PRESERVING WEALTH FOR PEOPLE AND PRIVATE COMPANIES

TAXES & WEALTHMANAGEMENT

IN THIS ISSUE

Editors: Martin Rochwerg, Miller Thomson LLP;

David W. Chodikoff, Miller Thomson LLP;

Hellen Kerr, Thomson Reuters

THE MOVEMENT TOWARD USING HIGH TAX JURISDICTIONS FOR INTERNATIONAL TAX PLANNING: THE COUNTER-REVOLUTION HAS BEGUNBy N. Gregory McNally, N. Gregory McNally & Associates Ltd.

INTRODUCTION

At their recent summit in St. Petersburg, the G20 members issued a communique stating that they will be commissioning recommendations to set up a system so that profits would be taxed “where economic activities deriving the profits are performed and where value is created.”1 Leaders at the summit also stated that they expect to begin exchanging information automatically on tax matters among G20 members by the end of 2015.

These measures have been principally crafted by the OECD and are aimed at traditional offshore finance centres (OFCs). On its web site, the OECD states that “The OECD and the G20 have a mutually beneficial relationship in the area of taxation. While the G20 has incentivised changes in OECD standards and initiatives, the OECD has in turn helped push forward cutting-edge issues on the G20 tax agenda.”2

The OFCs are also facing accusations from EU officials who state that they are complicit in assisting large multi-national companies and individual tax cheats in defrauding their member states from over 1.3 trillion Euros per year.3 The EU’s taxation Commissioner, Algirdas Semeta, stated that, “the EU, the world’s largest economy, is determined to push for a tough global automated exchange of banking information to catch tax cheats holding undeclared assets abroad. In the area of automatic information exchange we have the experience, the expertise and the collective weight to considerably influence the international environment.”4

1 “G20 leaders vow to crack down on tax evasion by multinationals”, online at: http://www.cbc.ca/news/business/g20-leaders-vow-to-crack-down-on-tax-evasion-by-multinationals-1.1699277.

2 “OECD and the G20”, online at: http://www.oecd.org/g20/topics/taxation/.3 “EU Ministers Seek to Strengthen Tax Evasion Fight”, online at: http://abcnews.

go.com/International/wireStory/eu-ministers-seek-ways-fight-tax-evasion-20256281.4 Ibid.

The Movement Toward Using High Tax Jurisdictions For International Tax Planning: The Counter-Revolution Has Begun .................................................................. 1

Use Behavioral Finance To Manage Risk........... 10

Are You A Serial Entrepreneur or a Closet Venture Capitalist? .................................. 11

Retirement’s Volatility Bogeyman ..................... 14

A Taxpayer’s Last Resort: The Remission Order ..................................................................17

Canada’s Anti-Spam Legislation (Casl) Is Coming Into Force On July 1, 2014: Why You Should Pay Attention And Some Suggestions For Compliance Preparation ....................................................... 19

Daimsis v. The Queen, 2014 TCC 118: Findings Based On Credibility: It Is Not As Easy As You Might Think ............................ 21

MAY 2014 | ISSUE 7-2

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TAXES & WEALTH MANAGEMENT MAY 2014

In addition to regulatory pressure from the various supranational organizations, the OFCs are facing initiatives from individual nations, such as France, which has recently added Jersey, Bermuda and BVI to its blacklist of uncooperative tax havens. “Being on the ‘blacklist’ triggers the application of 75 percent withholding taxes on French source flows to those territories and the strengthening of anti-abuse mechanisms.”5 This was done despite the fact that both Jersey and Bermuda signed tax information exchange agreements with France in 2010 and have complied with every request for information.6

As if this were not enough, various NGOs have also taken aim at the OFCs, including the Tax Justice Network and the International Consortium of Investigative Journalists, which blame OFCs for helping to reduce the standard of living in developing nations.7 Papers get published by these NGOs, which are then reported on by various media outlets, often supplementing stories based on government press releases on tax avoidance and OFCs.

The practical result of all of this attention is the isolation of the OFCs by individual financial service providers around the world. Certain banks in North America, Europe and the Middle East will not open accounts for, or transfer money to, entities based in traditional OFCs.

So what is the solution for the many professionals and business owners practising and operating in the OFCs?

One answer may be to co-opt a high tax jurisdiction in international tax and estate planning platforms. The concept is to use flexible laws (such as agency and trust law) from a high tax jurisdiction and amalgamate those with established operations based in the various OFCs. The process should start by finding an appropriate high tax jurisdiction as a potential partner.

An appropriate high tax jurisdiction (“HTJ”) should be one with the common law as its basis for legal forum. The common law provides individual flexibility through case law that is not supported in civil law regimes. This flexibility supports concepts like trusts and arguably provides a greater scope in respect of a concept such as agency.

Next, the ideal HTJ should likely be a high-ranking member of the G20 to give it enough political power to withstand pressure from the OECD and larger countries.

One possible HTJ candidate might be Canada. Canada has the 11th largest economy in the world and is one of the original G7

5 “France adds Jersey, Bermuda to tax-haven blacklist”, online at: http://www.reuters.com/article/2013/08/29/france-tax-jersey-idUSL6N0GU3PR20130829.

6 Ibid.7 “Secrecy for Sale: Inside the Global Offshore Money Maze”, online at:

http://www.icij.org/offshore.

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members.8 Canada is also a common law country drawing on judgments going back to UK decisions, which still hold certain authority in Canadian courts.

By using Canadian agency and trust law in conjunction with implementation from organizations based in the traditional OFCs, clients can continue to access legitimate tax, estate and business succession plans, without encountering newly-formed compliance barriers.

AGENCY LAW IN CANADA

Like the UK, Canada has always had a legal basis to support the concept of an agent to act as nominee or intermediary on behalf of a third party principal. However, one of the main issues is how such an arrangement may, or may not, be treated for tax purposes in Canada. Agency, for tax purposes, can be analyzed both in terms of the role of the “agent” and in terms of who has “beneficial ownership” of income derived from an asset or a business transaction conducted by the agent.

STATUTORY REFERENCES

The terms “agent” and “nominee” are not defined in the Canadian Income Tax Act, R.S.C. 1985, c.  1 (5th Supp.) (the “Act”). In fact, the term “nominee” is used only once and it is in conjunction with “agent” and both are used in the context of a legal representative.9 The term “agent” is used numerous

8 “The 40 Biggest Economies in the World”, online at: http://www.businessinsider.com/largest-economies-world-gdp-2013-6.

9 Act, s. 237(4)(b)

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times in the Act, both as a title, such as real estate agent, and as a description for a legal representative.10

However, while it appears that the Act recognizes the concept of agents acting as legal representatives on behalf of third parties, this alone does not prove that agents are not liable for taxes levied in respect of transactions or income attributable to third parties.

The main charging provision for taxation under the Act is found at s.  2, where income tax shall be paid on taxable income earned by resident Canadians or in respect of income earned in Canada by, or from taxable Canadian property attributable to, non-residents. It should therefore follow that the taxable income must be earned by the agent, or the agent must be responsible for a taxpayer’s liability on a third party basis. Barring specific references to the latter, which would be self-evident in the Act,11 general liability for taxation falling to an agent can only happen if the income is earned by the agent. To determine whether income is earned by an agent, it may be helpful to analyze any reference to “beneficial ownership” or “beneficial interest”.

The terms “beneficial owner” and “beneficial ownership” are used in the Act, but are not specifically defined. However, in s. 248, which is the interpretation section of the Act, the term “disposition” of any property includes a transaction entitling a taxpayer to the proceeds of the disposition, but exempts (subject to certain exceptions) dispositions where there is no change in beneficial ownership. The Act, therefore, links taxable transactions to beneficial ownership and to a right to the proceeds of the disposition of property.

Further, “beneficially interested” is defined in the context of a trust beneficiary at s. 248(25). Under this definition, a person has a beneficial interest in a trust where he or she has a right (widely defined) to the income or capital of the trust. Although this definition is used only with respect to the taxation of trusts under the Act, it clearly links the word “beneficial” (its root word being “benefit”) to the corpus of property in the trust or income derived therefrom, keeping in mind that legal title to the capital and income is in a third party’s name. Of course what follows from this definition is the nexus for taxation elsewhere in the Act.

