TAX LETTER for JULY 2004

Transcription

1 BLAIN M. ARCHER, B.Sc., CA* PAUL M. FOURNIER, B.Sc., CA* RUSS J. WILSON, B.Sc., CA* KATRIN BRAUN, B.B.A., CA* KELLY A. RIEHL, B. Comm., CA* TAX LETTER for JULY 2004 PRESCRIBED INTEREST RATES SUPER-LOW PRESCRIBED RATE OFFERS OPPORTUNITIES HARMONIZED SALES TAX DEALING WITH ATLANTIC CANADA HOME BUILDERS BEWARE! TAX DANGERS ABOUND GARNISHMENT VIA THE BANK'S HEAD OFFICE? 10-YEAR LIMITATION PERIOD ON TAX COLLECTION TAX PLANNING WHEN YOU HAVE DEALINGS OVERSEAS AROUND THE COURTS PRESCRIBED INTEREST RATES The Canada Revenue Agency has announced the prescribed interest rates for the third quarter of For July to September, interest charged by the CRA on late payments of tax and instalments is 6%, compounded daily. Interest paid by the CRA on late refunds is 4%, compounded daily. The minimum rate of interest for other purposes, such as shareholder loans and to avoid the attribution rules (see below), is 2%. These rates, which are based on the Bank of Canada rate, are each 1 percentage point lower than the rates that applied from October 2003 to June SUPER-LOW PRESCRIBED RATE OFFERS OPPORTUNITIES As noted above, the "prescribed interest rate" for inter-taxpayer transactions is currently at 2% for the third quarter of This is the lowest level it has ever been and that happened only once before, in the second quarter of tax "anti-avoidance" rules from applying. For example: If you lend money or property to your spouse and your spouse pays you interest every year at the prescribed rate that was in effect when the loan was made, then the "attribution rules" will not apply. Any income your spouse earns from the loaned funds will be your spouse's, not yours. If a corporation lends money to an employee to purchase a home as the employee's residence, there is no taxable benefit to the employee for 5 years as long as interest is paid on the loan at the "prescribed rate" that was in force when the loan was made. After 5 years a new prescribed rate is used. With the rate being so low, a number of planning opportunities arise for income splitting and other tax planning. However, you will have to act by September 30, since the rate for the fourth quarter of 2004 could be higher. EXAMPLE This rate is the minimum rate that must be charged on interest to prevent various income Bob and Faye are married. Bob earns $120,000 per year (paying tax in a 46% Page 1 of 7

2 bracket) and Faye earns $25,000 per year (and pays tax in a 22% bracket). Bob lends $100,000 to Faye in July 2004, and Faye agrees to pay 2% annual interest, which she does pay every January 30. Faye invests the $100,000 in long-term bonds, which yield 6% interest. Each year, Faye will earn $6,000 in interest and pay $2,000 to Bob. She will pay tax on the difference of $4,000. Bob will pay tax on the $2,000 earned in interest from Faye. Their total tax will be ($4,000 x 22%) + ($2,000 x 46%), or $1,800, instead of $2,760 ($6,000 x 46%). By lending the funds and paying the prescribed interest rate, they save almost $1,000 per year after tax. The above is only one tax planning example. Others could include a loan to invest in dividend-paying stocks; a loan to allow a family member to buy stock in a family holding company for future income splitting via dividends; or selling stock to a younger spouse or a child as part of an estate freeze. The possibilities are limited only by the creative tax planner's imagination. HARMONIZED SALES TAX DEALING WITH ATLANTIC CANADA If you have a business that operates in Atlantic Canada, or if you sell goods to customers in Atlantic Canada, you need to know about the rules for the Harmonized Sales Tax (HST). Although the HST has been around since April 1997, many business people that have only occasional dealings with it do not properly understand it. The HST is simply the GST at 15% instead of 7%. All of it is remitted to the Canada Revenue Agency, which sends the provincial component to the province. Where it applies, you charge 15% you don't have to worry about dividing out the provincial portion. The federal government is still hoping that all provinces will merge their provincial sales taxes with the HST. But this political process takes years, if not decades. In the meantime, the HST applies in the three largest Atlantic provinces. (It does not apply in Prince Edward Island.) If you ship goods to customers (whether businesses or consumers) in Nova Scotia, New Brunswick or Newfoundland, then you must collect 15% HST instead of 7% GST. (This does not apply to printed books, on which only the 7% tax applies.) There is no separate return for reporting the HST. You simply combine HST collected at 15% with GST collected at 7% (from sales to customers in other provinces), and remit the total (minus input tax credits and other adjustments) on your regular GST return. Services are generally taxed based on where they are performed. Thus, if you perform services in an HST province, you must generally add 15% instead of 7% to your invoice. If you obtain services from a business in Nova Scotia, New Brunswick or Newfoundland, and the services are substantially all performed there, then you will be charged 15% HST instead of 7% GST. If the services are an input to your business, your input tax credit will simply be the entire 15%. Again, this is simply combined with the input tax credits you claim for GST on other business purchases. Importations from outside Canada may be taxed at 7% or 15% at the Canadian border, depending on the circumstances. In general, businesses pay 7% GST on importations, though they may be required to self-assess the extra 8% if the goods are destined for an HST province and the business is not entitled to an offsetting input tax credit. Consumers who make "casual" imports are taxed at 15% if they reside in one of the HST provinces, even if they are not returning to Canada in that province. Thus, for example, an individual living in Halifax who returns from a foreign vacation through Toronto's Pearson International Airport will be assessed 15% Page 2 of 7

