductions

● Starting Point: subsection 8(2) provides that unless the deduction is specifically provided for in this

section (or another section in the Act), an employee cannot claim a deduction in calculating his/her employment income.

o As noted early, this approach to employment deductions makes it more attractive to provide services as an independent contractor since the general rule contained in paragraph 18(1)(a) is effectively the opposite – an expense that was incurred for the purposes of earning business or property income is deductible unless the Act (typically in section 18) explicitly prohibits it (or sets out a specific method of calculation – typically under section 20)

● Some of the common deductions in section 8 include:

o Legal expenses (paragraph 8(1)(b)): where the legal expenses were incurred to fight for an amount that, if received, would be reported as employment income for tax purposes.

o Sales Expenses (paragraph 8(1)(f)): includes non-capital expenditures (i.e. travel expenses and motor vehicle expenses) incurred by employees who earn commissions

o Travel Expenses (paragraph 8(1)(h)) and motor vehicle travel expenses (paragraph 8(1)(h.1)): available to all employees who:

▪ Ordinarily carry on their employment duties away from the employer’s place of

business, and

▪Was required under their employment contract to pay these expenses

o Dues and other expenses of performing duties (paragraph 8(1)(i))

▪ E.g., law society dues – primary beneficiary is the law firm, so if they pay for your dues

then that’s deductible for them as well.

▪ Exam: What would be better? Having the law firm pay the $3000 dues or having them

give you $3000 more each year and then you pay and deduct it?© Sprysak 2019

TAXATION


● Spencer says it’d be the same, if that means anything.

o Motor vehicle costs (paragraph 8(1)(j): this would include CCA and interest costs pro-rated for the employee’s work use

o Home office expenses (subsection 8(13)): to claim an expense for a home office, the work space is either

▪ The place where the employee principally (i.e. more than 50%) performs his or her

employment duties, or

▪ Used exclusively for the purpose of earning employment income and used on a regular

or continuous basis for meeting customers or other persons in the ordinary course of performing his/her employment duties.

▪ Further, the deduction can only be for non-capital expenses and cannot exceed the

employment income that is generated by the home office – with the ability to carry forward any excess expenses.

● Caution: for several of these expenses, in order for them to be deductible, in addition to the employee

being required to incur them as part of his/her employment, the employer must fill out a certificate (T2200 – Declaration of Conditions of Employment) as per subsection 8(10) which the employee must include in his/her tax return in order to get a deduction.

© Sprysak 2019

TAXATION

Unit #7 – Business and Property Income

What is a Business for Income Tax Purposes (and What Is Not)? 107

● According to subsection 248(1), a “business” “includes a profession, calling, trade, manufacture or undertaking of any kind whatever and... an adventure in the nature of trade, but does not include an office or employment”.

● In Smith v Anderson (1880), 15 Ch. D. 247 (Eng. C.A.) which was referred to favourably in the Supreme Court of Canada’s decision Stewart (at para 51), a “business” was described as “anything which occupies the time and attention and labour of a man for the pursuit of profit”.

● In his text (page 263), Professor Krishna describes the “quintessential characteristics” of a business being “activity, enterprise, entrepreneurship, commercial risk, and the pursuit of profit”.

● An “adventure in the nature of trade” has been defined by the courts as “an isolated transaction (which lacks the frequency or system of a trade) in which the taxpayer buys property with the intention of selling it at a profit and then sells it (normally at a profit but sometimes at a loss)”.

o The courts have also generally stated that to be “an adventure in the nature of trade”, there must be a “scheme for profit making” (although where a taxpayer’s activity is very financially successful, it often won’t take much for a court to find such a scheme/intention)

o Put another way (in my words), an adventure in the nature of trade is an isolated transaction that is carried out in roughly the same manner as someone in that “business” would carry out multiple/repeated transactions

o Its purpose is to prevent a one-time non-taxable gain (i.e. someone who flips one house)

● The leading case on whether an activity constitutes a business (and hence a source of income for tax

purposes) continues to be Stewart v R, [2002] 2 S.C.R. 645o Facts: Stewart was an experienced real estate investor who purchased four condominium units

(largely using debt) with the intention of renting out the condominiums to generate income.o Given the high amount of debt and associated interest involved in the acquisition, Stewart

projected that it would take roughly 10 years before he paid off enough debt for the expected rental income to exceed the interest expense (and hence make the investments profitable).

o As it turned out, he was correct. During the years in question (1990-1992), Stewart lost $27,814, $18,673 and $12,306 respectively.

o The CRA denied the deductibility of the losses suffered by Stewart for tax purposes on the basis that this investment did not constitute a source of income under the Act (i.e. he was not carrying on a “business” or an “investment/property” activity)

▪ In both the case law and the tax literature, these types of activities (that fall outside the

scope of the definition of a business – and the Act more generally) are commonly referred to as “hobbies”

107 This is essentially a section 3 question – does an activity that gives rise to positive receipts (or perhaps financial losses) fall within the scope of the Act? If it does not, then the receipts are not taxable and any losses are not deductible.© Sprysak 2019

TAXATION


o After his appeal was dismissed by Tax Court and the Federal Court of Appeal, Stewart was granted leave to appeal to the Supreme Court of Canada (another example of persistence paying off)

o Analysis/Decision: To determine if an activity constitutes a “source of income”, you must answer the following two questions – (1) did the taxpayer intend to carry on the particular activity in question in pursuit of profit and (2) is there objective evidence to support that intention (i.e. that the activity has been carried out in accordance with objective standards of businesslike behaviour – as opposed to as an activity for personal enjoyment)?