So while there is no specific definition of agency in the Act, there are numerous examples where the term is used in the context of legal representative, such that it appears to recognize the concept. Further, while there are a few specific references to tax liability or penalties for agents in the Act, there are no general taxing provisions in relation to agents. The general taxing provision of s. 2 of the Act uses the term “earned by” as the nexus

10 See s. 115(2)(b), s. 128(1), s. 222(7) and s. 124(3) of the Act as examples. 11 See s. 215 of the Act.

to taxation by a taxpayer, and if the Act recognizes agents as distinct entities from their principals, then it should follow that income cannot be earned by both the taxpayer and the agent. The use of the terms “beneficial ownership” and “beneficially interested” in the Act seem to support this interpretation as they link taxation to a beneficial right to the capital of, or income derived from, a property which the agent does not possess.

ACADEMIC ANALYSIS

Bowstead and Reynolds on Agency describes the basic notion of agency as follows:

The mature law recognises that a person need not always do things that change his legal relations himself: he may utilise the services of another to change them, or to do something during the course of which they may be changed. Thus where one person, the principal, requests or authorizes another, the agent, to act on his behalf, and the other agrees or does so, the law recognises that the agent has power to affect the principal’s legal position by acts which, though performed by the agent, are to be treated in certain respects as if they were acts of the principal.12

Furthermore, Bowstead goes on to state that under the common law there is no requirement for the agent to purport, or make express, that he is acting on behalf of a principal.13

With respect to remuneration, Bowstead explains that the agent’s relationship with the principal is commercial, but should not be commercially adversarial between the two parties. “But its [the remuneration’s] essence is that it is not an independent profit taken by the agent, but rather a fee paid to him by the principal in return for acting on his behalf.”14 This concept of remuneration has significance when considering a taxing authority’s position on the attribution of income to the agent. There is no support for allocating a share of the profits, only an arm’s length fee.

With respect to the difference between an agent and a trustee, Bowstead states that while the legal concepts underlying their functions may overlap, agents act on behalf of other persons and their rights are primarily personal. Whereas, trustees hold money or property for the benefit of other people, and their rights are primarily proprietary rather than personal, “... if he [an agent] does receive money from or for his principal, he may merely be in the position of debtor to his principal in respect of it, and if he receives goods he may hold them as bailee only.”15

12 Bowstead and Reynolds on Agency (19th ed., P. Watts, et al.), 2010 Thomson Reuters, at par. 1-005.

13 Ibid., at par. 1-008.14 Ibid., at par. 1-01515 Ibid., at par. 1-028

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TAXES & WEALTH MANAGEMENT MAY 2014

between the spouses would substantially lower the taxes paid due to graduated tax rates.

The tax payer won at the Income Tax Appeal Board level, but subsequently lost before the Exchequer Court and the Supreme Court of Canada (the “SCC”).

The SCC ruled that income tax is imposed on a person and not on property, and the person who must pay the tax is that person who has unfettered use of the income. The wife’s claim to the property, and therefore the income derived from it, was not absolute until dissolution of the marriage. Further, the husband enjoyed unrestricted use of the income on his own account. Therefore, the Court did not find that he acted as agent or fiduciary on behalf of his wife.20

Sura was then applied in Brookview Investments Limited et al. v. M.N.R.,21 with the opposite result. In Brookview, a group of resident taxpayers used an Ontario corporation called Armley Investments Limited to acquire a 60% interest in 200 acres of real property from two vendor corporations.

A portion of the purchase price was paid to the vendors directly from the taxpayers, with the balance of the purchase price being a debt owed from Armley Investments to the vendors, which was secured by a mortgage on the property. The taxpayers then failed to provide subsequent payment to the vendors as provided for in the mortgage and the vendors foreclosed on the property, taking title back from Armley Investments.

The Minister of National Revenue held that the loss was attributable to Armley Investments, which had no income to offset the losses. However, the Exchequer Court found that the original purchase and sale agreements made specific mention that the ultimate purchasers were to be represented by a company “to be incorporated”, i.e., Armley Investments. Further, there was an internal agreement between the taxpayers that clearly stated that Armley Investments would deal with the property at the direction of the group.

Therefore, the Court held that Armley was acting as bare trustee for the group and the loss belonged to the individual taxpayers for the purpose of their tax filings, and not the company.22

A more recent case dealing with beneficial ownership in the context of international tax planning is Prévost Car Inc. v. Her Majesty the Queen.23 In Prévost, the Canada Revenue Agency (“CRA”) levied withholding taxes on dividends paid by a Canadian subsidiary to its Dutch parent company (Prévost Holding B.V., “PHBV”) at higher rates consistent with the

20 Ibid., at p. 69.21 63 D.T.C. 1205, [1963] C.T.C. 316 (Ex. Ct.).22 Ibid., [1963] C.T.C. 316, at 325.23 2008 TCC 231, [2008] 5 C.T.C. 2306, 2008 D.T.C. 3080; aff’d 2009 FCA 57.

The term “bare trustee” is sometimes used in the same context as agency. “Bare trustee” is not used in the Act whatsoever. However, it is defined in Waters’ Law of Trusts in Canada as “a trust where the trustee or trustees hold property without any duty to perform except to convey it to the beneficiary or beneficiaries upon demand.”16 While this definition does not speak to the attribution of income or capital gains, it does convey the concept of beneficial ownership of the asset to which income or gains should follow, subject to an overriding agreement.

With respect to the term “agent”, Waters states that:

The agent for the trustees is in the same position as all other agents. He acts as a conduit, putting his principals, the trustees, in a contractual relationship with third parties. Thereafter, the agent drops out: no liability attaches to him in respect of the third parties or beneficiaries.17

Again, while this reference does not specifically address the attribution of income and capital gains in relation to assets held by an agent, it does speak to the nominee role that an agent would have under Canadian law. Therefore, the attribution of income and capital gains should similarly follow, not to the agent, but rather to the principal.

In addition to academic references, definitions in Black’s Law Dictionary are often cited in Canadian judgments. The definition of “Agency” contained in Black’s Law Dictionary includes the following quotation from The Law of Agency and Partnership § 1, at 3 (2d ed. 1990) by Harold Gill Reuschlein and William A. Gregory:

The basic theory of the agency device is to enable a person, through the services of another, to broaden the scope of his activities and receive the product of another’s efforts, paying such other for what he does but retaining for himself any net benefit resulting from the work performed.18

The academic analysis as offered from Bowstead, Waters and Black’s should be persuasive on Canadian courts in attributing income and capital gains from assets legally held in the name of an agent or bare trustee to a principal or beneficial owner.

CASE LAW

In Sura v. The Minister of National Revenue,19 a tax resident husband argued that income derived from rental properties in his name should be attributed equally between himself and his wife, as his wife was entitled to 50% of the properties under provincial matrimonial law. Being able to divide the income

16 Waters’ Law of Trusts in Canada (3rd ed., D. Waters et al., eds., 2005), at 32.17 Ibid., at 61-62. 18 Black’s Law Dictionary (7th ed., B. Garner et al., eds., 1999).19 [1962] S.C.R. 65; online at: http://scc.lexum.org/decisia-scc-csc/scc-

csc/scc-csc/en/6535/1/document.do

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However, certain provinces, such as New Brunswick and British Columbia, do not require resident Canadian directors, which may provide some practical benefits to the planning.

Unlike many OFCs, no Canadian jurisdiction allows corporate directors. All directors must be individuals.

The shareholder of the CNC can be a non-resident of Canada and the principal or another third party may have certain control with respect to assets registered in the name of the CNC (i.e., through a power of attorney), but care must be taken not to subject the CNC to common ownership with the principal. Common ownership by the principal of the CNC and the assets registered in the name of the CNC may result in income or capital gains tax being attributable to the CNC, if the Canadian tax authorities take the position that the assets were contributed to the company. At the very least, the dealings with the assets by the CNC could be subject to one of the approximately 145 references to arm’s length or non-arm’s length transactions contained in the Act, including possible reporting obligations under s. 233.1.

The best scenario is to have an independently owned and managed CNC acting on behalf of a Principal on an arm’s length basis. As such, the CNC and the Principal would enter into a formal agency agreement specifying the scope of the agency relationship and what the CNC is entitled to do on behalf of the Principal. The Principal may supplement the scope of agency with ad hoc directions to the CNC at any time. The CNC may also provide powers of attorney to the Principal or to any third parties to perform certain of its obligations under the agency agreement, so long as such assignment is not prohibited in the original agency mandate.

The CNC can open bank and investment accounts in its name and take title to assets, including real property, although all properly regulated financial institutions will require a source of funds declaration or Ultimate Beneficial Owner disclosure. The CNC can also enter into commercial contracts on behalf of the Principal, receiving and paying consideration. The CNC can also perform certain discretionary activities in relation to the Principal’s assets, but care should be taken not to create trusts that may be taxable in Canada (see Schedule A).