3 rather than 7% on any goods that are subject to GST (in excess of the standard travellers' exemptions). The HST rules become very complex when dealing with services performed in more than one location, or with intangible property. There are also numerous special rules. If you are located in Atlantic Canada or have regular dealings with businesses or customers there, informing yourself as to the HST rules will be important. HOME BUILDERS BEWARE! TAX DANGERS ABOUND It is well known that there is no tax on the gain on your principal residence when you sell it. The Income Tax Act deems the capital gain to be zero, and in practice you need not even report the gain to the Canada Revenue Agency, unless you have more than one residence for a given year and need to file a designation as to which one is your principal residence. Some small home builders try to use this rule to build a home, move into it for a short time, and then sell it. Sometimes they do this repeatedly, building and selling one home after another over a relatively short period. These builders are in for two nasty surprises when the CRA catches up with them. Income tax full tax on the profit First, the "principal residence" exemption only applies to capital gains. It does not apply to business profit or to an "adventure in the nature of trade". If the purpose of building a home was, at least in part, to sell it, then the gain will be fully taxable as income when the home is sold. Thus, not only will the principal residence exemption not apply, but the one-half taxation of capital gains will also not apply, and high tax rates (up to about 46% depending on the province) will apply to the profit. GST "self-supply rule" Second, the builder may be hit with a GST assessment under the GST "self-supply" rule, even before selling the home, simply by moving into it. The concept behind the "self-supply" rule is as follows. If a builder builds a new home and sells it, the sale is taxable. If the builder, instead of selling the home, leases it out or occupies it personally, then the builder is deemed to have sold the home (to himself), and GST is payable immediately on the fair market value of the home. This GST must normally be remitted to the CRA within one month after the end of the current reporting period. (Offsetting input tax credits will be available for the GST paid on construction materials and to subcontractors.) After that, a sale of the home is normally exempt. The idea is to tax the home as soon as it is occupied as a new home, and not to allow a lease or personal occupancy to postpone the application of the GST. The same principal also applies to residential condominium units and apartment buildings; in the latter case, the entire building is deemed to have been sold at its fair market value as soon as the first unit is occupied. These rules (in section 191 of the Excise Tax Act) have numerous conditions and exceptions. For example: if the builder can show that he built the home purely for personal occupancy and not for resale, he will not be a "builder" as defined, and the GST rule will not apply, even if he is a "builder", if he occupied the home as his primary place of residence (rather than, for example, to enhance its saleability), the self-supply rule may not apply. Page 3 of 7