▪ If the activity was undertaken solely in pursuit of profit and there is sufficient objective

evidence to support this conclusion, which were the facts in the case, then:

● The activity is a commercial activity and constitutes a source of income for tax

purposes;

● The next step is to determine (primarily by reference to the level of activity)

whether the activity constitutes a “business” or a “property/investment” activity; and

● The final step is to apply the relevant legislative provisions (i.e. sections 9, 12,

18, 20 and 67) to calculate the taxable income from the activity

▪ If the activity was carried out partially in pursuit of profit and partially for personal

reasons/enjoyment,108 then:

● In order for the activity to constitute a source of income for tax purposes, the

activity must have sufficient “indicia of commerciality”;

● In assessing whether this threshold is met, the CRA and Tax Court will consider

such things including:o Whether the activity had a “reasonable expectation of profit”,109 o What special skills (if any) the taxpayer possesses and used to carry on

this activity as a business, o To what degree the taxpayer was acting like a person would who carries

on this type of activity/business, etc.;

● If this activity meets the threshold, then even though there may also be some

“personal” (i.e. non-income earning) reasons for engaging in the activity, this

108 An example might be purchasing a rental property and then renting it out to a family member at a slightly reduced rate.109 This test came from an obiter comment made by Justice Dickson’s in his decision in Moldowan v R, [1978] 1 S.C.R. 480 (quoted at para 24 in Stewart) that “it is now accepted that in order to have a “source of income” the taxpayer must have a profit or a reasonable expectation of profit”© Sprysak 2019

TAXATION


doesn’t preclude the activity from being treated as a source of income with any associated net income being taxable and any net losses from being deductible.

● Of course, any personal expenses associated with the activity will be denied for

tax purposes pursuant to paragraphs 18(1)(a) and (h)110

▪ If the taxpayer did not intend to carry on the particular activity in question in pursuit of

profit and there is insufficient objective evidence to the contrary,111 then the activity (a) will be characterized as a hobby, (b) will not constitute a source of income under the Act, consequently (c) the expenses (and associated revenue/income) will not be deductible/taxable112

o Good summary by the Court at para 60:

▪ In summary, the issue of whether or not a taxpayer has a source of income is to be determined by looking at

the commerciality of the activity in question. Where the activity contains no personal element and is clearly commercial, no further inquiry is necessary. Where the activity could be classified as a personal pursuit, then it must be determined whether or not the activity is being carried on in a sufficiently commercial manner to constitute a source of income. However, to deny the deduction of losses on the simple ground that the losses signify that no business (or property) source exists is contrary to the words and scheme of the Act. Whether or not a business exists is a separate question from the deductibility of expenses.

o Applying approach to the facts in issue, Stewart’s activity was clearly and solely engaged in pursuit of profit (with no personal/hobby motivations) and hence constituted a source of income under the Act. Consequently, the appeal was allowed and Stewart’s losses were deductible.

Business Income Distinguished from Property Income

● As casually noted in the Stewart case, in many cases, there is not a lot of difference between earning income

from business and property for income tax purposes.

● Indeed, the rules for calculating income from business and property are generally the same

o Section 9, which is the first key section in the calculation of taxable income, states that “a taxpayer’s income for a taxation year from a business or property is the taxpayer’s profit from that business or property”

● That said, there are a few exceptions where it is necessary to distinguish between income from business and

income from property. Some of the more common exceptions include:o Access to the small business deduction (subsection 125(1)):

110 See the Supreme Court of Canada’s decision in Symes for a comprehensive discussion of the issues/considerations involved with determining whether expenses that have income-earning and personal components can be deducted for tax purposes.111 Of course, it is conceivable that some taxpayers may state that they had no subjective intention to profit (particularly where they did profit) to avoid having to pay taxes on their profits – but if the objective evidence contracts this, the court will generally follow the objective evidence as characterize the activity as a taxable business/investment activity112 An example could be purchasing a vacation/retirement property in Victoria and then very occasionally renting it out to family and close friends for a nominal amount.© Sprysak 2019

TAXATION


▪While described in the Act as a deduction, it is actually a rate reduction that is only

potentially available to Canadian controlled private corporations (CCPCs) earning up to $500,000 of “active business income” in its taxation year

▪Where it applies,113 it reduces the combined Federal and Alberta corporate tax rate to 12%

(for 2018)114

▪ For our purposes, corporate “active business income” is equivalent to “business income”

earned by an individual

▪ Put another way, the small business deduction is not available in respect of property income

earned by a corporation (which is called “specified investment business” income in subsection 125(7))

o Attribution Rules: As we have previously discussed, because of (1) Canada’s longstanding tax policy decision to tax individuals rather than couples/families, coupled with (2) our progressive rate regime, there is an incentive to couples/families to try to equalize incomes (i.e. transfer income for taxation purposes from a higher-income taxpayer to a lower-income taxpayer to take advantage of the lower-income taxpayer’s lower marginal rates).

▪ This is commonly referred to as “income splitting” or, as described in the 2017 consultation

document “Tax Planning Using Private Corporations”, “income sprinkling”.

▪While in some cases, this is allowed (or even encouraged by the Act115), in other cases, there

are legislative provisions (commonly referred to as “attribution rules”) which limit this tax saving strategy.116

▪With some exceptions, these anti-income splitting rules are generally directed to prevent

income sprinkling/splitting of property income and not business income. o Registered Retirement Savings Plans (RRSPs): earning business income is one of the primary

ways of accumulating the entitlement to contribute to an RRSP (with earning employment income being the other common way); in contrast, earning property income (other than rental of real property and royalties to the inventor, which do count) does not give a taxpayer the entitlement to contribute to an RRSP.

Types of Property Income

113 Note: in addition to the Federal small business deduction (which for 2018 is 18% - and which will be increased to 19% for 2019), the provinces and territories typically assess a reduced rate on corporate income eligible for the Federal small business deduction. For 2018, the Alberta corporate tax rate on such income is 2%. 114 For 2019, the combined Federal and Alberta corporate tax rate on active business income eligible for the small business deduction is 11%. 115 Examples that we address in the Estate Planning course include the use of Registered Education Savings Plans, Registered Retirement Savings Plans (and spousal RRSPs specifically) and Tax Free Savings Accounts.116 Another limiting provision is section 120.4 which subjects “split income” to tax at the highest marginal rate© Sprysak 2019

TAXATION


● Generally speaking, there are four main types of property income: interest, dividends, rents and royalties

o For each of these types of income, the income is derived primarily from the ownership of the underlying property which generates economic rent

o Where an individual earns one (or more) of these types of income, it will typically be characterized as property/investment income

o That said, this characterization is contextual and will additionally depend on the level of the taxpayer’s activity in relation to the creation/receipt of this income.

