management fee documentation

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1 Issue the tax factor e-communications from the cra READ MORE p4 management fee documentation READ MORE p6 relief on US FBAR requirements READ MORE p8 Changes to the Tax Deferral on Publicly Traded Company Stock Options Stock options are a common form of compensation provided by employers to their employees. For income tax purposes, there are specific rules that apply to tax the benefits employees receive from their stock options. A benefit will arise when an employee exercises their options and this will be taxed as employment income. This benefit is generally equal to the difference between the fair market value of the securities at the time the option is exercised and the amount paid by the employee to acquire the securities. If the employee chooses to hold the securities, a capital gain or loss will be realized when the securities are later sold. However, where a capital loss is realized, it can t be used to reduce the taxable employment benefit. Tax Deferral for the Taxable Employment Benefit Contents Changes to the Tax Deferral on Publicly Traded Company Stock Options Stock Option Cash Outs Withholding Requirements on Stock Option Benefits are Changing Electronic Communications from the CRA Protect Yourself Against Fraud and Identity Theft Do You Have Documentation for Your Management Fees? New Rules for Dispositions of Canadian Corporations by Non-Residents Further Relief Provided on US Foreign Bank Account Reporting The tax rules generally require that the taxable employment benefit be included in income at the time the options are exercised. An exception applies to options granted to purchase securities of a Canadian-Controlled Private Corporation (CCPC) where certain conditions are met. Where this exception applies, the benefit is instead included in income when the securities purchased under the options are sold. In 2000, the deferral on the timing of the benefit inclusion in income was extended to publicly traded company options. To take advantage of the deferral, certain conditions applied including the filing of an election. The deferral on public company options was introduced at a time when stock markets were strong, and stock option plans were popular and benefited employees well. However, not long after the extension of the deferral to public company securities, we saw large declines in the stock markets, largely in the technology sector. More recently, we have seen significant declines in the value of numerous companies with the recession that had hit us. Unfortunately, due to these market declines, many employees that made the election to defer the taxation of their taxable employment benefit now owe more tax on that benefit than the proceeds they will actually receive from the sale of their securities. As mentioned, capital losses realized on the sale of these securities can t be used to reduce their employment benefit. So the ability to defer has not served many employees well and in certain cases, employees have found themselves in financial difficulty.

2 2 Elimination of the Deferral and Special Tax Relief Proposed In the 2010 federal budget, the government proposed to eliminate the deferral on publicly traded company securities effective for employee stock options exercised after 4pm EST on March 4, The deferral of stock option benefits for most CCPC options will continue to be allowed. The government also proposed to provide tax relief to employees who have taken advantage of the deferral on publicly traded company securities, but who have found themselves in the unfortunate position of owing more tax on their benefit than the proceeds they will receive (or have received) on the disposition of their securities. This tax relief will be provided on an elective basis and will ensure that the tax liability on a deferred stock option benefit does not exceed the proceeds of disposition of the optioned securities, taking into account tax relief resulting from the use of capital losses on the optioned securities. Where an employee elects to apply this special tax treatment to their optioned securities, the employee will: Pay a special tax for the year equal to the proceeds of disposition they receive on the sale of the securities. For residents of Québec, the special tax will be equal to 2/3rds of the proceeds. (Québec will harmonize with the federal change, except that the Québec tax will be 50% of the proceeds); Be able to claim an offsetting deduction equal to the amount of the taxable employment benefit that has been deferred; and Include in income as a taxable capital gain, an amount equal to half the lesser of the taxable employment benefit and the capital loss that will result on the sale of the securities. This taxable capital gain may be offset by the allowable capital loss on the optioned securities, if that loss is not used to offset other taxable capital gains realized by the employee. The special elective tax treatment will only be available for stock option benefits on publicly traded company securities where a deferral election was made. It will apply for employees who dispose of their optioned securities after 2009 and before 2015, by making an election by the filing due date of their personal tax return for the taxation year of disposition of the securities. It will also apply retroactively for employees who disposed of their optioned securities before In this case, employees will be required to make the election for special tax treatment on or before their filing due date for the 2010 taxation year. To illustrate how this special elective measure will work, the following example provides a comparison of the regular tax treatment of a deferred benefit arising from stock options and using the special elective tax treatment. Example An employee was granted options to purchase 100 shares of ABC Company. The exercise price was $50 per share (equal to the fair market value of the shares at the date the options were granted). The employee exercised the options on March 15, 2005 and the fair market value of the shares on that date was $200 per share. The employee elected to defer the taxation of the benefit of $15,000 (fair market value of $20,000 less cost on exercise of $5,000). The employee sold their shares on March 30, 2010, when the fair market value had declined to $25 per share, resulting in a capital loss of $17,500 (proceeds of disposition of $2,500 less the adjusted cost base of $20,000). Assume the taxpayer pays tax at 46% and is not a resident of Québec. Regular Tax Treatment Special Elective Tax Treatment Deferred Taxable $15,000 $15,000 Employment Benefit 50% Deduction (7,500) N/A Special Deduction of N/A (15,000) Benefit Amount Net Benefit Amount for 7,500 Nil Income Inclusion Tax on Net Benefit 3,450 46% (A) Special Tax equal to N/A 2,500 Proceeds of Disposition (B) Total Tax (A) + (B) $3,450 $2,500 Allowable Capital Loss $8,750 $8,750 50% of Capital Loss on Disposition Less: Taxable Capital Gain N/A (7,500) (Special) ½ of the lesser of: 1) Taxable Employment Benefit = $15,000 2) Capital Loss = $17,500 Net Capital Loss Remaining $8,750 $1,250 As can be seen from the chart above, in this situation the tax liability will be less if the employee chooses the special elective tax treatment. However, the remaining net capital loss balance available to apply against other taxable capital gains will also be less as a portion of the allowable capital losses has been used to provide tax relief under the special calculation.