4 However, the Courts have held that, where the home was built with the intention of selling it, the fact the builder moved in with his family does not help him. In these cases the Court will usually hold that the property was part of the builder's "inventory", and is subject to the self-supply rule. Be warned! The CRA (and, in Quebec, Revenu Québec) call these builders "house hoppers", and will audit them with a vengeance. Real estate and property transfer records are kept very accurately for legal reasons, and are now electronic records in many areas, so it is not that difficult for an auditor to find such builders. It is often a simple matter for an auditor to trace a builder's recent addresses, whether from tax returns or any other source, and to research electronically the history of ownership of each of those addresses. Small builders must be careful in this minefield. Those who play the "build-it-movein-and-sell" game must be particularly aware of the double hit they will take, on both income tax and GST, if the tax authorities figure out what they are up to. Note also that, on the GST side, if the builder has not filed a GST return for the reporting period, he can be assessed at any time even 10 or 15 years after the transaction. Some builders, even today, are being assessed on homes that they built and moved into in the early 1990s. GARNISHMENT VIA THE BANK'S HEAD OFFICE? The federal budget of March 23, 2004 included a proposal which has received little attention in the tax world, but which may have a big impact on taxpayers who have unpaid tax arrears. Background As is well known, the CRA has wide power to issue a "Garnishment" notice, also known as a "Requirement to Pay" or a "Third Party Demand", for unpaid tax debts. Once 90 days have passed from the assessment date, and any objection or appeal has been dealt with, the CRA can proceed with collection action in this way. No court order is needed. If the CRA can identify anyone who owes money to the tax debtor, Collections officials will issue a Garnishment notice to that person (known as the "garnishee"). Then, if the garnishee proceeds to pay the tax debtor rather than paying the CRA, the garnishee can themselves be assessed for the amount they paid (up to the amount of the tax debt). These rules typically apply to employers and other sources of income. They also apply to banks and other financial institutions where the tax debtor has funds on deposit. Until now, to issue a garnishment notice to a bank, the CRA has had to send the notice to the particular branch at which the taxpayer has an account which means knowing which branch the tax debtor uses. The budget change The March 2004 budget proposes new rules that will allow the CRA to send the garnishment notice to a "designated office" of a bank (or trust company). Once this is done, the institution will have been notified, and must take action to freeze the tax debtor's account (at any branch), take out the funds and send them to the CRA. Clearly, this measure will give the CRA broad powers to "find" money that tax debtors have squirreled away at unknown bank branches. It would not be surprising, once this measure is enacted, to find Collections officials routinely sending garnishment notices to each of Canada's six largest banks, so as to scoop up whatever funds have been deposited at any branch of those banks. Tax debtors who want to avoid having their funds seized will likely want to open accounts at obscure credit unions instead of the big banks and trust companies. Page 4 of 7

5 This could also lead to incorrect freezing of innocent persons' assets, where someone has the same name as the tax debtor. It remains to be seen how carefully the banks are required to match up address and Social Insurance information, or if the CRA even provides that information in every case. Twenty years after 1984, Big Brother is watching you! 10-YEAR LIMITATION PERIOD ON TAX COLLECTION take collection action on those old debts will not expire until This applies even if the taxpayer obtained a Court order suspending collection action based on the Markevich decision. The same rules were also enacted for tax debts of other kinds, such as for GST, excise duties, excise taxes and the Air Travellers Security Charge. TAX PLANNING WHEN YOU HAVE DEALINGS OVERSEAS As we reported in June 2003, the Supreme Court of Canada ruled in the Markevich case that the Canada Revenue Agency could not take action on an old tax debt that it had written off internally and not proceeded with collection action for many years. The reason was that the Crown Liability and Proceedings Act provided a 6-year limitation period for legal actions by the federal government. The government has responded with new legislation, which passed through Parliament quickly and came into effect on May 14, 2004, before Parliament was dissolved for the recent federal election. These changes, to section 222 of the Income Tax Act, are now in force. Under the new rules, the CRA has 10 years to take collection action of any kind. Any collection action at all, including if the taxpayer acknowledges the tax debt or makes any payment, restarts the 10-year period. Collection against another party for the taxpayer's debt (e.g. where the taxpayer has transferred property or money to a family member) also restarts the period. Furthermore, the period is extended if the taxpayer becomes non-resident, or if collection action is restricted for any reason (such as an objection being filed or because of a proposal filed under the Bankruptcy and Insolvency Act). Any "old" tax debts from the past have their 10-year period reset to begin on March 4, The limitation period for the CRA to Canada has an valuable network of tax treaties (tax conventions) with other countries. These are crucially important for individuals and businesses that have financial connections with, or do business with, other countries. Tax treaties generally prevent or reduce double taxation, where certain amounts would otherwise be taxed by both systems. These treaties also reduce the withholding tax on payments made from one country to another, and can be extremely important for taxpayers who move between Canada and the other country. Five of Canada's tax treaties with the U.S., Austria, Germany, Netherlands and Norway also allow the Canada Revenue Agency to use the foreign tax administration to collect Canadian tax debts, and allow the CRA to enforce collection of the foreign country's tax debts. In the last few months, Canada has signed replacement tax treaties with Ireland and Romania. These new treaties are not yet in force, as they still have to be "ratified" (passed into law) by legislation in both countries. Other recently signed tax treaties have recently been ratified and are now in force. These include new treaties with Kuwait, Senegal, the United Arab Emirates and Venezuela, and a Protocol amending the tax treaty with the United Kingdom. The Page 5 of 7

