Qualified disability trusts: focus on the present, with an eye to the futureKrista Fox and Maureen De Lisser, Toronto

February 2017

Canada — TaxMatters@EY

In this issue

Online tax calculators and rates5Form T2200: an employer’s perspective6Running the numbers: how data analytics is transforming tax administration

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Building a better working world means understanding your tax situation and how the ever-changing global tax landscape affects you. TaxMatters@EY is a monthly Canadian bulletin that summarizes recent tax news, case developments, publications and more. For more information, please contact your EY advisor.

Prior to 2016, testamentary trusts were taxed in a more favourable way than inter vivos trusts. Specifically, inter vivos trusts other than grandfathered inter vivos trusts (generally an inter vivos trust created before 18 June 1971 that met certain conditions) were taxed at the top marginal tax rate on every dollar of income, while testamentary trusts and grandfathered inter vivos trusts enjoyed graduated rates of tax.

Effective for 2016 and subsequent taxation years, income generated in new and existing testamentary trusts, certain estates and grandfathered inter vivos trusts are taxed at the highest marginal tax rate applicable to individuals (currently 33% federally, plus the applicable provincial or territorial top rate), subject to two exceptions: graduated rate estates and qualified disability trusts (QDTs).

The spousal “half loaf” plan crumbles again10

2 Canada — TaxMatters@EY February 2017

An individual’s estate qualifies as a graduated rate estate during the first 36 months after the individual’s death, provided the estate is a testamentary trust, the estate has designated itself as a graduated rate estate and the individual’s social insurance number (SIN) is provided in the estate's return of income. Only one trust may be designated as a graduated rate estate in respect of any individual. Under the graduated rate estate rules, the estate continues to enjoy graduated rates of tax for 36 months following an individual’s death.

A QDT is a new type of trust available specifically for the benefit of disabled individuals. QDTs are taxed at graduated marginal tax rates for 2016 and subsequent taxation years, provided certain conditions are met.

The following discussion relates to the new rules in relation to QDTs. While this type of trust offers significant tax benefits, meeting the requirements to qualify as a QDT may not be easy. In addition, failure to continuously meet the requirements can result in changes in the status of the trust from one year to the next. This in turn may result in variable rates of tax from year to year. Individuals with disabilities, and family members who support them, should be aware that diligence is required to meet ongoing requirements.

QDTs: the basicsTo qualify as a QDT, the following conditions must be met:

• The trust must be a testamentary trust that arose on a particular individual’s death.

• The trust must be resident in Canada for the entire trust year (i.e., a trust that is deemed to be resident in Canada under the nonresident trust rules does not meet this requirement).

• The trust must jointly elect with one or more of the trust’s beneficiaries (the “electing beneficiaries”) to be a QDT for the year.

• Each electing beneficiary’s SIN must be included in the election.

• Each electing beneficiary must be named as a beneficiary by the particular individual in the instrument under which the trust was created (e.g., a will).

• Each electing beneficiary must be eligible for the disability tax credit (DTC) for the beneficiary’s taxation year in which the trust’s taxation year ends.

• An electing beneficiary cannot jointly elect with any other trust to be a QDT for the other trust’s taxation year that ends in the beneficiary’s taxation year.

• The trust must not be subject to recovery tax for the year (see below).

Disability tax creditTo qualify as a QDT in a year, an electing beneficiary must be eligible to claim the DTC for the beneficiary’s taxation year in which the trust’s taxation year ends. Generally, the DTC is available to an individual who is certified by an appropriate medical practitioner as having a severe and prolonged mental or physical impairment (or a number of ailments) that markedly restricts the individual’s ability to perform a basic activity of daily living. To claim the DTC, the individual (or a representative) must file Form T2201, Disability Tax Credit Certificate, which must be signed by a specified medical practitioner.The CRA sends a notice of determination on approval of Form T2201 and includes the years in which the individual is eligible to claim the DTC. Although a new form T2201 is not required to be filed each year (unless the CRA requests the individual to file), an improvement in the individual’s medical condition may result in the individual no longer meeting the DTC eligibility criteria. The CRA must be informed if this occurs.

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A QDT election is made using form T3QDT, Joint election for a trust to be a qualified disability trust, and is filed with the trust’s T3 return. The joint election must be made each year, and each year the beneficiary must qualify for the DTC, so the trust’s status may change from year to year.