3 3 Where the proceeds received on the sale of the optioned securities exceed the tax liability on the deferred benefit, this election would not be made. As well, if an employee has realized significant capital gains in the past three years or expects to do so in the future, it may be more beneficial to forgo the election and have a higher net capital loss balance that can be used to offset the realized or potential capital gains. In the example above, the net capital loss that was lost under the election ($7,500) would produce a tax saving of up to $3,450 if used to offset a future gain. Ignoring the time value of money, this could bring the tax cost of the election up to $5,950. Note also that if this election is available to be used retroactively on securities already disposed of, consideration will need to be given to the capital loss balance still available in If you have deferred benefits on publicly traded company options, contact your BDO advisor to find out if you should take advantage of this special tax relief. Stock Option Cash Outs Under employee stock option plans, an employee does not always end up holding securities when they exercise their options. Instead, some plans are structured to allow the employee to dispose of their stock option rights for a cash payment from their employer or some other in-kind benefit. From a tax perspective, this provided a benefit to both the employee and employer. Under the stock option rules, a taxable employment benefit will result if the employee exercises their options to purchase securities. Where certain conditions are met, a stock option deduction equal to 50% of the benefit will be allowed. For options granted to purchase publicly listed securities, the primary condition is that the exercise price cannot be less than the fair market value of the security at the time the option is granted. For Canadian-Controlled Private Corporation securities, generally a stock option deduction will be allowed provided a two-year holding test is met. The deduction effectively allows the benefit to be taxed at the same rate that applies to capital gains. The income tax rules also prevent employers from claiming a tax deduction for the issuance of securities under stock options plans. However, where a plan allowed for a cash payment instead of the issuance of securities, the cash payment was fully deductible to the employer, while the employee could generally benefit from the 50% stock option deduction. By allowing stock option benefits to be taxed at rates that normally apply to capital gains, the tax rules provide preferential tax treatment to employees. However, it was not the government s intention to provide a benefit to employers by allowing them to deduct the cost of such benefits. As a result, the government proposed a change in the federal budget to prevent both an employee from claiming a stock option deduction and an employer from claiming a tax deduction related to the same taxable employment benefit. The stock option deduction will continue to be available to employees who receive securities where current conditions are met. As well, employers will continue to be allowed to structure employee stock option plans that allow employees to receive cash and be eligible for the 50% stock option deduction, but only where the employer elects to forgo the deduction for the cash payment. If a deduction is claimed by the employer, then the option benefit will be 100% taxable. The draft wording of the rules indicate that the employer would file an election with the CRA to forgo the deduction. The employer would also provide the employee with written evidence of the election to not claim a deduction for the payment made to the employee. The employee would then be required to file this written evidence along with their tax return in which they claim the 50% stock option deduction. This measure will apply to dispositions of employee stock options that occur after 4pm EST on March 4, It will be important for employers to consider current employee stock option plans that allow for cash outs to determine the impact of these rule changes. As well, employers will need to determine if this type of plan is feasible on a go forward basis, due to the loss of the employer deduction where preferential tax treatment continues to be available to their employees or if other compensation strategies make more sense. Consult with your BDO advisor on the implications of these changes.