Where it is properly acting as an agent on behalf of a Principal, the CNC will not be subject to Canadian tax on any income or gains on assets held in its name or revenue generated by any contracts it enters into. The CNC will only be subject to Canadian tax on the fees it receives to act as agent.

There is no concept of a percentage attribution of income (i.e., 10%) in relation to the fee earned by the CNC, as is sometimes quoted in relation to the UK agency company. The fee paid to

Canada/UK and Canada/Sweden tax treaties. It did so because PHBV was itself a subsidiary of two companies, one being a UK company and the other being a Swedish company. The Canada/Netherlands tax treaty provides for 0% withholding tax payable on dividends from a Canadian company to a Dutch parent, whereas the Canada/UK and Canada/Sweden tax treaties provide for 15% and 10%, respectively.

The issue before the Tax Court of Canada was, “Who was the beneficial owner of the dividends?”

CRA argued that PHBV was only a holding company and that the term “beneficial owner” in relation to the Canada/Netherlands tax treaty should be defined as the entity (or entities) that ultimately benefit from the dividend payments, i.e., the UK and Swedish companies.

Since “beneficial owner” is not defined in the Canada/Netherlands tax treaty, the Tax Court of Canada had to look at Canada’s domestic law to make its determination. At paragraph 100 of the judgment, Rip A.C.J. stated, “The person who is beneficial owner of the dividend is the person who enjoys and assumes all the attributes of ownership… and this person is not accountable to anyone for how he or she deals with the dividend income.”

Conversely, Rip A.C.J. went on to state that “Where an agency or mandate exists or the property is in the name of a nominee, one looks to find on whose behalf the agent or mandatory is acting.… [The agent will not be considered to be the beneficial owner if the agent] has absolutely no discretion as to the use or application of funds put through it as conduit, or has agreed to act on someone else’s behalf pursuant to that person’s instructions without any right to do other than what that person instructs it”.24

Rip A.C.J. found no evidence of an agency mandate. He therefore declared that PHBV was the true beneficial owner. His judgment was upheld by the Canadian Federal Court of Appeal.

While the facts in Prévost determined against the existence of an agency arrangement, the case nonetheless proves that Canadian courts at the highest level respect the concept of agency and will attribute income and capital gains for tax purposes only to the beneficial owner of the assets and not the agent or bare trustee.

THE CANADIAN NOMINEE COMPANY

The Canadian Nominee Company ("CNC") is a Canadian company that can be used to hold assets or enter into business transactions on behalf of a principal, who may otherwise have used an OFC entity. The company can be incorporated in any one of the Canadian provinces, or under Federal legislation.

24 Ibid., at par. 100.

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TAXES & WEALTH MANAGEMENT MAY 2014

the CNC need only be what can be negotiated at arm’s length between two independent parties.

Income or gains in the name of the CNC cannot benefit from Canada’s tax treaty network. However, CNCs should still be able to benefit from Canada’s Foreign Investment Promotion and Protection Agreements, which dissuade foreign confiscation of assets and provide compensation in cases where expropriation on a legal basis takes place.

Lastly, the CNC will not have any audit or reporting obligations in Canada in relation to any assets held in its name or income or gains derived therefrom, unless, as noted above, there is common ownership with the CNC. No personal information on the principal is required to be made public. The only material information concerning the CNC that is made public is the names of its directors.

TAXATION OF TRUSTS IN CANADA

Income and capital gains generated by trust assets will only be subject to tax under the Act if:

a. the trust is, or is deemed to be, resident in Canada for purposes of the Act;

b. the trust is in receipt of taxable income earned in Canada, such as income from a business carried on in Canada, or taxable capital gains from the disposition of taxable Canadian property; or

c. the trust is in receipt of Canadian source income that is subject to withholding tax under Part XIII of the Act, including dividends paid or credited by a corporation resident in Canada.

The scope of this article will be restricted to the analysis of the application of trust residency for taxation purposes in Canada, as noted in subparagraph (a) above, which can be applied either by statute or by common law.

COMMON LAW RESIDENCY

Until last year, the common assumption in Canada was that, subject to specific deeming provisions, a trust is resident for tax purposes where its trustee resides. However, in the case of St. Michael Trust Corp., as trustee of the Fundy Settlement v. The Queen25 (referred to herein as “Fundy Settlement”), the SCC ruled that the residence of a trust for tax purposes should be determined by the principle that a trust resides at the location where the central management and control of the trust actually takes place, regardless of whether that central management and control is exercised by the trustee or by some other person.

25 2012 SCC 14.

In Fundy Settlement, a reorganization of a Canadian company called PMPL Holdings Inc. (“PMPL”) occurred, wherein two trusts (the “Trusts”) with Canadian beneficiaries were settled by an individual resident in St. Vincent with the sole trustee of each trust being St. Michael Trust Corp., a professional trustee resident in Barbados (the “Trustee”).

As part of the reorganization, the Trusts each subscribed for shares of a newly incorporated Canadian corporation (collectively the “Holdcos”) and the Holdcos in turn subscribed for new common shares of PMPL (the old common shares being converted into fixed priced redeemable preferred shares held by the taxpayers). The new common shares were issued for nominal consideration and the price for the redeemable preferred shares was set at CAD $50,000,000.

Shortly thereafter, the Trusts disposed of the Holdcos, realizing a combined capital gain of over CAD $450,000,000. Withholding tax was remitted to the Canadian government pursuant to s.  116 of the Act, and the Trustee filed tax returns on behalf of the Trusts the following year, attempting to receive a refund for the withholding tax by claiming exemption under the Canada-Barbados Double Tax Agreement.26 However, CRA denied the refund requests and the Trustee appealed CRA’s decision to the Tax Court of Canada (“TCC”).

At the TCC, CRA argued that the exemption did not apply for a number of reasons, the main ones of which are as follows:

1. although the corporate trustee of the Trusts was acknowledged to be resident in Barbados, the central management and control of each trust was in Canada;

2. the Trusts were deemed resident under the Act for having received property from a Canadian resident;

3. the Trusts were not validly constituted; and

4. the General Anti-Avoidance Rules (“GAAR”) in the Act would work to deny the exemption.

On evidence provided, the TCC found the following facts applied to the role of the Trustee in the case:

1. the Trustee was simply a subsidiary shell of a multi-national accounting firm, with no personnel and no expertise;

2. internal memoranda setting out the Trustee’s role made it clear that the Trustee’s participation would be limited — even more so than that provided for under the subject trust indentures;

26 Online at: http://www.treaty-accord.gc.ca/text-texte.aspx?lang=eng& id=102234.

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3. the protector mechanism under the trust indentures effectively enforced the subordination of the Trustee to the protector and ultimately to the taxpayers; and

4. no evidence existed, either written or oral, to demonstrate that the Trustee had taken an active role in managing the Trusts.

Conversely, in relation to the taxpayers the TCC found that:

1. the taxpayers made all of the investment decisions for the Trusts, including the sale of the shares in the Holdcos; and

2. the tax advisors of the Trusts were under the specific direction of the taxpayers.

Prior to Fundy Settlement, the leading case on the residency of trusts for Canadian tax purposes was Trustees of the Thibodeau Family Trust v. The Queen27 (“Thibodeau”). In Thibodeau, two of the trustees were resident in Bermuda and the third trustee was resident in Canada. The Federal Court held that the trust was resident in Bermuda because the majority of the trustees resided in Bermuda and the trust document allowed for majority decision-making.

In Fundy Settlement, the TCC ruled that Thibodeau could be distinguished upon the facts of that case. Moreover, it rejected the obiter dictum of the Court in Thibodeau, which stated that the central management and control test could not be applied for purposes of determining a trust’s residence, because a trustee cannot adopt a “policy of masterly inactivity” with respect to its fiduciary duties. Justice Woods, on behalf of the TCC, stated that in rejecting the central management and control test, the Court must have assumed that a trustee would always be compliant with their fiduciary obligations, which is not always the case.28

The TCC ultimately found in favour of the CRA assessments on the basis of the central management and control test as being the appropriate test for determining trust residence and that in the subject case, that test applied to make the Trusts resident in Canada for tax purposes.

The TCC felt that using a similar test for determining the residency of trusts and corporations promoted consistency, predictability and fairness, which are all fundamental principles underlying the Canadian tax regime. While acknowledging that there are significant differences between the nature of a trust and a corporation, Justice Woods stated that “from the point of view of determining tax residence, the characteristics are quite similar. The function of each is, at a basic level, the

27 78 D.T.C. 6376 (Fed. T.D.).28 Garron Family Trust v. The Queen, 2009 TCC 450, at par. 143.

management of property.”29 Moreover, she was not satisfied that there were good reasons to establish different tests of residence for trusts versus corporations.