▪Where the level of activity is low, such that it can be fairly said that the individual is a

passive investor who derives income from the mere ownership of the property, then it is likely that such income will be characterized as property/investment income to that individual

▪ However, as the level of activity increases, then it becomes more likely that the individual

will be characterized for tax purposes as carrying on a “business”

▪ Common examples: landlord (investment) vs. hotel operator (business), purchasing a Canada

Savings Bond (investment) vs. selling/managing millions of dollars of mortgages (business)

A Brief Overview of the Taxation of Interest vs Dividend Income 117

● Generally speaking, there are no special rules regarding the taxation of interest income.

o Paragraph 12(1)(c) generally provides that the full amount of interest “received or receivable” (depending on how the taxpayer’s reports his/her income for tax purposes) must be included in the taxpayer’s return

● In contrast, as we previously discussed, in the case of dividend income, to accomplish the principle of

integration, dividends received by an individual shareholder must be grossed up (in theory, to reflect the pre-tax corporate income) before the individual’s applicable marginal tax rate is applied to determine the initial personal tax liability.

o Also as we previously (and briefly) discussed, this initial tax liability is reduced by a dividend tax credit (in theory, to reflect the corporate taxes already paid on the corporate income used to pay the dividend)

● While an in-depth discussion of these calculations are beyond the scope of this course (and part of the

Corporate Taxation course), for our purposes, it is helpful to note that the amount of the gross up and the dividend tax credit depend on how the income was taxed at the corporate level

o Where, generally speaking, the corporate income was taxed at full corporate rates and not reduced by the small business deduction (which is generally the case for income earned by public

117 Generally speaking, rental and royalty income are taxed the same as interest income.© Sprysak 2019

TAXATION


corporations), the dividend (called an “eligible dividend”118) is “eligible” for an enhanced gross up of 38% of the dividend received and a tax credit of 25.02% of the grossed up dividend (15.02% federally; 10% for Alberta tax purposes)

o Where the corporate income was eligible for the small business deduction (i.e. “active business income” earned by a Canadian controlled private corporation (CCPC)), the dividend (commonly referred to as a “non-eligible” dividend), is subject to a gross up of 16% of the dividend received and a tax credit of 12.1% of the grossed up dividend (10.03% federally; 2.07% for Alberta tax purposes)

o Planning Point: Eligible dividends allow you to collect more than just interest. So if you have a choice between a bond (which collects interest) or a public company’s stocks (which pays equal dividends) then it is advantageous to go with the dividend.

▪ i.e., 10% dividend rate > 10% interest rate *from a tax perspective*

Business Income Distinguished from Capital Gains

● Whereas it is often more beneficial from a tax perspective to earn business income than employment

income, it is currently more beneficial to realize capital gains rather than earn business income due to the (current) 50% inclusion rate for capital gains

o Qualify this statement - a person would much rather have a taxable capital gain than business income.

o However, a person would much rather have a business loss than an allowable capital loss, since:

▪ Allowable capital losses are only deductible against taxable capital gains whereas business

losses are deductible against any other source of income, and

▪ 100% of business losses are deductible, whereas only 50% of net capital losses are deductible

● Just as there are many similarities and sometime subtle differences between business and property income,

so too is the case of business income and capital gains.o More specifically, in both cases, the taxpayer is selling an asset.

● As already briefly discussed, to determine whether a gain/loss is a business or a capital gain/loss, you must

first characterize the asset being disposed of.o If it is characterized (for tax purposes) as a capital asset, then the gain/loss on disposition will be a

capital gain/losso Conversely, if the asset is properly characterized as a business asset (commonly referred to as

“inventory”), then the gain/loss on disposition will be a business gain/loss119

118 Subsection 89(1)119 While subsection 248(1) does contain a definition of “inventory” – “a description of property the cost or value of which is relevant in computing a taxpayer’s income from a business…” – as it is somewhat circular (at least for our purposes), it is not helpful for our current purpose/discussion.© Sprysak 2019

TAXATION


● As the Act does not specify how to do this characterization, we must look to the case law. As you might

expect (given how common selling assets is and the tax advantages of a particular characterization), there is a lot of case law.120

o This case law has created the “primary” and “secondary intention” tests.121

o Important Point: generally speaking, these tests are applied at the time of acquisition of the asset (as opposed to the time of sale)

● Primary intention test: when the taxpayer acquired the asset, did he/she primarily intend to (a) sell the

asset for a profit, or (b) use the asset (either to generate income or for personal purposes)? o If it is the former (i.e. to sell for a profit), then generally speaking, the asset will constitute a

business/inventory acquisition and any subsequent gain or loss on the sale will be on account of business income (i.e. business gain/loss).

▪ If this is the answer to the primary intention test (and we will discuss how the court arrives at

this answer shortly), then you are done and do not have to go on to consider the “secondary intention” test.

▪ If it is for profit, it’s a business asset/inventory.

o However, if it is the latter (i.e. to use the asset), then the asset will constitute a “capital asset” unless the secondary intention test overrides this result.

▪ Use can be anything from generating income to personal enjoyment

● Secondary Intention Test: did the taxpayer have a secondary intention to sell the asset for a profit if the

primary intention was frustrated which motivated the taxpayer to purchase the asset (a “can’t lose situation” – my words)

o If the answer is yes, then the secondary intention test will override the results of applying the primary intention test and will characterize the asset (and hence the gain) as a business asset/gain.

o Consequently, it is only where a taxpayer didn’t have such a secondary intention to sell the asset for a profit that the acquisition be a capital acquisition and the gain when the asset is sold a capital gain.

● Important Point: the courts have generally stated that the possibility of early resale at a profit must have

been a motivating consideration at the time of acquisition of the property for the secondary intention test to make the acquisition a business acquisition.

o A mere intention to sell the asset for profit, cost, or a loss if the initial intention does not work out merely indicates a prudent investment decision and does not imply a secondary intention to engage in business or an adventure in the nature of trade.

120 A couple of the commonly cited Supreme Court of Canada cases include: Regal Heights Ltd. v Minister of National Revenue [1960] S.C.R. 902 and Friesen v Canada, [1995] 3 S.C.R. 103. Another commonly-cited case is Canada Safeway Ltd v R, 2008 FCA 24121 See e.g. Friesen v Canada, [1995] 3 S.C.R. 103 at paras 25-27. © Sprysak 2019

TAXATION


o However, there is a difference between a taxpayer who responds to a changing investment climate and a taxpayer who actively contemplates the potential of profit on resale at the time of the investment. Where the potential of profit from a quick sale is a motivating consideration, it suggests a secondary intention to engage in an adventure in the nature of trade (and hence business income treatment)

● Summary: Therefore, a taxpayer who claims that a gain is a capital gain must show two things: (1) that

his/her primary intention at the time of entering into the transaction was to make a capital investment, and (2) that he/she had no secondary intention at that time to trade in the particular property which motivated the taxpayer to make the purchase.