6 changes to the treaty with the UK generally take effect in Canada recently announced that it is in the process of negotiating new or amended tax treaties with Korea, Serbia/Montenegro and Singapore. If you are doing business with, have investments in, or are considering moving to any of these countries, you may wish to find out more details. People with interests in Hong Kong should be aware that the Canada-China tax treaty does not apply to Hong Kong, despite the territory having been returned to Chinese control. This position was upheld by the Federal Court of Appeal last year in the Edwards case. AROUND THE COURTS Court steps into to order CRA to waive interest The Federal Court has, over the past year or two, become increasingly willing to review decisions by the Canada Revenue Agency not to waive or cancel interest on a taxpayer's income tax balance. guidelines. If they do not apply them properly, the Court may step in. Galetzka was a recent such case. The taxpayer worked as a housekeeper at an inn. She asked the CRA to cancel her outstanding arrears interest on the basis of "financial hardship", which is one of the grounds for relief in the guidelines. The CRA denied her request on the basis that she had the ability to borrow funds to pay her debt and that she was not separated from her husband as she had represented. Ms. Galetzka applied to the Federal Court to review this decision. The Court allowed Ms. Galetzka's application. She provided a letter from the bank confirming that she could not borrow money to make a reasonable payment arrangement. She also confirmed that she lived separate and apart from her husband under the same roof solely for economic reasons. As they were separated, he would not consent to a mortgage loan on their jointly owned farm. Based on this information, the Court ruled that the CRA's decision was "patently unreasonable" which is the test required for the Court to intervene. Technically, this "waiver of interest", under subsection 220(3.1) of the Income Tax Act, is done at the CRA's discretion. The Act says that "The Minister may at any time waive or cancel all or any portion of any penalty or interest otherwise payable under this Act". It does not require the CRA to waive interest. However, the CRA has published guidelines as to when interest will be waived or cancelled, in Information Circular 92-2 (available on cra.gc.ca). These are the socalled "Fairness" guidelines. When one applies for "Fairness" relief including cancellation of interest, CRA officials are supposed to apply the What is even more interesting is the remedy. Normally in these situations the Court sends the matter back to the CRA for a new review, usually by a different CRA official. In this case the Court actually told the CRA how to exercise its discretion! The Court ordered that the "only fair and reasonable decision" would be one that cancelled all interest and penalty, provided the taxpayer paid $500 immediately as a "reasonable payment arrangement". Chalk one up to the taxpayer side. It remains to be seen whether the Federal Court continues to intervene in this way, telling the CRA what to do rather than simply ruling that the process (by which waiver of interest was denied) was not properly followed. Page 6 of 7

7 Court limits "fishing expedition" by CRA auditor In the recent Federal Court decision in Artistic Ideas Inc., a art flip promoter was being audited. The CRA auditor demanded the names and addresses of the donors and charities involved in the scheme. (Art flips involved buying art at a discounted price and donating it to a charity in exchange for a tax receipt based on a much higher valuation of the art. These schemes were shut down as of December 5, 2003 by new proposed amendments to the Income Tax Act.) Obviously this would make it easy to reassess the donors. Artistic Ideas challenged the demand by bringing an application for judicial review in Federal Court. The Court held that the CRA's demand was part of a valid audit of Artistic Ideas. The names of the charities could be requested without judicial authorization; but demanding the names of the donors required the CRA to make a Court application under subsection 231.2(3) of the Income Tax Act, which the CRA had not done. Therefore, the Court quashed the part of the demand that requested the names of the donors. The CRA has appealed this portion of the decision to the Federal Court of Appeal, so stay tuned. * * * This letter summarizes recent tax developments and tax planning opportunities; however, we recommend that you consult with us before embarking on any of the suggestions contained in this letter, which are appropriate to your own specific requirements. Page 7 of 7