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Ed Kroft, QC
Blake, Cassels & Graydon |
Risk-based assessment of large corporations
The Canada Revenue Agency (CRA) regularly audits large corporate
taxpayers. To improve efficiencies and cash recoveries, it has moved to a
risk-based assessment approach to auditing such taxpayers. Corporate
taxpayers are being assessed as low, medium or high risk, based on a
series of factors. The frequency and intensity of the audit processes
varies directly with the risk ascribed to the particular taxpayer. The
CRA is also promoting strong corporate governance regarding tax and is
discussing these governance issues with businesses to promote a more
conservative approach to undertaking tax risks. Consequently large
corporations which now face consistent audit scrutiny on domestic and
cross-border tax issues may find that CRA audit work abates or becomes
more focused on specific areas in which significant tax liabilities may
arise. Two areas of continuing review involve transfer pricing and
"aggressive tax planning", a term that the CRA regards as one referring
to arrangements which comply with the letter but not the spirit of the
statutory provisions that give rise to tax benefits.
Increased demands for information by tax authorities
The CRA is increasingly exercising its powers under the Canadian
Income Tax Act (ITA) to compel delivery of both domestic and
foreign-based information. Instructions to complete questionnaires,
requests for tax planning memoranda and demands for e-mail exchanges,
are but three of the strategies used to gather information. Failure to
comply may result in either the issuance of a subpoena known as a
requirement letter or in the making of a court application for a
"compliance order". Litigation over the provision of such information is
growing because taxpayers are increasingly resisting demands for
voluminous information and documents (including, in some cases, clearly
irrelevant or privileged documents) to be provided within short
time-frames. As a sign of its strategic focus over the next two years,
the CRA is having Department of Justice lawyers advise tax auditors on
accessing information from taxpayers.
The CRA is also looking to its treaty partners for exchanges of
information. The conclusion of a number of tax information exchange
agreements between Canada and various jurisdictions, including tax
havens, is facilitating further recovery of information. The CRA has
also begun to conduct joint audits of taxpayers doing business in Canada
with other treaty partners.
Need for strategic management of tax controversies
In many tax disputes involving large amounts, particularly in the
transfer pricing and aggressive tax planning areas, formal litigation in
the Tax Court of Canada is becoming acrimonious, much to the
displeasure of some judges who have, on occasion, been openly critical
of a perceived decline in cooperation between counsel and parties to the
proceedings.
If possible, taxpayers are looking for ways to avoid tax litigation.
This may be achieved through settlement conferences encouraged by the
Tax Court or through attempts to resolve disputes at earlier stages of
the tax controversy process. Statistics show that few disputes are
actually decided by judges of the Tax Court relative to the number of
disputes settled at earlier stages of the tax controversy process.
Domestically, alternative dispute resolution mechanisms such as
arbitration and mediation have enjoyed little or no success. However, in
the international arena, where double tax may be at issue, taxpayers
are attempting to find resolution in transfer pricing through the mutual
assistance procedure (including arbitration when available) involving
the Canadian competent authority and, in some cases, the conclusion of
advance pricing agreements.
Transfer pricing and aggressive tax planning – some audit initiatives
The CRA has been scrutinising international cross-border arrangements
and has been challenging transfer pricing arrangements. Challenges
involve penalties for inadequate contemporaneous documentation,
non-deductibility of costs incurred in cost contribution arrangements,
denial of deductions pertaining to the payment of royalties, and
attempts to recharacterise legal relationships and to attribute income
to Canadian resident taxpayers when offshore affiliates in low rate
jurisdictions are carrying on activities of the multinational group. The
CRA is also reviewing various financial transactions involving
guarantees fees, swaps, hedges, derivatives and factoring.
On the aggressive tax planning front, the CRA is challenging
interprovincial tax planning arrangements, tax sparing, foreign tax
credit utilisation, the shifting of tax attributes or losses to
arm's-length parties, leveraged donations and claims for artificial
capital losses. Tax authorities are also relying on the general
anti-avoidance rule (GAAR) , specific or targetted anti-avoidance rules
and judicial concepts such as "sham" and "ineffective transaction" to
deny tax benefits otherwise available in allegedly abusive arrangements.
Some recent jurisprudence
Between late 2011 and mid-2012, the Supreme Court of Canada heard a number of tax cases. A decision in Glaxo, the first transfer pricing case to reach the highest court, has not yet been released.