● To determine what the taxpayer’s intention was, generally speaking, a court will give more weight to the

taxpayer’s actions and conduct rather than any court statements (although to the extent that these statements are supported by his/her actions, they will likely be more credible)

● More specifically, a court will consider:

o Number of Similar Transactions: evidence of similar prior transactions is some evidence that the taxpayer is a trader and engages in this type of business - and the greater the number of prior transactions, the greater the possibility that this is business income (as opposed to capital).

o Return on Investment: how could a reasonable person have expected to make money through the acquisition and ownership of the property?

▪ If only way to get a reasonable rate of return is through the resale of the property, then

probably on account of business - these types of assets are referred to as “trading assets”

▪ In contrast, assets with a potential (even if somewhat remote) to yield income are generally

viewed as investment assets - for example, corporate shares with dividend rightso How does this Transaction Relate to the Taxpayer’s Business? A taxpayer’s profits from

transactions that are closely associated to her other ordinary business activities are usually characterized as business income.

▪ There is a strong presumption that a transaction connected in any way with a taxpayer’s usual

business is intrinsically part of that business - although this presumption is rebuttableo Degree of Organization: where a taxpayer deals with property in much the same way as a dealer

would with similar property, then any resulting profit is likely to be characterized as business income.

▪ This is effectively what an “adventure in the nature of trade” is

o Length of Ownership: if an asset is bought and sold in a relatively short period of time, then this suggests that the taxpayer may have bought the asset with the intention to sell

© Sprysak 2019

TAXATION


▪ That said, the courts have cautioned taxpayers that the converse (i.e. a longer ownership

period) is not necessarily reflective of a capital intention – particularly where the taxpayer really isn’t using it (or using it reasonably) during her ownership (i.e. buying land and then doing nothing/little with it)

▪ Important Point:

o Nature of Asset: the nature of the asset can be important in the characterization of any gain/loss from its disposition. This criteria can sometimes (almost) be determinative on its own.

▪ Land, especially raw land, (or the shares of a corporation set up to hold raw land) is

presumptively viewed as a business asset – bought to sell for a profit – but this is a rebuttable presumption (taxpayer can bring evidence to show that intention was to use the land to generate income)

▪ In contrast, corporate shares are presumptively viewed as a capital investment

● When a person buys shares, unless that person is a broker or day trader, you are

buying with the intention of owning those shares and keeping them to generate dividend income.

● Unless shares are not entitled to dividends or where the corporation has taken the

position that there will not be dividends for the foreseeable future.

● If there are no dividends, shares will likely be characterized as being bought

with the intention to sell to make a profit.

Characterizing an Asset and Characterizing the Income from that Asset

● When a taxpayer acquires an asset, there are two tax questions that must be considered:

o How will the asset be characterized for tax purposes?o How will any income derived from that asset be characterized?

● The 1st question will determine how to characterize the gain or loss on disposition, the 2nd question will

determine how to report the income generated by the asset while owned.

● For example, with respect to the purchase of a residential condominium unit:

o It may have been purchased to sell for a profit – in which case when the condo is sold, the gain will be a 100% includable business gain.

o Alternatively, it may have been purchased to use (with no secondary intention to flip) – in which case, when sold, the gain will be a 50% taxable capital gain.

© Sprysak 2019

TAXATION


o Regardless of which of the 2 scenarios apply, the condo might be rented out during the period of ownership. Depending on the level of activity associated with renting the condo out, such rental income might constitute business (i.e. hotel) or property income (merely renting out the space).

o In short, when you have an asset that is generating income, there are 2 characterizations that have to be made – the characterization of the income generated by the asset (if any) and the characterization of the gain/loss on disposition.

o Put simply, even though by virtue of the primary and secondary intention tests, an asset may be properly characterized as a capital asset, such a capital asset may generate business or property income while it is owned and being used.

▪ Renting out a house that you bought with the primary intention of selling – rental income is

characterized as property income since it’s passive, not active.

▪ Characterization of the property does not necessarily extend to the characterization of

the income.

The Election for Capital Gains Treatment

● Given this uncertainty as to when a sale will be on account of income vs. capital, subsection 39(4) was

enacted to give taxpayers (both individuals and corporations) the option to elect that all dispositions of “Canadian securities” (subsection 39(6) - share of the capital stock of a Canadian resident corporation, etc.) will be deemed to be on account of capital.

o Note: once a taxpayer elects to have gains from the sales of Canadian securities to be on account of capital, then all subsequent dispositions will be treated as such. In other words, once the election is made, the taxpayer cannot pick and choose which share sales will be on account of income and which will be on account of capital.

o This means that while any gains from such sales will be capital gains, any losses from such sales will be capital losses.

o Note: this election is generally not available to dealers/traders

● The election to be completed is a T123 election form.

The Calculation of Income from a Business or Property

● In calculating business income, there is, effectively, a 6 step approach

● Step #1 - Is there a source of income pursuant to section 3 (i.e. a Stewart analysis)?

● Step #2 - Assuming that it is a source (and, more particularly, income from business or property), then next step is to apply section 9, which essentially imports a non-tax calculation of income (profit) as the starting point to the calculation of business/property income for tax purposes.

o While the case law emphasizes that “income for tax purposes” is a legal concept (and not something determined by the accountants and “generally accepted accounting principles” and/or international

© Sprysak 2019

TAXATION


financial reporting standards (IFRS)), it is also important to note that we start with a commercial, GAAP/IFRS, number and then modify it to make it a “tax number”.