While there can also be nonelecting beneficiaries in a QDT, special rules ensure that they do not benefit from graduated rates of tax. Any distributions of capital made by a QDT to a nonelecting beneficiary (i.e., a beneficiary who was not an electing beneficiary of the trust for the current year or a preceding year) will be subject to a recovery tax.

Recovery taxThe recovery tax claws back the tax savings obtained by a QDT on income that was taxed at graduated rates under any of the following circumstances:

• At the end of the trust’s current taxation year, none of the beneficiaries was an electing beneficiary of the trust in an earlier year (this would include the year in which the electing beneficiary, or the last electing beneficiary, dies)

• The trust ceases to be resident in Canada (which deems the trust’s taxation year to have ended immediately before that time)

• The trust makes a capital distribution to a nonelecting beneficiary in the year (i.e., the flowing-out of current income or payments to a beneficiary in their capacity as a creditor of the trust would not attract the recovery tax)

4 Canada — TaxMatters@EY February 2017

The recovery tax calculation is fairly complex. However, in general terms, the federal recovery tax is calculated as the additional amount of federal tax that would have been paid on the trust’s taxable income in a previous year if the trust had not been a QDT for that previous year (and would therefore have been subject to the highest marginal rate of tax). Taxable income for purposes of this calculation excludes amounts that were distributed to an electing beneficiary, and the tax paid by the trust that was reasonably attributable to those amounts. A similar calculation applies for purposes of determining the applicable provincial or territorial recovery tax.

A trust subject to recovery tax must complete Form T3QDT-WS E, Recovery Tax Worksheet.

Planning considerationsTo continue to benefit from a QDT designation, the following issues must be kept in mind:

• Limit of one QDT per electing beneficiary – A beneficiary can only elect to have one trust as a QDT in a year.

• If an individual is a beneficiary under multiple trusts, he or she should designate a trust as a QDT in such a way that that the designation will lead to the greatest tax savings.

• Annual election – The QDT election must be made by the trust and the electing beneficiary each year. There is no late election available for QDTs, so if the election is not filed on time, the trust does not qualify as a QDT for the year, and income taxed in the trust will be subject to the top marginal rate of tax. Issues may also arise as to the capacity of a beneficiary to make the QDT election annually, and a guardian may be required to make the election on the beneficiary’s behalf.

• Named beneficiary – A beneficiary must be specifically named as a beneficiary in the instrument under which the trust was created. The CRA has stated that, for QDT purposes, a beneficiary who is part of a class of persons identified in the instrument (e.g., identified in general terms such as issue, descendants or children) is not considered to be a named beneficiary. Individuals should ensure their will or beneficiary designation is updated, as changing circumstances require, such as when a child is born with, or develops, a condition which may be eligible for the DTC.

• Disability tax credit – To be an electing beneficiary, the beneficiary must be certified by a medical practitioner as being eligible for the DTC. Not all disabilities or impairments result in eligibility for the DTC. In addition, changes or improvements in an individual’s condition will affect a trust’s ability to be designated as a QDT.

• Potential liability of QDT trustee – When the last remaining electing beneficiary of a QDT dies, recovery tax is payable on any undistributed income from previous years still remaining in the trust. Currently, there are no specific provisions in relation to the responsibility for payment of recovery tax in this situation. As such, the general principles apply, and a QDT trustee or the estate of the electing beneficiary may find themselves jointly liable with the trust for payment of the recovery tax (the CRA does not consider the estate of an electing beneficiary to qualify as an electing beneficiary). Legal representatives should ensure that a clearance certificate is obtained prior to any distribution of property.

ConclusionsWhile QDTs can be a very useful planning tool for the continued care of disabled individuals, trusts and estate plans should be regularly reviewed to ensure the benefits available under QDTs are not lost due to changing circumstances or failure to meet QDT eligibility requirements. u

Check out our helpful online tax calculators and ratesLucie Champagne, Alan Roth, Candra Anttila and Andrew Rosner, Toronto

Frequently referred to by financial planning columnists, our mobile-friendly 2017 Personal tax calculator is found at ey.com/ca/taxcalculator.

This tool lets you compare the combined federal and provincial 2017 personal income tax bill in each province and territory. A second calculator allows you to compare the 2016 combined federal and provincial personal income tax bill.