4 4 Withholding Requirements on Stock Option Benefits are Changing The 2010 federal budget clarified employer withholding requirements on employee stock option benefits to ensure tax is withheld and remitted to the government on these benefits, eliminating the ability to reduce withholdings by claiming undue hardship. Based on this clarification, employers will be required to withhold tax on stock option benefits net of the 50% stock option deduction (if applicable). The intent behind this change is to ensure an employee can meet their tax obligations up front, in the event that the value of their securities declines after the options are exercised to purchase the shares. The government is therefore shifting the tax collection risk to the employee and/or employer. These withholding requirements will apply to stock option benefits on securities acquired by employees after 2010, to give employers time to adjust compensation arrangements and update their payroll systems for this change. Note that the change will not apply in respect of options granted before 2011 under a written agreement entered into before 4pm EST on March 4, 2010 if, at that time, a condition existed in the agreement restricting the employee from disposing of the optioned securities for a period of time after exercise. Given that stock option benefits are a non-cash employment benefit, employers will need to consider alternatives to ensure employees have sufficient cash income or proceeds from which the required tax liability on the stock option benefit can be withheld. Consideration should be given to how stock option agreements are written to ensure the employer is able to meet their withholding obligations. Agreements may require a condition for immediate disposition of a portion of the securities to ensure sufficient proceeds are available for the tax withholding. As well, adjustments may need to be made before the end of 2010 for current agreements not meeting the exception noted above. Contact your BDO advisor to discuss the implications of this change on administrative processes related to your employee stock option plans. Electronic Communications from the CRA Few would disagree with the fact that computers and the internet have greatly enhanced how businesses operate. They have provided businesses with the ability to transfer information freely, and to have instant access to knowledge. In spite of this, up until now, the Canada Revenue Agency (CRA) has not corresponded with taxpayers electronically and has continued to rely mostly on the ordinary mail system. The 2010 federal budget proposed significant changes on this front that will allow the CRA to issue electronic notices, such as notices of assessment that can currently only be sent by ordinary mail. (Notices that are specifically required to be served personally or by registered or certified mail will not be eligible to be transmitted electronically.) The proposed measures will provide the CRA with the ability to issue electronic notices if authorized by a taxpayer, which will be made available on the CRA s existing web site (i.e. My Account for individuals and My Business Account for corporate tax). The CRA states that they will inform taxpayers that provide such authorization that a new electronic document is available in their secure online account by sending the taxpayer an to that effect. The CRA states that they intend to provide this service in respect of the following: Notices of assessment and reassessment of tax under Part I of the Income Tax Act, Notices of determination and redetermination in respect of the GST/HST credit, and The Canada Child Tax Benefit. Although legislation has not been passed to implement these changes, you should start to consider how this will impact your dealings with the CRA. To begin with, you should continue to notify your BDO advisor if you receive any correspondence from the CRA that may require a response or follow-up. This would include any notices of assessment that you receive. If you receive a high volume of and a CRA could be missed, you should probably think twice about using electronic communications. Also, you will need to remember that you must notify the CRA if there are any changes, such as the retirement of a staff member that handles CRA correspondence. As well, you should be mindful of the various fraudulent communications that are currently in circulation. See our article titled Protect Yourself Against Fraud and Identity Theft in this edition of the Tax Factor. It is most important that you ensure that the communication you receive is authentic and that it was actually issued by the CRA. An authentic from the CRA will simply notify you that new information is available and waiting for you in My Account or My Business Account. Contact your BDO advisor if you receive any correspondence from the CRA that requires follow-up or that you are unsure about.

5 5 Protect Yourself Against Fraud and Identity Theft In this day and age, you can never be too careful to protect yourself against fraud and identity theft. Whether you have experienced it first hand or not, chances are you have heard of the various methods used by criminals to steal your personal financial information. Often these criminals go to great lengths to gain access to your personal information such as your social insurance, credit card, bank account and passport numbers. Unfortunately, many fraudsters claim to be the Canada Revenue Agency (CRA) in these communications, and the CRA provides warnings and updates on these from time to time. The sole purpose of these communications, which can be by telephone, mail or , is to gain access to your personal financial information. What this means is that you must exercise caution when you receive any communication that appears to be from the CRA. With technical advancements, it is very easy to create fraudulent electronic and written communications that look authentic. These communications often claim that your personal information is needed so that you can receive a refund or benefit payment. One common technique used by criminals refers you to a web site that resembles the CRA s web site where you are asked to verify your identity by entering personal information. To help differentiate a fraudulent communication from a genuine one, the CRA has provided some general guidelines on their web site. In particular they have provided a list of items which are not in accordance with the way the CRA operates, including the following: The CRA will not request personal information of any kind from a taxpayer by . They generally have the personal information they need. The CRA will not divulge taxpayer information to another person unless formal authorization is provided by the taxpayer. The CRA will not leave any personal information on an answering machine. The CRA also provides a list of items that you should consider when you receive a communication from them. In particular the CRA suggests that you ask yourself the following: Am I expecting additional money from the CRA? Does this sound too good to be true? Is the requester asking for information I would not include with my tax return? Is the requester asking for information I know the CRA already has on file for me? How did the requester get my address? Am I confident I know who is asking for the information? The CRA has also provided examples of fraudulent letters, s and online refund forms on their web site so that you can see exactly what you are protecting yourself from. This site is updated as new frauds are discovered. The extent of this problem will likely worsen when legislation is passed that will allow the CRA to issue electronic notices, such as notices of assessment (historically the CRA did not send s to taxpayers, other than to those where the CRA had initiated an audit or review). So, it will be more important than ever to carefully read s that appear to be from the CRA in the future. See our article titled Electronic Communications from the CRA in this edition of the Tax Factor, for more information on this. If you have received a communication from the CRA and are unsure whether or not it is authentic, contact your BDO advisor.