Interestingly, in relation to the other arguments presented by CRA noted above, the TCC felt that the Trusts were validly constituted and that they did not receive property from a Canadian taxpayer, such as to invoke the deeming provisions of the Act. Also, the TCC did not find that the GAAR in the Act applied as they were argued by CRA.

The case was then appealed to the Federal Court of Appeal (“FCA”), which found in favour of the TCC’s main reason that the central management and control test should govern the basis of residency of a trust for tax purposes. However, they disagreed with the trial judgment on the application of the deeming provisions of the Act, finding that the Trusts would have been taxable in Canada as having received contributions from Canadian tax residents.

On further appeal to the Supreme Court of Canada, the SCC stated that subsection 2(1) of the Act is the basic charging provision, and its reference to a “person” must be read as a reference to a taxpayer whose taxable income is being subject to income tax. In relation to the taxation of trusts, “person” means the trust itself, which is deemed by subsection 104(2) of the Act to be an individual in respect of the trust property, notwithstanding that a trust is not considered to be a person at common law.

While subsection 104(1) of the Act states that a reference to a trust shall, unless the context otherwise requires, be read to include a reference to the trustee, the SCC agreed with the finding of the FCA that subsection 104(1) was for administrative purposes to enable trusts to be taxed despite the absence of legal personality, and does not create a rule of law that the residence of a trust must be the residence of the trustee in all cases.

The SCC went on to find that there are many similarities between trusts and corporations that would justify the application of the common law rule regarding central management and control test. Some of these similarities include:

1. Both hold assets that are required to be managed;

2. Both involve the acquisition and disposition of assets;

3. Both may require the management of a business;

4. Both require banking and financial arrangements;

5. Both require the instruction or advice of lawyers, accountants and other advisors; and

29 Ibid. at par. 159.

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6. Both may distribute income, corporations by way of dividend and trusts by distributions.30

It concurred with Justice Woods that “The function of each is, at a basic level, the management of property.”31

The SCC determined that as with corporations, residence of a trust should be determined by the principle that a trust resides for the purposes of the Act where the central management and control of the trust actually takes place. They further endorsed wording in a previous decision, which described central management and control as “where its real business is carried on”.32 “This is not to say that the residence of a trust can never be the residence of the trustee. The residence of the trustee will also be the residence of the trust where the trustee carries out the central management and control of the trust, and these duties are performed where the trustee is resident.”33

The SCC dismissed the taxpayers’ appeal, finding that the Trustee had a limited administrative role in respect of the Trusts and that the central management and control was carried on by the taxpayers. Given that it had dismissed the appeal on these grounds, it refrained from commenting on the arguments of deemed taxation under the Act, as was found by the FCA, or taxation based on GAAR, which was again argued in the alternative by the Minister of Revenue.

STATUTORY RESIDENCY

The Act does not contain a statutory definition or rule for determining the residency of a trust. However, s. 94 of the Act deems a trust to be resident in Canada for tax purposes if it receives a contribution from a Canadian resident taxpayer, or an individual that was previously a Canadian resident taxpayer for more than five years and has been non-resident for less than 60 months (except in the case of a testamentary trust, where the time period is shortened to 18 months), and in respect of a non-resident contributor, there is a resident of Canada who is beneficially interested in the trust.

THE CANADIAN TRANSNATIONAL TRUST

A company can be incorporated in Canada to act as a private trust company (“PTC”). The PTC would then act as trustee in relation to a trust either on declaration or settlement. Thereafter, the PTC would engage a co-trustee or a trust administrator from outside of Canada to perform the day-to-day management of the trust. Provided the trust is exclusively managed and controlled at all times outside of Canada, any

30 Fundy Settlement, at par. 14.31 Ibid.32 De Beers Consolidated Mines, Ltd. v. Howe, [1906] A.C. 455, at p. 458

(U.K. H.L.).33 Supra, at par. 15.

income or gains earned in the trust will not be subject to tax in Canada.

Canada does not have specific PTC legislation, which creates both opportunities and challenges. One issue is trustee licencing. While most provinces do not have express exemptions for non-commercial trustees, Ontario does. This makes Ontario more attractive as a jurisdiction for the incorporation of the PTC.

Some provinces like British Columbia and New Brunswick have no resident director requirements. However, Ontario requires that at least 25% of the Board of Directors be resident in Ontario. Therefore, the PTC should have one director resident in Ontario and two or three resident outside of Canada.

There are no foreign ownership restrictions for Ontario companies. Therefore, an Ontario PTC could be owned by the client directly or indirectly by some sort of foreign entity, such as a corporation, trust or foundation (see Schedule B).

Control of the trust by the client is often a worry, hence the delineation of reserved powers in a number of trust acts. However, a review of the facts in Fundy Settlement reveals a high tolerance by Canadian courts for third party involvement in managing a trust, without ruling the trust a sham. Involvement by a non-resident Canadian (such as a client) in the management and control of a TNT only helps the tax position of the trust.

Provided the TNT is exclusively managed and controlled at all times outside of Canada and receives no contributions at any time from a current or recently former Canadian resident, the trust will not be treated as resident in Canada for tax purposes. Income or gains received by the TNT will not be subject to Canadian tax provided such income does not arise from a Canadian source. Also, given that the TNT is not subject to tax in Canada, there is no requirement to file a tax return or any sort of foreign asset information return.

In contrast to the TNT, the PTC will be subject to tax in Canada on the fees it receives in acting as trustee for the TNT. A tax return must be filed annually on behalf of the PTC, but it will not have to file any foreign asset information return, as it is not the beneficiary of any assets in the TNT.

Unfortunately, the TNT cannot access Canada’s treaty network as it is not resident in Canada for tax purposes. However, multi-national tax planning can be accomplished where required by having the PTC own (on behalf of the TNT) a corporation or other entity in a foreign jurisdiction with a favourable tax treaty.

Although the TNT does not qualify for Canada’s treaty network, it would qualify for protection under Canada’s network of Foreign Investment Promotion and Protection Agreements.

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TNT assets resident in countries that have an investment protection treaty with Canada cannot be expropriated by those foreign governments without due compensation to the TNT.

CONCLUSION

In this author’s opinion, the evidence is irrefutably clear. Despite the overwhelming compliance over the years by the OFCs to OECD standards of anti-money laundering and tax transparency, the professional advisors and service providers in the OFCs will not survive in isolation. They must incorporate entities based in HTJs to continue to provide planning tools and services.

Based on the criteria outlined in the introduction, Canada is an excellent candidate as an HTJ jurisdiction. Moreover, unlike New Zealand and Barbados, Canada’s new trust laws are not based on ring fencing concepts (which are highly criticized by the OECD) and Canada is much stronger in the international

political arena.34 That does not mean that Canada would not implement a recommendation by the OECD to further the interests of its high tax jurisdiction colleagues, but it would not likely do so if it were detrimental to its own tax administrative practices. Canada’s agency and trust laws are primarily based on its own domestic economic drivers. It would be difficult and complicated to change those simply to protect the tax base of third party countries.

Gregory McNally, BA, LL.B, MBA, JD, LL.M (Int’l Tax), TEP, N. Gregory McNally & Associates Ltd.

Greg can be reached at greg.mcnally@ngma.ca

34 “Canada seen as holdout on G8 pledge for tax reform”, online at: http://www.theglobeandmail.com/report-on-business/international-business/european-business/g8-seen-striking-pact-aimed-at-cracking-secret-havens/article12630105/; “Canada’s ‘No’ to Iraq War a Defining Moment for Prime Minister, Even 10 Years Later”, online at: http://www.huffingtonpost.ca/2013/03/19/canada-iraq-war_n_2902305.html.

SCHEDULE A

SCHEDULE A

ILLUSTRATION 1;

Agency Agreement

ILLUSTRATION 2;

Bank /Investment Account Discretionary Manager

Agency Agreement

ILLUSTRATION 3;

Agency Agreement

Purchase/Sale Purchase/Sale Agreement Agreement

Resident Shareholder Corporation

Canadian Nominee Company

Non-Resident Directors

Client

Int’l Asset Managers

Canadian Nominee Company

Client

Client

Canadian Nominee Company

Seller

Buyer

SCHEDULE B

SCHEDULE B

ILLUSTRATION 1;

ILLUSTRATION 2;

ILLUSTRATION 3;

Administration Agreement

Canadian Transnational

Trust

Grantor or Settlor (must be non-resident)

Non-resident Beneficiaries

Ontario Private Trust Company/

Trustee

Canadian Transnational

Trust

PTC Shareholder (Can be non-

resident)

Ontario Private Trust Company/

Trustee

Majority Non-resident

Directors

Canadian Transnational

Trust

Ontario Private Trust Company/

Trustee

International Administrator

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TAXES & WEALTH MANAGEMENT MAY 2014

According to prospect theory, even though the investor is presented with the same mutual fund, he or she is more likely to buy the mutual fund from the first advisor, who expressed the rate of return as an overall 8% gain over five years, rather than a combination of both high returns and losses.