You’ll also find our helpful 2017 and comparative 2016 personal income tax planning tools:

• An RRSP savings calculator showing the tax savingfrom your contribution

• Personal tax rates and credits, by province andterritory, for all income levels

In addition, our site offers you valuable 2017 and comparative 2016 corporate income tax planning tools:

• Combined federal–provincial corporate income taxrates for small-business rate income, manufacturingand processing income, and general rate income

• Provincial corporate income tax rates for small-business rate income, manufacturing and processingincome, and general rate income

• Corporate income tax rates for investment incomeearned by Canadian-controlled private corporationsand other corporations

You’ll find these useful resources and several others — including our latest perspectives, thought leadership, Tax Alerts, up-to-date 2017 budget information, our monthly TaxMatters@EY and much more — at ey.com/ca/tax.

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Form T2200: an employer’s perspective

Individuals earning business income are generally permitted to deduct a wide range of expenses incurred to earn business income. Employees, on the other hand, are only permitted to deduct specially listed expenses that were incurred to earn employment income. In addition, there are significant conditions that must be satisfied before employees can claim some deductions.

Two common expenses employees seek to claim are automobile expenses and home office expenses. Claims of home office expenses are becoming more prevalent, as employers seek to reduce occupancy costs and employees seek greater flexibility by doing all or a portion of their work from home. In order for an employee to claim either of these expenses (or other less common employment expenses), the employee must receive a signed form T2200 from his or her employer certifying that the conditions for the deduction are met.

The courts have described the function of the form T2200 as a “statutory condition precedent”1 to the claiming of employment expense deductions. In other words, a T2200 is not sufficient for an employee to claim certain employment-related expenses, but without form T2200 the employee cannot claim the expense, even if all the other conditions are satisfied.

When considering whether to issue a T2200 for home office expenses, the employer is required to answer the following questions:

10. Did this employee's contract of employmentrequire him or her to use a portion of his or herhome for work?

If yes, approximately what percentage of theemployee’s duties of employment were performedat their home office?

Did you or will you reimburse this employeefor any of his or her home office expenses?

If yes, indicate the type of expense and amountyou did or will reimburse.

Employers typically struggle with the following two questions:

1. Did the employee’s contract of employment “require”the employee to use a portion of his or her homefor work?

2. What level of proof does the employer need with respect to the approximate percentage of theemployee’s duties that were performed at thehome office?

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Lawrence Levin and Edward Rajaratnam, Toronto

“Required” by contract of employment to use a portion of home for workWhile a situation where the employee’s contract of employment provides that he or she will work from home would clearly satisfy this condition, the requirement to work from home is arguably broader. In the case of Morgan v The Queen,2 the court held that the requirement for the expenditure is not limited to the wording of the employee’s contract and may be implied from the circumstances. In order to determine if an expense incurred by an employee was actually an implied requirement of the contract of employment, the courts have reviewed whether or not the failure to meet the requirement could result in the cessation of employment, a poor performance evaluation or other disciplinary action on the part of the employer.

As a practical matter, the requirement to maintain a workspace in the home will not likely be satisfied if an employee has a workspace available to him or her at the employer’s premises. However, in a situation where an employee is “on the road” and is required to perform certain administrative tasks, the requirement to maintain a work space in the home may be implied.

Level of proofAs noted, it is often difficult for the employer to know the percentage of the employee’s duties that were performed from the home office.

The employer need not know with certainty the percentage of duties performed by the employee from the home office, but must have reasonable grounds to believe that the employee performed >50% of their duties from the home office. Since many employers do not know the percentage of duties performed by employees from their home office, where an employee requests a T2200 it has become common practice for the employer to ask the employee to provide the percentage of duties performed from his or her office. The employer should

then ask a manager or supervisor familiar with the employee to confirm that the figures provided by the employee are reasonable.

Due to the increased prevalence of CRA employer compliance (payroll) audits, employers should consider their internal processes in relation to issuing T2200s, to ensure that they are aligned with the legislation.

Ask your EY advisor for guidance. u

¹ Schnurr et al v The Queen 2004 DTC 35312 2007 TCC 4753 See, for example, CRA Document 2011-0392721E57 Canada — TaxMatters@EY February 2017

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Driven by revenue pressures and shrinking headcounts, tax authorities across the globe are increasingly relying on digital methods to collect taxpayer data and administer their tax systems. Amid increasing demands for tax transparency by governments and supranational organizations, many tax authorities are building sophisticated data-gathering platforms that enable matching and sharing of taxpayer data. They are then using data analytics to mine this data to help increase tax collections, target compliance initiatives and improve overall efficiency.

Practically speaking, this means an unprecedented amount of taxpayer information is flowing between governments and businesses. This data is being analyzed and used in new and more expansive ways. The Organisation for Economic Co-operation and Development’s (OECD’s) country-by-country reporting (CbCR) requirements mandate increased data collection and disclosure.