6 6 Do You Have Documentation for Your Management Fees? Do you use more than one corporation (or other entities such as trusts or partnerships) for business purposes? Do you use management fees to bill central management expenses to these entities or to bill other entities for services performed? If you do, not only must the fees you charge be reasonable, but it is critical that you can prove the fees are truly management fees with the proper documentation should a Canada Revenue Agency (CRA) auditor ask for details of the fees charged. management fees and proper documentation is critical. The amount charged must also be reasonable when compared to the work performed. The CRA will generally be looking for the following as evidence of true management fees: In a recent Tax Court of Canada case, Les Entreprises Rejéan Goyette Inc., the judge disallowed the deduction of management fees because the taxpayer was unable to prove the fees were true management fees. In this case, an individual was the sole shareholder of a holding company with two wholly-owned subsidiaries (let s refer to them as X Co and Y Co) whose intercorporate management fees were at issue. X Co was a corporation that operated a residential housing construction business. Y Co was in the business of purchasing land for urban development and for preparing the lots for X Co. Y Co paid for the usual development costs of the land, while X Co paid for any out of the ordinary development work. X Co paid intercorporate management fees to Y Co which offset non-capital losses of Y Co for the taxation years in question. However, the deduction of the fees was disallowed. The planning itself was not unacceptable had the fees in fact been true management fees, but this is where the case was lost for X Co. There was no agreement in place for the provision of management services or the payment of management fees by X Co to Y Co nor were there any corporate resolutions authorizing such services or payments. The only evidence in respect of the fees given to the courts was two invoices, which showed only the total amount of the fees and the period to which they related (each covered an entire year). There was no information regarding the services provided such as the nature of the services, the hours of service or who provided the services. X Co argued that the fees were related to out of the ordinary development work including the supervision of this work and were management services to be charged by Y Co. However, this explanation was inconsistent with the financial records of Y Co. In addition, similar fees were not charged by other land development corporations that operated within the corporate group. In the end, the Court concluded that Y Co was not in the business of providing management services and the fees were paid as a tax planning scheme put in place to make use of the noncapital losses of Y Co. This case serves as a reminder that where intercorporate management fees are used, there must be a legal obligation to pay General corporate information: The names of shareholders as well as the number of shares held by each. A listing of management fees paid, including: Names of recipients and their business/social insurance number, The amount paid and the date of payment, Whether the amount was paid by cheque or journal entry, and The relationship between the corporation and the recipients. Details of the services provided, including: A description of the work performed, The amount of time spent, and Details on how often the services were provided. The CRA will also likely want to see a copy of the contract of services between the parties. Although you would generally have used the above information when you set the amount of your management fees, you should keep the information available in case the CRA requests it (rather than having to track it down later). It is also important to resist the urge to charge a reasonable fee based on general information and estimates. The CRA will be looking for specific proof of how your management fees were determined. You should consider retaining back-up copies of time records of the employees performing the work and a detailed description of the work performed for the other company. The important point to keep in mind here is that otherwise reasonable fees could be denied if there is insufficient documentation to back up the fee charged. If you have questions concerning management fee documentation, contact your BDO advisor. They can help you determine whether your management fees are properly documented.