Regret Aversion

Investors act to avoid feeling the pain of regret resulting from a poor investment decision. It is not just financial loss they regret: it is also the feeling of responsibility for the decision that gave rise to the loss. Regret aversion also causes herding behavior. Investors tend to seek comfort in crowds and invest in the same companies. That way, if the stock price falls, they can eliminate one part of regret aversion – that of feeling responsible for the poor decision. In other words, how can everyone be wrong?

Mental Accounting

Economist Richard Thaler established the concept that human beings compartmentalize their lives into separate “mental accounts”. As a result, investors tend to treat each element of their investment portfolio separately, a propensity that can lead to inefficient decision-making. For example, an individual may borrow at a high interest rate to buy a car while earning a low interest rate on a GIC. Mental accounting has implications for portfolio rebalancing as well: investors may be unwilling to sell a losing investment because its “account” is showing a loss.

Overconfidence

People tend to be overconfident in their own abilities, including their skill at predicting the markets.

Overconfidence applies to professional analysts as well, who are often reluctant to revise their opinion on a stock’s prospects, even when confronted with new and contradictory information.

Representativeness

Representativeness refers to the tendency to assume that recent events will continue into the future. This is one reason why investors chase hot stocks and shun stocks with poor recent performance.

CONCLUSION

Risk has different meanings for each of us. Moreover, it is a moving target and, as such, can never be completely mastered. A good grasp of behavioral finance can help investors pinpoint market trends that may have to do more with human psychology than with fundamental reasons. More importantly, it can allow us to recognize our own irrational behavior from time to time and therefore save us from making poor investment decisions.

USE BEHAVIORAL FINANCE TO MANAGE RISKBy Tina Tehranchian, Senior Financial Planner and Branch Manager, Assante Capital Management Ltd.

The stellar performance of North American, Japanese and European markets in 2013 has put the issue of risk on the backburner for many investors, but it has also started to create anxiety for some investors who fear imminent pull backs and corrections in the near future to bring returns back to normal historical levels.

In general, human beings lack the ability to accurately measure risk and reward. Of course, understanding the basic mathematical underpinnings of risk management would help greatly, but not all of us may be mathematically adept enough to be able to gain such an understanding. Failing that, gaining knowledge of our own, as well as other people’s, perceptions of risk can also give us the upper hand when it comes to investing.

In the early 1970s, Amos Tversky and Daniel Kahneman, pioneers in the field of behavioral finance, investigated apparent contradictions in human behavior. They discovered that when offered a choice phrased one way, subjects might display risk aversion, but when offered essentially the same choice phrased in a different way, they might display risk-seeking behavior. Kahneman cites the example of people who will drive across town to save $5 on a $15 calculator, but won’t drive across town to save $5 on a $125 coat.

In 1979, Kahneman and Tversky called their studies of how people manage risk and uncertainty “Prospect Theory”. Key concepts addressed by this theory as well as other important behavioral finance theories that effect the decision-making of investors include:

Loss Aversion

People place different weights on gains and losses: they are more distressed by losses than they are made happy by equivalent gains. Individuals also respond differently to the same situation depending on whether it is presented in the context of a loss or a gain. On the whole, people make financial decisions based on the fear of losing rather than the hope of winning.

To demonstrate the point, let’s take an example where one investor was presented with the recommendation to buy the same mutual fund by two different financial advisors. The first tells the investor that the mutual fund has had an average annual return of 8% over the past five years. The second advisor tells the investor that the same mutual fund has had above-average returns compared to its peer group in the past five years but has been declining in the past eighteen months.

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As Walt Kelly (1913 – 1973, creator of Pogo) said, “We have met the enemy and it is us”.

Sources:

- Thaler, R.H., 1999. Mental Accounting Matters. Journal of Behavioral Decision Making.

- Kahneman, Daniel and Amos Tversky (editors), 2000. Choices, Values, and Frames, Cambridge University Press.

- www.behaviouralfinance.com

Tina Tehranchian, MA, CFP, CLU, CHFC, is a Branch Manager and Senior Financial Planner with Assante Capital Management Ltd., located in Richmond Hill, Ontario, and can be reached at 905-707-5220 or through her web site at www.tinatehranchian.com.

Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada.

ARE YOU A SERIAL ENTREPRENEUR OR A CLOSET VENTURE CAPITALIST?

Editor’s Note: A Love of Tax and Providing Tax Advice That Does Not Quit – I am delighted to share with our readers an article prepared by Gerald Courage. Gerald (known to his colleagues and friends as Gerry) has been a tax lawyer for over 35 years. Following his distinguished service as Chair of the law firm of Miller Thomson LLP, Gerry returned to his first love – the practice of tax law and the rendering of tax planning advice to both domestic and international clients. Upon his return to practice and after hibernating in his office for months to “bone up” on the law, Gerry, in an elegant, succinct article, discusses one of the lesser known income tax savings provisions – the small business rollover.

David W. Chodikoff, Miller Thomson LLP

By Gerald Courage, Partner, Miller Thomson LLP

As our readership will be well aware, Canadian federal and provincial tax legislation supports and encourages small business in a variety of ways too numerous to mention. One less well-known incentive for investment in small business is the so-called small business rollover contained in section 44.1 of the Income Tax Act (Canada) (the “Act”). This is a useful tax deferral provision that can be used in conjunction with or as an alternative to the better known $750,000 (proposed to be $800,000) capital gains exemption on disposition of qualified

small business corporation shares (although the rules to qualify for the capital gains exemption and the small business rollover do differ). To qualify, the small business rollover basically requires that a vendor reinvest the proceeds from the sale of shares of a small business corporation in what are called “replacement shares”. Since tax can be avoided on the initial disposition, the entrepreneur will have more cash available to invest in replacement shares. Thus, the share business rollover is a tax efficient way for entrepreneurs to get back “in the game” for those who still have the entrepreneurial itch.

THE BROAD CONCEPT

Reduced to its essentials, if an individual (other than a trust) has made a “qualifying disposition” (essentially of a qualifying small business corporation share discussed in more detail below), the individual’s capital gain for the year from such disposition will be reduced by the individual’s “permitted deferral” (essentially proceeds of disposition reinvested into other qualifying small business corporation shares) and the adjusted cost base of the “replacement shares” will be reduced by the amount of the permitted deferral. (There are rules to allocate the adjusted cost base reduction if investments are made in multiple corporations.) In other words, the capital gain is deferred to the extent of the amount of the reinvested proceeds until the replacement shares are sold (unless those proceeds are also reinvested in other replacement shares). A very simple example will illustrate the point:

Individual holds qualifying shares with an adjusted cost base of zero and sells them for $1,000,000. Absent the small business rollover, the individual would be required to take $500,000, the taxable capital gain, into income. Instead, the individual reinvests the $1,000,000 proceeds in qualifying replacement shares within the time period required. The result is that the $1,000,000 capital gain is deferred and the $1,000,000 adjusted cost base which would otherwise arise for the replacement shares is reduced to zero. Thus, on a subsequent sale of the replacement shares at $1,000,000 with no reinvestment of the proceeds, a taxable capital gain of $500,000 would result and the deferral of the original taxable capital gain of $500,000 would end.

Assuming the individual is willing to reinvest in the small business sector, this deferral can be a useful alternative or a supplement to the capital gains exemption where both provisions are applicable.

WHAT SHARES QUALIFY FOR THE ROLLOVER?

(a) When the Original Shares are Acquired

There are several requirements for shares to qualify for the small business rollover. First, the shares must be “common

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TAXES & WEALTH MANAGEMENT MAY 2014

a taxable Canadian corporation (i.e., incorporated in Canada and not exempt from tax) all or substantially all (generally, 90% or more) of the fair market value of the assets of which is attributable to: (i) assets used principally (i.e., more than half) in an active business carried on by the corporation or a related ABC; (ii) shares issued or debt owing by other related ABCs; or (iii) any combination thereof. A Disqualified Corporation is excluded from being an ABC. In other words, the corporation need not remain a Canadian-controlled private corporation or an ESBC after the shares are acquired and the business can be carried on in part (but not primarily) outside of Canada (but see the comments in Hold Period below).