With several countries, including the United States, having adopted the CbCR requirements and many more countries soon to follow, the volume and pace of data collection and analysis will only continue to grow. In this environment, companies, and especially their tax and finance functions, need to know what information they are expected to share and have confidence that it is accurate, secure and formatted correctly.

Data is the foundation upon which this new digital tax world is being built, and the quality of the outcomes that result will depend on the quality of the data that goes in. To match what governments are doing and stay one step ahead, tax departments must look at the tax function through the lens of big data and data analytics.

Big data refers to the increasing volume of data now available, as well as its variety and the speed at which it can be processed.

Analytics is the means for extracting value from this data — the tool that generates actionable insights.

How tax authorities are using data analyticsMany tax authorities pull together data from a variety of sources to develop a more complete picture of companies’ tax profiles. Companies are increasingly being asked to submit client invoices, statements of accounts, customs declarations, vendor invoices and bank records, all in formats specified by the government — and on an accelerated schedule (often in real or near-real time). Moreover, the formats in which these data are submitted may differ from how companies track and collect the data themselves.

Tax authorities are using real-time or near-real-time data analytics engines to validate invoices and lag discrepancies, verify sales and purchase declarations, verify payroll and withholding declarations and compare data across jurisdictions and taxpayers. Based on these analyses, tax authorities make determinations, including tax and audit assessments. While countries such as China, France and Russia have advanced digital authorities, some of the other leaders in digital tax are in the Americas.

Running the numbers: how data analytics is transforming tax administrationExtract from EY’s “Global Tax Policy and Controversy Briefing Issue 18, October 2016”

CanadaExamples of information required: Tax returns and supporting documentation (paper or digital format)

Frequency of submission: Varies depending on type of information required

The CRA, like [certain] other tax authorities…, collects large amounts of taxpayer data and uses data analytics to gain “better business intelligence about taxpayer behavior” and support its compliance and collection efforts. In a recent report to Parliament, the CRA identified some examples of how it uses data analysis, including:

• To predict the assessed value of certain unfiled returns and target follow-up action (resulting in $127m in additional assessments in the 2013–14 tax year)

• To identify accounts that would “self-resolve,” allowing the CRA to focus collection efforts on higher-risk accounts

• To predict for which instalment-payment taxpayers were likely to make payments; the CRA was then able to better target follow-up phone calls (resulting in $31m in additional negotiated payments in the 2013–14 tax year)

The CRA uses available business intelligence, including mandatory reporting of electronic funds transfers, to identify high-risk cases and emerging offshore arrangements through its Offshore Compliance Division.

It also recently implemented an automated tool that links taxpayer information from its various databases and applies risk algorithms to calculate an automatic risk assessment for all “large files.”

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What it means for companiesTax authorities’ enhanced use of data analytics means that companies — and their tax and finance departments — need a shift in mindset around how they collect, store and analyze tax and financial data. Documents may be stored in various places, such as network shared drives, personal hard drives, external providers’ systems, document management systems and emails. Adding to the challenge, the requested information may be spread across different functions and geographic locations. This can make it hard to find data when it’s needed and know when that data has been collected or delivered.

These challenges can be mitigated through development of a robust data management and analytics system.

The volume of requests and short response time for compliance means that companies need sophisticated data management and analytic capabilities that meet or exceed those used by tax authorities. They also need people familiar with these enhanced data requirements to develop and maintain those systems. Further, they must take proactive steps to create files that are “audit ready” when submitting requested information to tax authorities — particularly in this environment of increased transparency and information exchange.

Action stepsWhile companies can face significant challenges in modifying their data management and analytics capabilities to meet the requests and rapid turnaround times requested by tax authorities, it is critical that they face this challenge head on. We see forward-looking companies taking the following steps to develop a new approach to compliance in this digital environment:

• Performing detailed reviews of data requirements, processes and technologies that support digital tax authority requests across the globe

• Testing and reviewing submitted data to provide the company with visibility into what tax authorities are doing with the transmitted data — quantifying and mitigating risks as issues are found

• Developing multi-country data management and analytic capabilities to create efficiencies and provide real-time visibility into the transmitted data

• Shifting focus from traditional compliance activities to real-time digital audit readiness activities — changing technologies, processes and people to support this shift

• Keeping abreast of legislative and regulatory changes affecting tax data collection and submission — and providing input to policymakers as appropriate

ConclusionAs tax authorities rely more on data to make compliance and audit determinations, and are increasingly sharing this data with tax authorities in other jurisdictions, companies will face risks and exposure if their people, processes and systems are dated or out of sync with government requirements and expectations.