▪ By implication, this means that there may be several possible ways to calculate “profit” – and generally speaking, they may all be suitable as the starting point for tax purposes

o Effectively, the test in section 9 is whether the expense (or revenue - although less often an issue) would be included in the calculation of profit using “well accepted principles of business (or accounting) practice” or “well accepted principles of commercial trading”122

▪ FCA in Tonn also states that “profit” implies and requires that there be an intention to make a profit - there must be an income earning purpose to the activity

o Note: in practice, this can be more difficult than it sounds, since many expenses might be incurred both for an income earning purpose and for personal purposes (or to satisfy a “non-business need” – see Symes)

o This section/test is also important in that it screens out “capital expenses”, which are expenses that are generally incurred for the purpose of bringing into existence “an asset of enduring benefit” (i.e. a building, computer, etc.) and which are not generally included in the calculation of “profit” (since their useful life is more than one taxation year)

▪ Instead of deducting capital acquisitions, they are generally reported on the balance sheet as an (capital) asset

▪ As we will see in Step #4, to be sure, there is a specific prohibition in paragraph 18(1)(b) against deducting capital acquisitions in calculating Net Income for Tax Purposes

● Step #3 - apply section 12 to (possibly) increase income for tax purposes.

o Section 12 (Income Inclusions) effectively provides that there are certain amounts that have to be included in income/profit from a business or property even if these amounts would strictly speaking not be included in the calculation of income for commercial purposes (or not in a particular period).

o The general rule is set out in paragraph 12(1)(b) – you recognize revenue when you have done everything necessary to become entitled to payment (i.e. sold property or provided services) even though you might not be entitled to payment at this time.

▪ This is the recognition event for business revenue – which looks to substance rather than cash (which is the recognition rule for employment income)

▪ This revenue rule is more generally part of “accrual accounting”

▪ On the expense side, you do not generally record an expense until (a) you are legally liable for the expense, and (b) you can estimate the amount of the liability with reasonable accuracy.

o Caution: there are many exceptions to these rules. One of the most common exceptions is the “matching principle”, which generally provides that for particular expenses that relate to particular revenue streams, you must “match” the expenses to revenue

122 Symes v R, [1993] 4 S.C.R. 695© Sprysak 2019

TAXATION


o Other important rules in section 12:

▪ Paragraph 12(1)(a): recognize an amount that has been received in respect of services to be rendered or goods to be delivered in the future (brings prepaid revenue and deposits into tax revenue)

▪ Paragraph 12(1)(g): recognize any amounts received by the taxpayer that was dependent upon the use or production from property (e.g., earn-outs) whether or not it was an instalment on the sale price of the property (excluding agricultural land)

● Note: this is a potentially punitive provision – converts what would otherwise be a 50% includable taxable capital gain into a 100% includable business gain – be careful!

● You do not want to accidentally trigger this provision.

● Step #4 - Even though a particular expense/deduction may be allowed for purposes of calculating “profit” using ordinary principles of commercial trading and well accepted principles of business, there are certain expenses that are expressly prohibited from being deducted in calculating business and property income for tax purposes by virtue of section 18. For example:

o Paragraph 18(1)(a) is a general limitation against deductibility of expenses unless it was incurred for the purpose of gaining or producing income from a business or property

▪ Put another way, the expense must have been incurred within a business framework, bearing some relation to the income earning process

▪ The FCA in Tonn noted that this is a “subjective intention” test - there is no objective reasonability required by the statutory provision

▪ Also, it is important to note that this is a “purpose” test and not a “results” test. Consequently, even though the expense may not generate any business income, it will be deductible (assuming it otherwise satisfies all of the requirements)

▪ Finally, it is the primary purpose of the expenditure that is relevant in determining its deductibility.

o Paragraph 18(1)(h) is a restriction against the deductibility of “personal or living expenses” other than travel expenses incurred by the taxpayer while away from home in the course of carrying on the taxpayer’s business

▪ FCA finds that there is further overlap here with paragraph 18(1)(a) - but the Court also goes on to find that this paragraph creates an objective test as to what is personal in nature

▪ “Personal and living expenses” are defined in subsection 248(1) to include “the expenses of properties maintained by any person for the use or benefit of the taxpayer or any person connected with the taxpayer… and not maintained in connection with a business…”

© Sprysak 2019

TAXATION


● This appears to set up a bright line test between business expenses, which generally will be deductible for tax purposes, and personal expenses, which generally will not.

● As we have already discussed (and as briefly set out in Tonn), in practice, in can be difficult to differentiate between business and personal expenses (since they could arguably belong in both categories) just as it can be difficult to distinguish between business and capital expenditures123

▪ Generally speaking, judges will determine whether an expense is a deductible business expense or a non-deductible personal and living expense based upon its primary purpose. In “difficult” cases (i.e. childcare), judges may additionally consider:124

● Whether the expense would be incurred (and to the same extent) regardless of the business activity?

● What “specific business need” does the expense satisfy (and is this need intrinsic to the business)?

● Does the expense make the taxpayer available to the business (which would constitute a “personal” expense) or is it part of the business (which would be a “business” expense)?

● Historically, how has this particular expense been treated for tax purposes?

o Childcare is dealt with by its own provision.o Powerade/water/food for a bike courier may be a business expense (analogous

to fueling a car).o Paragraph 18(1)(b): disallows the deduction for tax purposes of an outlay, loss or replacement of

capital, a payment on account of capital or an allowance in respect of depreciation, depletion or obsolescence

▪ This is the legislative basis for the non-deductibility of capital expenses in calculating business/property income.

▪ Interest expense is denied under section 18 on the basis that it was not incurred to produce income but rather was incurred to acquire a capital asset.

o Paragraph 18(1)(l): as already discussed in connection with the Rachfalowski case, taxpayers generally cannot deduct expenses related to the use of recreational facilities (i.e. golf courses, fitness clubs, etc.)

o Section 67.1: which generally limits the amount of “meals and entertainment” expenses incurred in the course of carrying on a business activity to 50% of the amount incurred

123 In the text (on page 333), Professor Krishna (rightfully) notes that there is no such problem in the case of calculating employment income given the general rule in subsection 8(2) that no expenses are deductible unless specifically provided for in section 8. 124 See Symes for a comprehensive discussion/analysis of the approach(es).© Sprysak 2019

TAXATION


● As a general policy position in Canada, tax doesn’t consider the legality or morality of the activity or expenses. We only focus on the rules in the Act and the Stewart test. BUT:

o Section 67.5: Any illegal payments or something under the criminal code are not deductible for tax purposes.

▪ 67.5(2): There is no limitation period – whenever the CRA finds out about these expenses they can tax them.

▪ 67.6: non-deductibility of fines and penalties imposed by law.

● Can’t deduct a speeding ticket you got when working.

● Does not cover fines and penalties imposed on parties by contract – therefore these are deductible.

● Step #5 - Despite section 18, which denies certain expenses being claimed for tax purposes, section 20 will allow certain expenses to be deducted. For example:

o Paragraph 20(1)(a): allows a deduction for capital cost allowance (CCA)

▪ Very generally, assets that decline in value through time and/or use (i.e. computers, machinery, buildings, etc.) are pooled in various classes defined in Schedule II in the Regulations.