In Fundy Settlement v Canada (also known as St Michael Trust Corp or Garron Family Trust),
the court confirmed that the "central management and control" test used
to determine residency of corporations for tax purposes also applies to
the determination of the residence of trusts. Taxpayers that have
relied exclusively on the residence of a trustee as being determinative
of the residence of a trust should re-examine their arrangements. It is
clear that the issue of legal substance remains critical for the
threshold question of establishing residence. The court's decision
demonstrates that a presumption that central management and control
resides in the place of residence of a trustee of a trust (or by
analogy, the place where the board of directors of a corporation meets)
can be displaced where evidence to the contrary is available. Trusts or
corporations wishing to establish residence in a treaty jurisdiction
should ensure that meaningful decisions about the management of these
entities are made in that jurisdiction. To further support the residence
of trusts and corporations for tax purposes there should also be
evidence of physical meetings in the jurisdiction and of relevant
information being provided to permit meaningful decisions to be made. As
this decision emphasises, having local agents that merely rubber stamp
documents will be insufficient to establish central management and
control in a particular place. By contrast, the recent decision of the
Tax Court in Velcro Canada Inc seems to have placed less emphasis
on the governance of a holding company for purposes of determining
beneficial ownership of certain payments for treaty purposes.
The Supreme Court in Fundy Settlement decision also has
implications beyond the trust context. Though this case confirms the
application to trusts of the test commonly understood to apply to the
determination of the residence of corporations, there is little
higher-court jurisprudence on the applicable test for determining the
residence of corporations for Canadian tax purposes. This decision
provides definitive authority for the application of the central
management and control test to corporations.
In recent audits of Canadian resident trusts, the CRA has taken the
position that trusts are resident in the province of residence of the
beneficiaries, rather than the province of residence of the trustee.
This affects the provincial tax rate applicable to the trusts. One or
more proceedings have been commenced in the provincial courts to contest
the assessment of provincial tax on this basis.
On December 16 2011, the Supreme Court of Canada released its decision and reasons in Copthorne Holdings Ltd v Canada 2011 SCC 63 (Copthorne).
All nine judges unanimously determined that the taxpayer's appeal
should be dismissed, as it had been in the two lower courts below. The
decision thoroughly canvasses issues relating to the application and
interpretation of the GAAR in section 245 of the ITA.
Unsurprisingly, the decision reinforces and consolidates principles
enunciated in three earlier GAAR cases decided by the Court (Canada Trustco, Kaulius and Lipson)
and expresses both caution and direction about the future application
of the GAAR by tax officials. In doing so, the court has also left
readers of the decision with a number of impressions about the types of
circumstances in which the GAAR should and should not be applied in
future and the ability of taxpayers to arrange their affairs to minimise
taxes payable.
Perhaps what is most striking in the reasons of the Supreme Court are
its comments about the appropriate methodology for the interpretation
of taxing statutes and the unique methodology that is to be used when
the GAAR is in play. The court has also openly admonished both the lower
courts and readers of tax legislation (including the GAAR) that
"determining the rationale of the relevant provisions of the Act should
not be conflated with a value judgment of what is right or wrong nor
with theories about what tax law ought to be or ought to do" (paragraph
70). So it seems that judges are not to use a so-called "smell test" or
an interventionist approach when deciding tax cases and that the
so-called "end must not justify the means". However, it remains to be
seen whether this admonition will be heeded.
All readers of Copthorne are no doubt trying to discern
whether the commentary and analysis of the Supreme Court favours
taxpayers or the Crown. It has elements that both sides will embrace.
Both sides however must realise that it seems unlikely that the Supreme
Court will be open to granting leave in another GAAR case any time soon
given that the Copthorne reasons were written by Mr Justice Rothstein, one of the dissenting justices in Lipson. He unanimously expressed the consolidation of earlier principles enunciated in Canada Trustco and the more fractured decision in Lipson. The court made it very clear, in paragraph 57, of the Copthorne
reasons that "Trustco is a very recent decision" and that there must be
"substantial reasons to believe the precedent was wrongly decided" for
it to be revisited. To the extent that any points about the
interpretation of GAAR issues are not addressed in Copthorne, one should presume that any applicable comments in Trustco and the other two earlier Supreme Court decisions will govern.
The Supreme Court also granted leave to appeal in Daishowa-Marubeni
, which deals with the impact of contingent liabilities assumed by the
purchaser of a business. The Federal Court of Appeal, which hears
appeals from the Tax Court and the Federal Court, determined that the
assumed liabilities should be added to the proceeds of disposition of
the vendor. This case (to be heard in 2013) could have significant
commercial implications.
The court also will hear the appeal of Envision Credit Union sometime
in 2013. This case will deal with the tax consequences of a
non-statutory merger. The taxpayer was unsuccessful in both lower
courts.
The Federal Court of Appeal will also soon hear two important appeals dealing with the GAAR (Triad Gestco and 1207192 Ontario).
The Tax Court has exclusive original jurisdiction to hear federal
income tax and GST cases. It released decisions on topics such as the
GAAR and international tax planning. These include GE Capital, (transfer pricing), FLSmidth (foreign tax credits), and McClarty Family Trust and MacDonald (GAAR). A decision in McKesson involving the factoring of receivables and the transfer pricing rules is expected within the next few months.
The Alberta Court of Appeal is expected to release two interesting decisions (Husky, Canada Safeway)
relating to rebuffed attempts by the tax administration of Alberta to
apply provincial GAAR legislation to tax planning designed to minimise
or eliminate Alberta income tax.