The tax department has an opportunity to deliver value in this new era of digital tax by embracing enterprise initiatives and transformations that facilitate enhanced data management.

Companies can realize this value by harnessing data analytics to manage risk, control costs, and inform communications and business decisions. u

The spousal “half loaf” plan crumbles againGervais c. Sa Majesté la Reine, 2016 CCI 180 Maude Lussier-Bourque and Marie-Claude Marcil, Montreal, and Allison Blackler, Vancouver

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In the course of these appeals, both the Tax Court of Canada (TCC) and the Federal Court of Appeal (FCA) have had the opportunity to examine the taxation of a series of transactions, commonly referred to as a “‘half loaf” plan, in which a husband sought to split a capital gain under the Income Tax Act (the Act) with his wife in order to access both of their capital gains exemptions, in the context of an impending arm’s-length sale of the shares of a qualifying small business corporation.

The case was first decided by the TCC, then overturned by the FCA and returned back to the TCC to consider the application of the general anti-avoidance rule (GAAR), which had not been addressed in the initial TCC decision. Spoiler alert: it’s now on its way back to the FCA for a second time.

FactsThe taxpayers in these appeals are a husband and wife, both of whom were involved in the running of a family business. The share capital of that family business was owned by the husband and his brother, but not by his wife.

In 2002, an arm’s-length purchaser made an offer to purchase the shares of the family business. Once the offer had been accepted, but prior to the closing of the sale, the husband and wife consulted with their tax advisors to attempt to minimize the tax impact of the sale and to find an efficient way to recognize his wife’s contribution to the business over the years. The advisors’ plan required the husband and wife to undertake the following pre-closing transactions:

• First, the husband sold his wife shares, worth approximately $1 million,4 and as consideration, she issued him a $1 million promissory note payable over five years with interest. The husband elected not to have the automatic spousal rollover rules of subsection 73(1) of the Act apply to the transfer. Consequently, the sale occurred at the shares’ fair market value (FMV), the husband recognized a taxable capital gain, and the wife obtained the shares with an adjusted cost base (ACB) equal to their FMV. Because the transaction was not subject to the spousal rollover rules, and by virtue of subsection 74.5(1) of the Act, any capital gain on the future sale of the purchased shares by the wife would not attribute back to the husband.

• Next, the husband gifted shares of the same class to his wife, also worth $1 million. For this transfer, the husband elected to have the shares transferred on a rollover basis under subsection 73(1) of the Act. As a result, the transfer occurred at the ACB of the shares, the husband did not recognize a taxable capital gain, and the wife obtained the shares with a nominal ACB. Unlike a gain on the purchased shares, and by operation of subsection 74.2(1) of the Act, any capital gain on the future sale of the gifted shares by the wife would attribute back to the husband.

Because the shares were all of the same class, under subsection 47(1) of the Act, the ACB of all of the shares now owned by the wife was determined by averaging the

4 All amounts have been rounded for simplicity.

5 Irrigation Industries Ltd. v M.N.R., [1962] S.C.R. 346.

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high-ACB shares she purchased and the low-ACB shares she was gifted. As a result, following the pre-closing transactions, the wife’s shares were averaged to have a FMV of $2 million and an ACB of $1 million in total.

When the family business was sold to the arm’s-length purchaser, the wife recognized a capital gain of $500,000 in respect of the purchased shares, and a capital gain of $500,000 in respect of the gifted shares. She reported the gain on the purchased shares for income tax purposes; however, in respect of the gifted shares, that gain was attributed back to her husband under subsection 74.2(1) of the Act. Both spouses made use of their capital gains exemptions to shelter some or all of these gains.

The Minister of National Revenue (the Minister) assessed the wife on the basis that the entire gain she made in respect of the purchased and gifted shares should be taxed as business income, not as a capital gain. The Minister also assessed the husband on an alternative basis, that if the gain should not be taxed as business income to his wife, then the entire gain should be removed from her income and added to the husband’s income as a capital gain under the general anti-avoidance rule (GAAR). The Minister conceded, however, that if one of the assessments was upheld, the other appeal should be allowed, as the capital gains should not be included in both spouses’ incomes. The husband and wife appealed their assessments to the TCC.