▪ For each pool, a maximum CCA rate is provided, which determines the maximum amount of CCA that a taxpayer can deduct in calculating Net Income for Tax Purposes for the year.

▪ Note: the amount of CCA claimed (up to the calculated maximum) is at the taxpayer’s discretion

▪ In theory, when depreciable assets are sold, a taxpayer may have an income inclusion (if too much CCA was claimed) or an additional deduction (if not enough CCA was claimed)

o Paragraph 20(1)(c): allows a deduction for interest expense paid or payable pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property.

o Paragraph 20(1)(l): allows a deduction for bad debts on accrued revenueso Paragraph 20(1)(m): allows a taxpayer to claim a reserve on goods and services that are to be

provided in the next taxation year (but had to be included under paragraph 12(1)(a) because the taxpayer had received the funds for those goods/services)

● Step #6 - Section 67: General limitation regarding expenses - no deduction shall be made in respect of an outlay or expense except to the extent that it was reasonable in the circumstances

o Notes:

▪ This provision is generally applicable to any deduction claimed for tax purposes.

© Sprysak 2019

TAXATION


▪ It also incorporates both quantitative (i.e. how does the magnitude of the expense compare to the associated revenue?) and qualitative (i.e. in the context of the particular business, was it reasonable to incur this type of expense regardless of the amount?) components.

An Overview of the Deductibility of Employment Expenses and the Inclusion of Employment Income

● With the information contained in Units #6 and #7, it is now possible to appreciate the full tax treatment of

employment expenses (to the employer) and income (to the employee), as well as opportunities for tax planning.

● As discussed earlier in the course, if a taxpayer can deduct an expense, this means that the expense is

effectively paid out of pre-tax income (which is cheaper to the taxpayer)o Put another way, if an expense is deductible, it reduces the taxpayer’s income and his/her associated

tax liability

● In the context of employment expenses/income:

o The typical scenario is that the amount will be deductible to the employer (as a business expense) and taxable to the employee (as employment income).

o In contrast, a “bad” situation (from a tax perspective) is where an amount is NOT deductible to the employer but is still taxable to the employee

o The third possible scenario – which is the best from a taxpayer perspective, is where the amount is deductible to the employer but non-taxable the employee (because of a statutory, case law or administrative exception/exclusion)

© Sprysak 2019

TAXATION

Unit #8 – Taxable Capital Gains

Introduction

● Respectfully, there is no good definition of “capital property” in the Act.

o Section 54 defines “capital property” as (a) any depreciable property and (b) any other property, the gain or loss from the disposition thereof would constitute a capital gain or loss,

o Paragraph 39(1)(a) effectively defines “capital property” as anything other than what it lists as exceptions

● Practically speaking (and as supported by several court decisions), “capital property” is anything other than business property (inventory) (as well as anything excepted out by paragraph 39(1)(a)

● Important Point: as noted in the previous Unit, the determination of property being “capital property” or “inventory” is a taxpayer-specific determination, as opposed to a property-specific determination – typically based upon the taxpayer’s primary intention when acquiring the property

● Despite not having a good general definition, the Act refers to (or has provisions affecting) several types of “capital property”. For our purposes, they are:

o “Depreciable Property” – which is referred to in the definition in section 54 and further defined in subsection 13(21) as property that entitles the taxpayer to claim capital cost allowance expense pursuant to paragraph 20(1)(a)▪ For our purposes, “depreciable capital property” is capital property that typically declines

in value through time or use (or both).

▪ Examples: buildings, computers, manufacturing equipment, etc.

▪ To the extent that such property is used to generate business (or property) income (i.e. manufacturing equipment, office computer, etc.), to calculate an “accurate” amount of income, the Act allows you to deduct an amount which (in theory) is supposed to reflect the deterioration in value in assets used to generate the income (but is based upon strict rates)

o “Non-Depreciable Property” – which, while not defined in the Act, can be defined (as has been treated this way by the courts) as capital property that does not decline in value through time or use (or both)

▪ Examples: shares and land

o “Personal Use Property” - which is defined in section 54 as property owned by a taxpayer that is used primarily for his/her personal use or enjoyment (or any individual related to the taxpayer)

▪ Examples: my house, car, golf clubs, etc.

o “Listed Personal Property” – which is defined in section 54 as certain (listed) types of personal use property, namely: works of art, jewellery, rare books, stamps, and coins

▪ The interesting feature about LPP (and why it is defined as a subset of personal use property) is that it typically appreciates in value

© Sprysak 2019

TAXATION


▪ While personal use property is often depreciable capital property, you do not get to claim capital costs allowance against depreciable personal use property because it was not used to generate income.

● As already mentioned, capital gains (and losses) were not subject to tax before January 1, 1972. Before this time, capital gains were an exempt source of income (excluded from the tax base).

● Now, it is a recognized source of income just like employment, business, investment/property, etc.

o Strictly speaking, it is treated the same as any other source of income and taxed at the same marginal tax rates

o The unique aspect of capital gains compared to the other sources of income is in the inclusion rate - only 50% of capital gains are taxable as “taxable capital gains” (where as other forms of income are typically (but not always) fully included in income for tax purposes)

o As a result, some people factor this into the marginal rates and say that at the highest tax bracket, capital gains are taxed at 24% (i.e. 48% x 50%)

● Question: why have this special treatment for gains (and losses) on capital assets?

o Answer:

▪ (1) to account for some of the gain being due to inflation – should people be taxed based on gains attributable to inflation? Government compromises and only taxes 50%.

▪ (2) to incentivize investment and further purchase and sale of capital assets. If it was fully taxed, people might just hold onto their capital property to avoid the tax.

▪ (3) Recognition event for capital gains & losses, for employment income it’s the receipt of cash/benefit, for bus/prop income its using rules of accrual accounting, recognition event for capital gains and losses is when we dispose of the property. Some economists have said if there is significant tax imposed on disposition of property, people may defer disposing of property and re-investing isn’t something that’s better investment for them personally and the economy so we allow break for free transfer.

▪ (4) We are generally reporting income on a yearly basis, but for capital income we don’t have to report until we’re disposing of the asset – this means that several years of appreciation can all be subject to tax at one time (bunching problem).