Subsection 44.1(8) of the Act contains a relieving rule with respect to cash. If the corporation is otherwise considered to be carrying on an active business, a property held by the corporation will be deemed to be used in the course of carrying on that active business for the 36 months preceding the acquisition of the property if the corporation issued a share or debt, disposed of property or accumulated income in order to acquire money for the purpose of acquiring property to be used in an active business or any combination thereof. In other words, provided cash is acquired or accumulated in the manner described above in order to acquire active business assets within a 36-month period thereafter, the cash will be considered to be an active business asset. Otherwise, an excessive accumulation of cash could disqualify the corporation from ABC or ESBC status.

THE HOLD PERIOD

In order to qualify for the rollover, the shares must be held for at least a 185-day period before the disposition by the individual. Thus, effectively a slightly more than six-month hold period is required.

Further, a disposition will not qualify unless the active business of the corporation was carried on primarily (more than half) in Canada at all times during the period the individual held the share or for the 730 days (essentially two years) preceding the disposition of the share, whichever is less. For this purpose, the individual is considered to have disposed of identical shares in the order in which the individual acquired them. In other words, shares with the longest holding period will be considered to have been sold first.

There are a number of special rules to provide for continuity of the holding period where ESBC shares are transferred in certain tax deferred circumstances. Where the individual dies, a surviving spouse or common law partner will be considered to have held the shares throughout the period the shares were owned by the deceased spouse if the shares are acquired from the deceased spouse on a rollover basis under subsection 70(6) of the Act. A similar rule applies in the case of a child acquiring

shares”. That is, they must be “pure” common shares with “no bells or whistles” attached, such as restrictions on or preferential entitlement to dividends or payment on liquidation of the corporation, convertibility, redeemability at the option of the holder and so on. Simply put, anything that makes the share not look like a common share is not permitted. (Full details are contained in section 6204 of the Income Tax Regulations.)

Second, the shares must be issued by the corporation from treasury to the individual: they cannot be acquired from another shareholder.

Third, at the time the share is issued, the corporation must be an “eligible small business corporation” (an “ESBC”) as defined in subsection 44.1(1) of the Act. An ESBC is a Canadian-controlled private corporation, all or substantially all (generally, 90% or more) of the fair market value of the assets of which at the time of issuance of the share are attributable to: (i) assets used principally in an active business carried on primarily (basically more than half) in Canada by the corporation or a related eligible small business corporation; (ii) shares issued by or debt owing by other related eligible small business corporations; or (iii) a combination of the foregoing.

Excluded from the benefit of the deferral provisions of the small business rollover are professional corporations (i.e., carrying on the practice of an accountant, dentist, lawyer, medical doctor, veterinarian or chiropractor), specified financial institutions, and real estate corporations, i.e., corporations whose principal business is leasing, rental, development or sale of real estate, or a corporation more than 50% of the fair market value of the property of which (net of debts incurred to acquire the property) is attributable to real property (collectively, a “Disqualified Corporation”).

Fourth, immediately before and after the share is issued, the total “carrying value” of the assets of the corporation and corporations related to it cannot exceed $50 million. Carrying value is based on the valuation of the assets on the corporation’s balance sheet as of the relevant time if the balance sheet were prepared in accordance with Canadian GAAP, except that shares or debt issued by related corporations are deemed to have a carrying value of nil. Care therefore needs to be taken to ensure that the subscription itself does not take the corporation over the $50 million threshold.

(b) Requirements during the Holding Period

In addition to being an ESBC at the time of issuance of the share to the individual, the corporation must qualify as an “active business corporation” (an “ABC”) throughout the period during which the individual owned the share as defined in subsection 44.1(1) of the Act. The test for being an ABC is somewhat less onerous than that for being an ESBC. The corporation must be

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the remainder of the capital gain (assuming the proceeds are reinvested appropriately in replacement shares).

ELIGIBLE POOLING ARRANGEMENTS

It is possible to engage an investment manager to invest in replacement shares on behalf of the individual. If there is an agreement in writing providing for the transfer of funds or other property by the individual to the investment manager to make purchases of ESBC shares with those funds within 60 days after receipt thereof and the investment manager issues statements of account monthly to the individual disclosing details of the portfolio held and the transactions made, the transactions are considered to be transactions of the individual and not of the investment manager, with the result that the investments could qualify (assuming all other requirements are met) as replacement shares for purposes of the small business rollover.

ANTI AVOIDANCE

The Act contains provisions denying the rollover where transactions have been entered into, one of the main purposes of which was to permit an individual (or a greater number of individuals) to take greater advantage of the rollover than would otherwise have been permissible before the proscribed transactions.

PLANNING CONSIDERATIONS

There are a number of planning considerations which must be borne in mind in respect of the small business rollover. First, the shares must be owned by an individual and cannot be owned by a trust. Therefore, when structuring the initial investment in an ESBC, one should be thinking ahead to the disposition and how to shelter the gain. Second, care must be taken to ensure that the shares are ESBC shares at the time of issuance and that the corporation remains an active business corporation thereafter. This involves monitoring the assets of the corporation, and in particular, cash and real estate. Third, since real estate corporations are not eligible for the rollover, it may be prudent to hold real estate in a separate corporation from the corporation carrying on the active business. Fourth, before reinvesting, some due diligence should be made about the replacement shares to make sure they qualify for purposes of the rollover. Finally, some thought should be given to the interplay between the capital gains exemption and the small business rollover when planning the disposition of the ESBC shares. Typically, the capital gains exemption would be used first if it is available.

CONCLUSION

The small business rollover is an effective and efficient tax deferral option. It is plainly not well known and its utilization requires adherence to the detailed compliance rules. Moreover,

ESBC shares on the death of a parent, if the acquisition qualifies for the rollover under subsection 70(9.2) of the Act. Where there is a marriage breakdown and the ESBC shares are acquired by the individual’s former spouse, the holding period is also continued if the shares are acquired by the former spouse on a rollover basis under subsection 73(1) of the Act.

There are also continuity of hold period rules on certain corporate reorganization or rollover transactions. Specifically, new ESBC shares acquired by the individual as the sole consideration in exchange for old ESBC shares on a rollover under sections 51, 85(1)(h), 85.1(1), 86 or 87(4) will be considered to be owned throughout the holding period of the individual, provided the transaction took place on a full rollover for tax purposes. Further, on such an exchange, if the exchange constitutes a qualifying disposition of the individual, the new shares are deemed to be ESBC shares and shares of an ABC owned throughout the holding period of the exchanged shares by the individual.

A BRIEF COMPARISON TO THE REQUIREMENTS FOR THE CAPITAL GAINS EXEMPTION

It is worth noting at this stage that: (i) the requirements at the time of issuance of the ESBC share are more onerous than those for the capital gains exemption; (ii) the requirements during the holding period bear some similarity but do differ from and are more onerous than the capital gains exemption; (iii) the requirements for the shares at the time of disposition are similar to the capital gains exemption; (iv) the holding period itself is considerably shorter than for the capital gains exemption; and (v) there is no dollar limit on the rollover (cf. $800,000 for the capital gains exemption). Thus, in order to qualify for both provisions, one must be mindful of the differing requirements for each. (It is beyond the scope of this article to describe the requirements for the capital gains exemption in any detail.)

WHAT ARE REPLACEMENT SHARES?

In order to qualify for the small business rollover, the individual must reinvest in “replacement shares”. These must be ESBC shares (see the requirements above) that are acquired during the year or within 120 days after the end of the year in which the qualifying disposition took place. Further, the shares must be designated by the individual in the individual’s return of income for the year to be a replacement share and a late filing of a designation is not permitted.

It is important to note that it is possible to designate some, but not all, of the replacement shares acquired by an individual with the result that the individual may manipulate the interaction between the small business deferral and the capital gains exemption, presumably first to utilize the capital gains exemption and then have the small business rollover apply to

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TAXES & WEALTH MANAGEMENT MAY 2014

monitoring ongoing qualification for the rollover is of vital importance. If you think that your situation would benefit from this tax strategy, you should consult a tax specialist.

Gerald Courage is a Partner in Miller Thomson LLP’s Tax Group. Gerald was Chair of Miller Thomson LLP from 2008 to 2013.