Tax Court of Canada’s first decision [2014 TCC 119]The TCC began by analyzing the half-loaf plan in the context of the wife’s appeal.

Beginning with the purchased shares, the TCC concluded that the wife had acquired and disposed of them on account of income in the course of an adventure in the nature of trade. In reaching this conclusion, the TCC acknowledged that the Supreme Court of Canada (SCC)

decision in Irrigation Industries5 suggests that there is a presumption that shares are capital assets unless there are strong indications to the contrary.

However, the TCC distinguished that decision, concluding that the facts were sufficiently different as to render the decision not applicable. Instead, the TCC was persuaded by certain other factors which it found were indicative of income. Specifically, the factors were that the wife had always intended to sell the shares even before she acquired them, the shares produced no income while she held them and were resold less than two weeks after she acquired them, and her investment was not paid immediately, but by repayment of a promissory note over five years.

The TCC acknowledged that she had no profit intention in acquiring the shares, since she sold them for the same price for which she acquired them, which would ordinarily suggest a capital investment. However, the TCC reasoned that because she repaid the promissory note over five years, she obtained the financial benefit of improved cash flow over that time. In the TCC’s view, this analysis was sufficient to conclude that she acquired the shares on income account.

However, with respect to the gifted shares, the TCC concluded that they were held on capital account, even though they were also intended to be resold. In the TCC’s view, realizing on the value of a gift is very different from buying property to resell, and there must be much more than a quick sale to indicate that property received as a gift was an adventure in the nature of trade.

Having concluded that the purchased shares were held on account of income, and the gifted shares were held on account of capital, the TCC then determined that the ACB averaging rules in subsection 47(1) of the Act could not apply, and therefore the gifted shares retained their nominal ACB.

Turning then to the tax consequences flowing from the wife’s sale of the purchased and gifted shares, the TCC held that no business income resulted on the wife’s immediate resale of the purchased shares as she had sold them for their purchase price, and a capital gain of $1 million arose from her immediate resale of the gifted shares, that gain to be attributed back to her husband under subsection 74.2(1) of the Act. Given this conclusion, the TCC declined to analyze the husband’s assessment under the GAAR. As a result, the wife’s appeal was allowed, while the husband’s appeal was dismissed.

Federal Court of Appeal decision [2016 CAF 1]The husband appealed to the FCA on the basis that the TCC had erred in finding that the wife’s sale of the purchased shares was on account of income, with the result that the capital gain on her sale of the gifted shares was attributed back to him. The Minister cross-appealed, arguing that no distinction should be made between the wife’s purchased and gifted shares and that her sale of all of those shares should be considered as an adventure in the nature of trade and the gains in respect of the entire disposition treated on income account.

The FCA agreed with the husband and wife, and in particular agreed that the TCC’s conclusion that the wife’s purchased shares were held on income account was incorrect in law. In particular, the FCA refused to distinguish Irrigation Industries, stating that the TCC’s departure from that precedent was not justified.

The FCA also took issue with the TCC’s suggestion that by paying for the purchased shares with a promissory note the wife had gained a financial advantage in the form of improved cash flow, and that this was a sufficient benefit to conclude that the sale of those shares gave rise to income despite the fact no profit was made.

6 Friesen v Canada, [1995] 3 S.C.R. 1037 Copthorne Holdings Ltd. v The Queen, [2011] 3 S.C.R. 721.

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The FCA found no jurisprudence to support the TCC’s conclusion, and instead cited the SCC’s decision in Friesen,6 to deny that the improved cash flow could be such a benefit in the absence of a reasonable expectation to profit from the sale. With respect to the gifted shares, while the FCA did not entirely agree with the TCC’s reasoning, it did agree with the conclusion that they were held on capital account.

As a result, the FCA allowed the husband’s appeal and denied the Minister’s appeal on the basis that the wife’s sale, in its entirety, was on capital account. However, the FCA concluded that the TCC should have considered the application of the GAAR, and therefore referred the matter back to the TCC to complete that analysis.

Tax Court of Canada’s second decision [2016 CCI 180]Since the FCA had decided that the wife’s sale of the shares was all on capital account, the only issue remaining was whether the husband’s assessment could be upheld, and more particularly, whether the entire gain – and not just the gain on the gifted shares which had attributed to the husband – should be removed from her income and added to his as a capital gain under the GAAR.

As always in any GAAR analysis, the TCC started by restating the key requirements for the GAAR to apply, specifically that there must be (1) a tax benefit, (2) an avoidance transaction and (3) an abuse or misuse of the Act.