7 7 New Rules for Dispositions of Canadian Corporations by Non-Residents The 2010 federal budget contained changes that will be of benefit to non-residents of Canada investing in Canadian companies and other entities. This change will reduce the compliance burden for non-resident vendors that are resident in countries which have a tax treaty with Canada that provides relief for gains on shares of Canadian corporations. For non-residents that reside in non-treaty countries or where a treaty does not provide specific relief for these gains, the change will also provide a tax saving. Non-residents are subject to Canadian tax on dispositions of shares of corporations and certain other interests in Canadian businesses which fall into the definition of taxable Canadian property. Under the rules that applied before the budget, where the value of the company was not derived principally from real property, tax treaties between Canada and the vendor s country of residence would, for many, exempt the gain from the sale of the shares from Canadian tax. However, even with the recent change to exempt tax withholdings for treaty-protected property, it was still necessary to file a form with the Canada Revenue Agency (CRA). And, many nonresident vendors could not take advantage of the change as they had to basically prove to the purchaser that the treaty exemption was available. In addition to showing that the property was eligible for treaty relief, the non-resident had to prove to the purchaser s satisfaction that they were eligible for treaty relief in general. This often made the change problematic to apply in arm s length transactions. Where the treaty-protected property exemption could not be used, it was necessary for non-resident vendors to obtain a clearance certificate from the CRA so that the proceeds from the sale would not be subject to withholding tax. This can be an expensive and time consuming process. The proposed rules released in the 2010 federal budget will help resolve these issues. With the budget changes, the definition of taxable Canadian property under Canadian domestic tax law will be amended to exclude shares of corporations (and other interests) that do not derive their value principally (generally more than 50%) from real or immovable property situated in Canada, Canadian resource property or timber resource property, at the time of sale and during the previous 60 months under a look back rule. This change will apply in determining whether a property is a taxable Canadian property after March 4, In addition to share transactions, these changes will also benefit trust administrators. As long as less than 50% of the value of a trust or estate is derived from real or immovable property situated in Canada, Canadian resource property or timber resource property, at the time of sale and during the previous 60 months, there will be no need to obtain clearance certificates for trust distributions to non-resident beneficiaries, either because treaty protection was not available or because the trustee was not willing to rely on a nonresident s assertions that a treaty exemption was available. Although the change is very good news, there are some issues that may arise. First, there will be situations where valuation issues may exist or there may be a lack of information. That is, it may be difficult to determine with certainty whether the 50% test has been met at the time of sale and during the last 60 months. Without absolute certainty, purchasers may still require the vendor to go through the clearance process so that they are relieved of any potential withholding requirement. In this regard, it is unfortunate that a due diligence exception for purchasers who make reasonable inquiries was not included in the draft rules. Such a rule would relieve a diligent purchaser of the requirement to withhold if they make reasonable inquiries, shifting responsibility to the vendor to make a final determination of whether the property is taxable Canadian property.

8 8 A second problem is the look back rule. Some of Canada s trading partners have rules similar to those introduced in the budget, but focus on the value of the property at the time of sale. In some cases, the corporation or trust may have had real estate (or other immoveable property) in the past, and disposed of that property in a taxable transaction during the 60 month period before the entity is disposed of. Under the draft rules, the policy of treating these interests as taxable Canadian property is questionable as the underlying immoveable property was already taxed. Although there are a couple of issues to consider with the budget changes, from an overall perspective they will help make investing in Canada by non-residents more attractive and will also relieve compliance issues for existing shareholders and trust beneficiaries. For more information on these changes, contact your BDO advisor. Further Relief Provided on US Foreign Bank Account Reporting The Internal Revenue Service has continued its suspension of certain US foreign bank account reporting requirements. In February, they announced that persons who are not US citizens, US residents or US domestic entities do not need to file Form TD F , Report of Foreign Bank and Financial Accounts (FBAR) for 2009 and earlier calendar years. This is welcome relief for non-residents of the US who are in or conducting business in the US. As previously advised in our Tax Factor publication, the US Treasury had expanded who was required to file this form to include a person in and doing business in the United States. This could have caught a Canadian individual or corporation who is conducting business in the US, even if the individual or corporation is not subject to US federal tax on its business activities because they do not have a permanent establishment in the US. In June 2009, this filing requirement was initially suspended for non-us persons for the 2008 calendar year. As noted above, this suspension is now continued for the 2009 calendar year. The filing requirement will still apply to a US person, which is defined as a citizen or resident of the US, a US domestic partnership, a US domestic corporation, or a US domestic estate or trust. The penalties for not filing when required are substantial. This form is due on June 30, 2010 for the 2009 calendar year. Note that relief has been provided in certain specific situations. Draft regulations and filing instructions dealing with future FBAR filing requirements have been released for comment and further announcements are expected. Contact your BDO advisor if you have any questions about your US filing obligations. The information in this publication is current as of May 1 st, This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it. BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.