Gerald can be reached at gcourage@millerthomson.com

RETIREMENT’S VOLATILITY BOGEYMANBy Adam Butler, Mike Philbrick and Rodrigo Gordillo, Portfolio Managers with Butler|Philbrick|Gordillo & Associates at Dundee Goodman Private Wealth

Investment marketing is like watching a talented magician ply his trade. While the marketing geniuses keep everyone focused on the hottest new funds and stocks in an effort to chase strong returns, people forget about the single most important thing that matters to your retirement portfolio: volatility.

So let’s be crystal clear: retirement sustainability is extremely sensitive to portfolio volatility. Further, volatility is the only portfolio outcome that we can actively control. Therefore, volatility is the critical variable in the retirement equation, not returns.

To repeat:  Volatility is the critical variable in the retirement equation, not returns.

FORGET RETURNS: IT’S ABOUT SWR AND RSQ

If you are within five years of retirement, or are already in retirement, it is time to learn some new vocabulary:

Safe Withdrawal Rate (SWR): The percent of your retirement portfolio that you can safely withdraw each year for income, assuming the income is adjusted upward each year to account for inflation.

Retirement Sustainability Quotient (RSQ): The probability that your retirement portfolio will sustain you through death given certain assumptions about lifespan, inflation, returns, volatility and income withdrawal rate. You should target an RSQ of 85%, which means you are 85% confident that your plan will sustain you through retirement.

Forget about investment returns! From now on, the only question a retirement-focused investor should ask their Investment Advisor when discussing their options is: How does this affect my RSQ and SWR?

PORTFOLIO VOLATILITY DETERMINES RSQ AND SWR

The chart below shows how higher portfolio volatility results in lower SWRs, holding everything else constant:

All portfolios deliver 7% average returns.

Future inflation will be 2.5%.

Median remaining lifespan is 20 years (about right for a 65-year-old woman).

We want to target an 85% Retirement Sustainability Quotient (RSQ).

Note how SWR declines as portfolio volatility rises.

11595785.1

Note how SWR declines as portfolio volatility rises.

The green bar marks the volatility of a 50/50 stock/U.S. Treasury balanced portfolio over the long-term, while the red bar marks the long-term volatility of a diversified stock index. Note the SWR of the stock/bond portfolio is 6% versus 3.4% for the stock portfolio, highlighting the steep tax volatility levies on retirement income.

STEADY EDDY AND RISKY RICKY

This is actually quite intuitive when you think about it. Imagine a scenario where two retired persons, Steady Eddy and Risky Ricky by name, draw the same average annual income of $100,000 from their respective retirement portfolios. Both draw an income that is a percentage of the assets in their retirement portfolio at the end of the prior year.

Steady Eddy’s portfolio is invested in a balanced strategy with a volatility of 9.5%, while Risky Ricky is entirely in stocks with a volatility of 16.5%. Both portfolios earn the same return (as they have done for the past 15, 20 and 25 years, though we will address this in greater detail below).

Due to the lower volatility of Steady Eddy’s portfolio, his income is less volatile: 95% of the time his income is between $82,000 and $117,000. In contrast, Risky Ricky’s portfolio swings wildly from year to year, and therefore so does his income: 95% of the time his income is between $67,000 and $133,000. Of course, both of their incomes average out to the same $100,000 per year over time.

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amount of variability each year then you would tend to be more conservative in your spending: perhaps you would squirrel away some income each year in case next year’s income comes in on the low end of the range.

This relates directly to the impact of volatility on SWRs in the chart above. Volatility introduces uncertainty, which is amplified by the fact that money is being extracted from the portfolio each and every year regardless of portfolio growth or losses.

HOW MUCH GAIN WILL NEUTRALIZE THE PAIN?

Of course, this effect can be moderated by increasing average portfolio returns, which would then increase average available income. The question becomes, how much extra return is required to justify higher levels of portfolio volatility?

The chart below defines this relationship quantitatively by illustrating the average return that a portfolio must deliver to neutralize an increase in portfolio volatility. In this case we hold the following assumptions constant:

Withdrawal rate is 5% of portfolio value, adjusted each year for inflation.

Inflation is 2.5%.

Retirement Sustainability Quotient target is 85%.

Median remaining lifespan is 20 years.

11595785.1

Again, the green bar represents the balanced stock/Treasury bond portfolio discussed above, and the red bar represents an all-stock portfolio. From the chart, you can see that the balanced portfolio needs to deliver 6.8% returns to achieve an 85% RSQ with a 5% withdrawal rate. The higher volatility stock portfolio, on the other hand, requires a 9.2% returns to achieve the same outcomes.

In theory, higher returns in your retirement portfolio should equate to higher sustainable retirement income. In reality, higher returns at the expense of higher volatility actually reduces your retirement sustainability.

FOCUS ON WHAT YOU CAN CONTROL

There are many ways of improving the ratio of returns to volatility in a portfolio, mainly through thoughtful diversification across asset classes (our particular specialty). However, many investors are (perhaps rationally) concerned about diversifying into bonds now that the long-term yield is 3% or less, so let’s see what can be done with a pure stock portfolio to take advantage of the growth potential of stocks while keeping volatility at an appropriate level to maximize RSQ and SWR.

What if, instead of letting the volatility of the stock portfolio run wild, we set a target volatility for our portfolio and adjust our exposure to stocks up and down to keep the portfolio volatility within our comfort zone.

The green bar marks the volatility of a 50/50 stock/U.S. Treasury balanced portfolio over the long term, while the red bar marks the long-term volatility of a diversified stock index. Note the SWR of the stock/bond portfolio is 6% versus 3.4% for the stock portfolio, highlighting the steep tax volatility levies on retirement income.

STEADY EDDY AND RISKY RICKY

This is actually quite intuitive when you think about it. Imagine a scenario where two retired persons, Steady Eddy and Risky Ricky by name, draw the same  average  annual income of $100,000 from their respective retirement portfolios. Both draw an income that is a percentage of the assets in their retirement portfolio at the end of the prior year.

Steady Eddy’s portfolio is invested in a balanced strategy with a volatility of 9.5%, while Risky Ricky is entirely in stocks with a volatility of 16.5%. Both portfolios earn the same return (as they have done for the past 15, 20 and 25 years, though we will address this in greater detail below).

Due to the lower volatility of Steady Eddy’s portfolio, his income is less volatile: 95% of the time his income is between $82,000 and $117,000. In contrast, Risky Ricky’s portfolio swings wildly from year to year, and therefore so does his income: 95% of the time his income is between $67,000 and $133,000. Of course, both of their incomes average out to the same $100,000 per year over time.

All other things equal, which person would you expect to be more conservative in the amount of income they spend each year? Obviously, if your income were subject to a large

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TAXES & WEALTH MANAGEMENT MAY 2014

with the balance in cash. If stock volatility drops to 15%, our allocation would be 10% / 15% = 66.6% invested, with the balance in cash.

For the purposes of this example, we will assume that cash earns no interest, because it currently does not, and we want to focus on the effect of managing volatility alone.

More specifically, let’s assume we measure the trailing 20-day volatility of the SPY ETF (which tracks the performance of the U.S. S&P500 stock market index) at the end of each month, and adjust our portfolio at the end of any month where observed volatility is 10% above or below the volatility we measured at the end of the prior month.

For example, if we measured volatility last month at 15% annualized, and the volatility this month was greater than 16.5% or less than 13.5% (10% either way from the prior month), then we adjust our exposure to the SPY ETF according to the most recently observed volatility using the technique described in the last paragraph. If this month’s volatility does not exceed the threshold to rebalance, then we do not trade this month.

By using this simple technique to control volatility since the SPY ETF started trading in 1993, we achieve 6.65% annualized returns with a realized average portfolio volatility of 10.73%. This compares with returns on the buy and hold SPY ETF of 7.99% with a volatility of 20%. Note that our average exposure to the market over that period was just 69%, with the balance earning no returns. All returns include dividends.

The chart below shows the Sustainable Withdrawal Rate for the two portfolios: the volatility target SPY and the buy and hold SPY.

11595785.1

Source: Butler|Philbrick|Gordillo& Associates, 2012, Algorithms by QWeMA Group.

You can see that by specifically targeting portfolio volatility our sustainable withdrawal rate rises to 4.7% per year, adjusted for inflation (at 2.5%) versus the Buy and Hold portfolio, which will support a withdrawal rate of 3.65% per year. This despite the fact that the Buy and Hold portfolio outperforms the volatility-targeted portfolio by 1.35% per year.

We cannot control the returns that markets will deliver in the future, but we can easily control portfolio volatility by observing and adapting. Withdrawal rates from retirement portfolios are highly sensitive to this volatility, and we have demonstrated that by controlling volatility we can increase our safe withdrawal rates, and therefore boost retirement income, by almost 30% before tax.