With respect to the first requirement, the finding of a tax benefit, the TCC determined that the husband had two objectives in carrying out the half-loaf plan: to sell his shares of the family business and to give his wife $1 million. However, the TCC observed that he could have accomplished these two objectives by simply giving her the funds from the proceeds of the share sale, while paying tax on the full gain in respect of those shares. The TCC concluded that he had clearly obtained a tax benefit

as a result of the planning, as it allowed him to reduce his taxable capital gain on the sale.

With respect to the second requirement, the existence of an avoidance transaction, the TCC based its analysis on the authority of the SCC in Copthorne.7 More particularly, the TCC acknowledged that an avoidance transaction is one which, on its own or as part of a series, gives rise to a tax benefit, unless it can reasonably be considered to have been undertaken primarily for other bona fide non-tax purposes. Where a transaction is undertaken for both tax and non-tax purposes, then the primary purpose must be determined. If, following that determination, one transaction in a series is not undertaken for primarily bona fide non-tax purposes, then avoidance will be found.

The husband argued that their primary purpose in undertaking the series of transactions had been to benefit his wife — to recognize her contribution to the family business over the years and to enable her to make personal use of her portion of the proceeds. The TCC acknowledged that this was certainly one of their purposes for undertaking the series of transactions.

However, in the TCC’s view, this objective co-existed with their desire to reduce taxes and, importantly, some of the steps undertaken in the series of transactions were not “necessary” to achieve the asserted non-tax purpose, and therefore could not be said to have had bona fide non-tax purposes. In making this determination, the TCC observed that the husband and wife considered tax implications and made specific tax choices at various steps of the series of transactions. In particular, the choice to elect, and not to elect, was intentionally made in order to achieve the desired application of the ACB averaging rules in subsection 47(1) of the Act and the tax consequences that then resulted from the eventual sale of the shares to the third party. As a result, the TCC concluded that the series of transactions was primarily undertaken to obtain the identified tax benefit. The TCC therefore found that the second requirement had also been met.

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8 Lipson et al v The Queen, [2009] 1 S.C.R. 3.

Finally, with respect to the abuse or misuse of the Act, the TCC followed the growing body of jurisprudence that directs that the object, spirit or purpose of the provisions that are relied on for the tax benefit must be considered, having regard to the scheme of the Act as a whole. As the SCC has repeatedly made clear, abuse or misuse will be found if those provisions are used to (1) achieve a result that the provisions are designed to prevent, (2) defeat the underlying reason for such provisions, or (3) allow the circumvention of such provisions in a way that frustrates or defeats their object, spirit or purpose.

The TCC focused in particular on the spousal attribution rules found in sections 74.1 to 74.5 of the Act, which the SCC had previously considered in a GAAR context in Lipson.8 The TCC concluded that the series of transactions in this half-loaf plan frustrated the purpose of these spousal attribution provisions, because it led to a result that the provisions aimed to prevent. More particularly, the spousal attribution rules were designed to allow the deferral of tax consequences until the transferred asset was disposed outside of the family unit. They were not designed to allow the reduction or avoidance of such tax consequences. The TCC also briefly considered the purpose of subsection 47(1) of the Act, concluding that it was designed to calculate the average ACB in respect of identical property obtained at different times in order to facilitate the capital gains calculation on sale.

The TCC then concluded that when the whole series of transactions was considered together, the husband’s use of the ACB averaging rules in subsection 47(1) of the Act, in conjunction with the spousal attribution rules in subsection 74.2(1) of the Act, gave rise to the result that subsection 74.2(1) of the Act was intended to prevent,

the reduction or avoidance of tax, thereby defeating its purpose. Therefore, taken together, the whole series of transactions resulted in a misuse or abuse of the Act.

As a result, the TCC upheld the Minister’s assessment of the husband and confirmed that the GAAR applied to the series of transactions to attribute the wife’s entire taxable capital gain to him.

Lessons learnedLike many appeals that cycle back and forth through the courts, there are a few distinct messages that taxpayers can take away from these decisions.

On the one hand, they offer a clear reminder from the FCA that the nature of an asset is an important factor in determining its characterization as a capital or income asset and that there remains a strong presumption that the sale of shares is on capital account. They also contain a firm rejection of the notion that a financial advantage in the form of improved cash flow can be a sufficient benefit on its own to conclude that a sale gives rise to

income despite the absence of any profit on that sale. On the other hand, they serve as a further warning for taxpayers undertaking tax planning to always consider the applicability of the GAAR, both in the context of arm’s-length and non-arm’s-length transactions.