The Calculation of Capital Gains and Losses

● The calculation of capital gains/losses begins with section 38 of the Act.

o Paragraph 38(a) provides that a taxpayer’s taxable capital gain is ½ of the taxpayer’s capital gain; similarly, paragraph 38(b) provides that a taxpayer’s allowable capital loss is ½ of the taxpayer’s capital loss

● Section 40 defines:

© Sprysak 2019

TAXATION


o A capital gain as being the amount by which a taxpayer’s proceeds on the disposition of property exceeds the adjusted cost base (ACB) of the property and any associated expenses of disposition

o A capital loss as being the excess of the ACB of a property and any expenses of disposition over the proceeds of disposition

● To properly calculate capital gains and losses for income tax purposes, we need to (at least) answer four key questions, namely:

o 1st – what constitutes a disposition (and when does a disposition occur) for tax purposes? o 2nd – what are proceeds of disposition (and how are they calculated)?o 3rd – what is the ACB (and how is it calculated)?o 4th – what are included in the associated expenses of disposition?

● Proceeds of disposition = xxx

● Adjusted cost base (ACB) = <xx>

● Selling expenses = x

● Add them all up and you get capital gain/capital loss = xx/<xx>

● Multiply by the inclusion rate (50%) = *50%

● Result is the taxable capital gain/allowable capital loss

Dispositions

● A disposition is very generally defined in paragraph 248(1)(a) to include “any transaction or event entitling a taxpayer to proceeds of disposition of the property”. The provision then continues to give specific examples of transactions that will and will not constitute dispositions.

o The most common form of a disposition (which is recognized as such for tax purposes) is a voluntary sale of property for fair market value (FMV) consideration.

o That said, recognized dispositions can be voluntary (i.e. sale or gift) or involuntary (i.e. expropriation/theft), can be for consideration (i.e. sale) or for no consideration (i.e. gift), and can be for monetary or non-monetary consideration (i.e. a barter transaction).

▪ In the case of gifts subsection 69(1) deems the donor taxpayer to have received the fair market value (FMV) of the gift (as proceeds of disposition) as well as deems the donee recipient to receive the property with an adjusted cost base (ACB) equal to FMV

▪ This means that a gift has the potential of creating a tax liability to the donor even though the donor hasn’t received anything (monetary) in the course of making the gift with which to pay the triggered tax liability

© Sprysak 2019

TAXATION


▪ Practice Point: where transferring property between non-arm’s length parties (i.e. spouses and common law partners, shareholders and their wholly-owned corporations), it is very important that the transaction occur at FMV

● If not and if discovered by the CRA, the Act gives the CRA the power to do one-sided adjustments (i.e. to one of the two taxpayer’s tax returns) to, in effect, create double tax with respect to all or a portion of the gain – be careful!

o Further, the Act may deem property to be disposed of even if there is no actual change in legal title

▪ Common examples include: on death, on a change in use of asset from non-income earning to income earning and vice versa, and when severing or acquiring residency

o Despite the (wide) scope of the definition of a “disposition” in section 248(1), it also sets out some transactions that are not considered to be dispositions, including: transfers of legal but not beneficial title to property (“bare trust”), transfers of property to secure a loan, bailments, leases, granting of an option, licences, etc.

● In addition to being able to recognize that a disposition has occurred, it is also important (obviously) to know when a disposition has occurred.

o Generally speaking, a disposition occurs for tax purposes when the vendor has an absolute but not necessarily immediate right to be paid the sale proceeds (i.e. all condition precedents have been satisfied even if the proceeds are to be paid using instalments).

o Other “tests”/descriptions of when a disposition occurs:

▪ It is when the attributes of ownership pass to the purchaser – “when the transferor divests itself of all of the duties, responsibilities and charges of ownership and also all of the profits, benefits and incidents of ownership even though they retain legal title”.

▪ If a formal contract exists, it may be the time of transfer specified in the agreement

▪ In the case of shares sold on a stock exchange, the CRA takes the view that the date of disposition is not the “trade date” (i.e. the date on which the sale goes through the exchange) but the “settlement date” (i.e. the date on which the seller is required to deliver the share certificates and the purchaser is required to pay for the shares)

● Example: Grandma bought a painting for $100 way back when. She now disposes of it by gifting it to you. The painting’s FMV is now $1000.

o FMV = $1000o ACB = <$100>o Taxable capital gain = 900 * 50% = $450

Proceeds of Disposition

© Sprysak 2019

TAXATION


● As set out in the definition in section 54, on an arm’s length sale, the proceeds of disposition is generally the amount of the sale price of the property sold (excluding GST)

● However, as the section 54 definition illustrates, the proceeds of disposition will generally include any and all consideration flowing to the (now former) capital property owner

o Important Point: While not explicitly set out in the definition, the proceeds of disposition will also generally include the value of any non-cash consideration received.

Adjusted Cost Base

● When a taxpayer acquires inventory (i.e. business property), then generally speaking, the taxpayer is allowed to deduct the purchase price in calculating his/her business income pursuant to paragraph 18(1)(a)125

o However, when a taxpayer acquires capital property, the paragraph 18(1)(b) prohibits a deduction (for all capital expenditures).

o Instead, the taxpayer gets to record the cost for purposes of (later) calculating the capital gain/loss on the subsequent disposition

● As defined in section 54, the ACB is, generally speaking, the original cost of the capital asset (including any purchasing, legal, etc.) plus any costs necessary to put the asset in a usable state. That cost may then be adjusted upward and downward by the Act

● Where a taxpayer acquires identical properties (i.e. same type of shares of a corporation) at different costs, the taxpayer is required by section 47 to average the costs among all of the property

o Example: John buys 100 shares of Blackberry Corporation on June 1, 2016 for $10/share ($1,000 total). When the share price (on the Toronto Stock Exchange) declines to $5/share in November 2016, John purchases another $1,000 of Blackberry shares.

▪ Questions: how many Blackberry shares does John have at the end of 2016 and what is their ACB?