As hinted above, this decision on GAAR was appealed to the FCA in October 2016. What remains to be seen at this point is whether the FCA will fully adopt the TCC’s GAAR analysis. For instance, it remains to be seen whether the FCA will agree with the TCC’s emphasis on the “necessity” of a transaction being determinative of whether there is an avoidance transaction. Perhaps more important, however, will be whether the FCA will also frame its analysis entirely as an abuse of subsection 74.2(1) of the Act, or whether more emphasis will be placed on subsection 47(1) of the Act. After all, it was the averaging of the ACB that enabled the tax result that was found to be abusive. Accordingly, this decision may be of particular interest well beyond the context of spousal attribution. u

14 Canada — TaxMatters@EY February 2017

Tax Alerts – Canada Proposed amendments to the ETA: closely related election under section 150 or 156 — 2016 Issue No. 47 On 25 October 2016, federal Finance Minister Bill Morneau tabled Bill C-29, which includes measures announced in the 2016 federal budget to limit application of the election under section 150 and 156 of the Excise Tax Act (ETA). These new measures could have implications for elections under sections 150 and 156 of the ETA currently in effect, as well as effective after 22 March 2016 or on or after 22 March 2017.

SCC concludes general intention of tax neutrality insufficient for rectification in common law and civil law— 2016 Issue No. 48 On 9 December 2016, the Supreme Court of Canada (SCC) released decisions on two cases regarding rectification in the tax context . Both decisions agree that a general intention of tax neutrality is insufficient to justify a rectification order.

New Alberta tax credit to stimulate investment and create jobs — 2017 Issue No. 1 Effective 1 January 2017, companies can apply for the new Capital Investment Tax Credit (CITC). The two-year credit will provide $70m in investment credits for manufacturing, processing and tourism infrastructure to spur economic diversification and job creation in Alberta.

Alberta's Venture Capital Tax Credit— 2017 Issue No. 2 The Alberta Government introduced the Alberta Investor Tax Credit (AITC) to stimulate investment in certain industries with strong job-creation potential. The AITC offers a 30% tax credit to investors who provide venture capital to eligible companies during the three-year period in which the AITC program is in force, and is offered on a first come, first served basis. The program started accepting applications on 16 January 2017.

Publications and articles Board Matters Quarterly The January issue features a compilation of recently published material by the EY Center for Board Matters. This issue highlights top priorities for boards in 2017: governance trends at Russell 2000 companies, IPO corporate governance then and now, and five ways board committees are evolving to address new challenges.

How anti-BEPS policies are changing transfer pricing The second report in the 2016 Transfer Pricing Survey Series analyzes what respondents in 36 jurisdictions and 17 industries said about how they are adapting to changes catalyzed by the Organisation for Economic Co-operation and Development (OECD) in its 15 Action Plans for curtailing base erosion and profit shifting (BEPS).

EY Trade Watch This quarterly publication outlines key legislative and administrative developments for customs and trade around the world. In this issue we report on the UK vote to leave the European Union, highlights of the Canada-Ukraine free trade agreement and other matters.

Websites EY Law LLP Our national team of highly qualified lawyers and professionals offers comprehensive tax law services, business immigration services and business law services. Serving you across borders, our sector-focused, multidisciplinary approach means we offer integrated and comprehensive advice you can trust. Visit eylaw.ca.

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CPA Canada StoreEY’s Guide to Preparing 2016 Personal Tax ReturnsEditors: Lucie Champagne, Maureen De Lisser, Janna Krieger, Gael Melville and Yves Plante

This is the line-by-line guide busy tax professionals rely on throughout the tax season. The guide includes a summary of what’s new for the 2016 taxation year as well as tips, suggestions and reminders to consider when preparing 2016 personal tax returns. Available as an easy-to-use and searchable internet collection (includes access to four years of previous internet editions).

EY’s Complete Guide to GST/HST, 2016 (24th) EditionEditors: Jean-Hugues Chabot, Dalton Albrecht, Sania Ilahi, David Douglas Robertson

Canada's leading guide on GST/HST, including GST/HST commentary and legislation, as well as a GST-QST comparison. Written in plain language by a team of EY indirect tax professionals, the guide is consolidated to 15 July 2016 and updated to reflect the latest changes to legislation and CRA policy. Includes legislative and regulatory proposals released on 22 July 2016 and 29 July 2016 at the end of Volume 2.

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