▪ Answer:

● Once a capital asset is acquired, then generally speaking, any subsequent improvements made to the capital property will also be characterized for income tax purposes as capital expenditures and, as such, will be added to the ACB of the asset

o In contrast, if a taxpayer simply repairs and/or maintains a capital asset, then the taxpayer will generally be able to deduct such repairs and maintenance expenses in the year incurred (pursuant to paragraph 18(1)(a)) – but only to the extent that the capital property is used to generate business/property income

125 As an exception to this general principle, when inventory is purchased in one taxation year but is sold in the subsequent taxation year, then generally speaking, the taxpayer will be required to wait to deduct the inventory expense and match it to the associated revenue (not surprisingly, referred to as the “matching principle”) – which the courts have found results in a more accurate calculation of income. © Sprysak 2019

TAXATION


▪ Note: there is no ability to deduct repairs and maintenance expenses on “personal use capital property”, as we will discuss shortly

o This difference in tax treatment creates the incentive for a taxpayer to try to characterize all expenses incurred in respect of existing capital assets as repairs and maintenance expenses rather than capital improvements – gives the taxpayer an immediate deduction (as opposed to having to wait until the underlying capital property is disposed of)

● In the Minister of National Revenue v Algoma Central Railway, [1967] C.T.C. 130 (Ex. Ct.) (aff’d by SCC [1968] S.C.R. 447) - the court set out the general test for determining whether an expenditure in respect of a capital asset should be characterized as a capital improvement or a repairs and maintenance expense, namely, “was the expenditure made with a view to bringing into existence an advantage for the enduring benefit of the taxpayer’s business?”

o If the answer is “yes”, then the expenditure is characterized as a capital expenditure; if the answer is “no”, then the expenditure is characterized as a repairs and maintenance expense.

● In the Central Amusement Co. v. Minister of National Revenue, [1992] 1 CTC 218 (F.C.T.D.) case, the court added the following (related) questions/indicia to assist in answering the general question set out in Algoma:

o Is the expenditure annual, recurring or continuous?

▪ The more frequent the expense, the more likely it is a current, rather than a capital, expense.

o Is the purpose of the outlay to provide a “temporary advantage”?

▪ The more temporary the benefits of a particular expense, the more likely it is a current expense.

o What is the magnitude of the expense in relation to the value of the asset as a whole?

▪ If it is large relative to the value of the capital asset, then it is more likely a capital expenditure.

o What is the useful life of the expenditure?

▪ The shorter the life, the more likely it is a current expense.

● As we have already discussed, for capital properties that were purchased prior to 1972, you have to determine their V-Day values (which represents their value/cost at January 1, 1972 and which is necessary to ensure that pre-1972 gains are not taxed) using the ITARs.

Expenses on Disposition

● Generally speaking, expenses incurred for the purposes of making the disposition (i.e. putting the property in a saleable condition) are deductible in calculating the capital gain/loss.

o That said, there can be an issue as to exactly what expenses are properly deductible under this category.

© Sprysak 2019

TAXATION


o In Avis Immobilien G.m.b.H. v Canada, [1996] F.C.J. No. 1551 (F.C.A.), the Court distinguished between:

▪ Expenses “incurred or made directly for the for purposes of making the disposition” (which are deductible), and

▪ Expenses “which may have merely facilitated the making of the disposition or which were entered into on the occasion of the disposition” (which are not deductible)

▪ As can be imagined, this “distinction” causes practical uncertainty in its application – what is the difference between “directly incurred” and “facilitated” or “occasioned”?

● As noted in the Krishna text (page 451), expenses that are typically deductible in calculating a capital gain/loss on the disposition of a capital asset include: fixing up expenses, finder’s fees, sales commissions, brokers’ fees, surveyor’s fees, transfer taxes, legal expenses relating to the disposition, etc.

Reserves

● As set out in subsection 40(1), a taxpayer is required to calculate his/her capital gain or loss in the taxation year in which a taxpayer disposes of capital property and include (50% of) it in his/her tax return.

o Where the disposition is in the form of a sale for fair market value and the taxpayer receives full consideration in the year of the sale, there is typically no problem. The taxpayer has the cash to pay any associated taxes.

o However, in cases where the sale price is agreed to be paid over a period of years, the taxpayer vendor may have a cash flow problem. Specifically, he/she will have to pay taxes on the entire gain without having the necessary cash from the sale to do so.

● To provide some relief in these situations, paragraph 40(1)(a) allows a taxpayer to claim a “reasonable” reserve, which has the effect of deferring the recognition (and taxation) of a portion of the gain to a future year.

o Generally speaking, this provision requires the taxpayer to recognize the greater of: (a) 20% of the total gain and (b) the proportion of the proceeds actually received in the year (i.e. a “reasonable amount”)

o Important Point: if commercial possible, make sure that the commercial contract and the cash flows don’t create a problem for the vendor

● Example: Rosie sells all of the shares of “Rosie’s Pizza Inc.” to Rahullah for $1 million. Pursuant to the terms of the Share Sale Contract, Rahullah will pay Rosie $100,000 at the time of closing (March 31, 2017), $200,000 on March 31, 2018, $300,000 on March 31, 2019, and $400,000 on March 31, 2020. Rosie’s shares have an ACB to her of $1,000. Assume that there are no deductible selling expenses. What does Rosie have report on her tax returns in respect of this sale?

o Answer: She has to report the full taxable amount, but may be able to reserve.

© Sprysak 2019

TAXATION


▪ FMV = $1M

▪ ACB = <$1000>

▪ Total reportable tax = $999,000 * 50% = $499,500.

▪ Reserve = 20% of total gain OR proportion received in the year (whichever is greater). 20% is greater. Therefore reserved taxable gain = $999,000 * 20% = $199,800.

Personal Use Property

● As personal use property (PUP) is still capital property, generally speaking, it follows the same rules in the Act, with two main exceptions:

o First – generally speaking, if a taxpayer suffers a loss from the disposition of PUP, that loss is deemed to be nil by virtue of paragraph 40(2)(g); and

o Second – if a taxpayer realizes a gain from the disposition of PUP, then that gain is taxable only if (and to the extent that) both the proceeds of disposition and the ACB are greater than $1,000 (commonly referred to as the “garage sale rule”) by virtue of subsection 46(1)

● In the case of listed personal property (which as noted earlier, is a subset of personal use property), losses can be deducted – but only against capital gains from listed personal property, pursuant to section 41126

126 Note: to the extent that losses are incurred from the disposition of listed personal property in a particular taxation year but without any gains from listed personal property, the losses can be carried back 3 years and forward 7 years.© Sprysak 2019

cans.s3-us-west-2.amazonaws.com2019-2020/tax+… · web view(1887), 12 app. cas 575 (p.c.), which...

Documents