Just imagine what is possible with a diversified portfolio of asset classes when you volatility-size them (see www.darwinstrategies.ca).

Adam Butler and Mike Philbrick and Rodrigo Gordillo are Portfolio Managers with Butler|Philbrick|Gordillo & Associates at Dundee Goodman Private Wealth in Toronto, Canada.

Adam, Mike and Rodrigo and can be found at www.bpgassociates.com

Again, the green bar represents the balanced stock/Treasury bond portfolio discussed above, and the red bar represents an all-stock portfolio. From the chart, you can see that the balanced portfolio needs to deliver 6.8% returns to achieve an 85% RSQ with a 5% withdrawal rate. The higher volatility stock portfolio, on the other hand, requires 9.2% returns to achieve the same outcomes.

In theory, higher returns in your retirement portfolio should equate to higher sustainable retirement income. In reality, higher returns at the expense of higher volatility actually reduces your retirement sustainability.

FOCUS ON WHAT YOU CAN CONTROL

There are many ways of improving the ratio of returns to volatility in a portfolio, mainly through thoughtful diversification across asset classes (our particular specialty). However, many investors are (perhaps rationally) concerned about diversifying into bonds now that the long-term yield is 3% or less, so let’s see what can be done with a pure stock portfolio to take advantage of the growth potential of stocks while keeping volatility at an appropriate level to maximize RSQ and SWR.

What if, instead of letting the volatility of the stock portfolio run wild, we set a target volatility for our portfolio and adjust our exposure to stocks up and down to keep the portfolio volatility within our comfort zone.

For example, let’s set a target of 10% annualized volatility, so if stock volatility is 20%, our allocation to stocks =

target vol/observed vol = 10% / 20% = 50%,

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17

10 years prior to the date on which the relief is requested, regardless of when the underlying tax liability arose. Successful taxpayer relief requests can therefore be particularly helpful in cases involving extenuating circumstances or lengthy delays attributable to the actions or omissions of the Canada Revenue Agency (the “CRA”). Nonetheless, subsection 220(3.1) of the ITA only provides the CRA with the discretion to waive or cancel interest and penalties, and not the underlying tax debt. Taxpayers who, despite having exhausted the objection and appeals process provided for under the ITA, remain unable to effectively deal with this tax burden, may have limited options left. In such cases, taxpayers may want to carefully consider their circumstances and determine whether they warrant requesting a remission order as a remedy of last resort.

REMISSION ORDERS UNDER THE FINANCIAL ADMINISTRATION ACT (CANADA) (THE “FAA”)

Subsection 23(2) of the FAA permits the Governor in Council (generally the Governor General, acting on the advice of the Federal Cabinet) to cancel the collection of tax or of a penalty when it would be unreasonable or unjust to do so, or if it would otherwise be in the public interest to remit the tax or penalty in question. Taxpayers, or their representatives, begin the process of requesting a remission order by filing their submissions with the Remissions and Delegations Section/Committee of the Legislative Policy and Regulatory Affairs Branch of the CRA. Taxpayers’ requests for remission orders are first reviewed by this Committee. If approved, the requests are forwarded to the Assistant Commissioner, Legislative Policy and Regulatory Affairs, for review. Thereafter, if approved, requests for remission orders are forwarded first to the Commissioner and then to the Minister of National Revenue, for recommendation to the Federal Cabinet.2

In determining whether to recommend the granting of a remission order, the CRA generally follows its own internal guidelines. As cited in Germain v. Canada,3 these guidelines state that the CRA is to consider each request for a remission order on its own merits, in accordance with the broad terms set out in subsection 23 of the FAA. However, to assist CRA officials in their assessment, remission order requests are evaluated against the following general criteria:4

1. extreme hardship;

2. incorrect action or advice on the part of CRA officials;

3. financial setback coupled with extenuating factors; and

4. unintended results of the legislation.

2 See David M. Sherman, Notes to subsection 220(3.1) in Practitioner’s Income Tax Act, 2014, 45th ed. (Toronto: Carswell) [Practitioner’s Act].

3 2012 FC 768.4 Ibid. at para. 40.

A TAXPAYER’S LAST RESORT: THE REMISSION ORDERBy Rahul Sharma, Associate, Miller Thomson LLP

INTRODUCTION

Taxpayers with substantial amounts owing to the Receiver General of Canada often ask what can be done to reduce or eliminate their tax debts. It is not uncommon for taxpayers to be left with sometimes staggering debt burdens that they simply cannot pay off, including after having been reassessed on account of their participation in a structured plan or arrangement that was later determined to constitute an impermissible tax shelter.

To the extent that the amount owed by a taxpayer consists, in part, of interest and penalties, the taxpayer may apply for the waiver or cancellation of such interest and penalties under subsection 220(3.1) of the Income Tax Act (Canada) (the “ITA”). Pursuant to the 2011 decision of the Federal Court of Appeal in Bozzer v. The Queen,1 subject to being eligible for relief under subsection 220(3.1), taxpayers may request to have the interest and penalties payable by them waived for the period beginning

1 2011 FCA 186.

Source: Butler|Philbrick|Gordillo& Associates, 2012, Algorithms by QWeMA Group.

You can see that by specifically targeting portfolio volatility our sustainable withdrawal rate rises to 4.7% per year, adjusted for inflation (at 2.5%) versus the Buy and Hold portfolio, which will support a withdrawal rate of 3.65% per year. This despite the fact that the Buy and Hold portfolio outperforms the volatility-targeted portfolio by 1.35% per year.

We can't control the returns that markets will deliver in the future, but we can easily control portfolio volatility by observing and adapting. Withdrawal rates from retirement portfolios are highly sensitive to this volatility, and we have demonstrated that by controlling volatility we can increase our safe withdrawal rates, and therefore boost retirement income, by almost 30% before tax.

Just imagine what is possible with a diversified portfolio of asset classes when you volatility-size them (see www.darwinstrategies.ca).

Adam Butler, Mike Philbrick and Rodrigo Gordillo are Portfolio Managers with  Butler|Philbrick|Gordillo & Associates  at Dundee Goodman Private Wealth in Toronto, Canada.

Adam, Mike and Rodrigo can be found at www.bpgassociates.com

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TAXES & WEALTH MANAGEMENT MAY 2014

These factors differ from those the CRA generally considers under subsection 220(3.1) of the ITA when determining whether to provide relief from interest and/or penalties. According to 2008 presentation materials released by the CRA, cases of extreme hardship may apply to businesses whose financial troubles or heavy tax burden could adversely affect a large group or community. The CRA may also recommend that tax be remitted in cases where written or other acceptable evidence substantiates the fact that incorrect actions were taken or that incorrect advice was given by CRA officials. Cases involving financial setbacks, coupled with a serious illness or other factors beyond a taxpayer’s control, could also be legitimate subjects for a remission order request, as well as cases involving clearly inequitable tax consequences to a taxpayer arising from the application of tax legislation to his or her circumstances (until the problem can be remedied by a legislative change).

In Waycobah First Nation v. Canada,5 the Waycobah First Nation requested a remission order as a result of its failure to collect harmonized sales tax (“HST”) from non-natives who bought gasoline and tobacco from a gas station located on the reserve. Under the terms of its treaty, Waycobah argued that it was not required to collect HST from its customers. Accordingly, the First Nation continued to refuse to collect HST until it lost its judicial battle in June 2003, when the Supreme Court of Canada denied leave to appeal the decision of the Federal Court of Appeal (which had upheld the earlier judgment of the Tax Court of Canada).6

In seeking a judicial review of the CRA’s decision to not recommend that a remission order be granted, Waycobah argued, inter alia, that the Assistant Commissioner fettered his discretion by treating the CRA’s remission guidelines (or the criteria outlined above) as being exhaustive. Waycobah’s position was that the Assistant Commissioner failed, in particular, to refer to or adequately consider Waycobah’s submission that, “unless its tax debt was remitted, it could not move forward towards self-governance in accordance with government policy.”7

Although the Federal Court of Appeal disagreed with Waycobah’s position, Evans J.A. noted (in obiter) that it was “unfortunate” that the CRA’s remission guidelines were marked “for CRA use only” and not otherwise available to the general

5 2011 FCA 191 [Waycobah].6 By the time Waycobah’s litigation was over, as a result of having not

collected HST, its tax debt amounted to over $1.3 million in 2001, including interest and penalties. Although Waycobah attempted to negotiate a payment plan with the CRA, it was not able to adhere to its terms, leaving a total debt exceeding $3.4 million in September 2009—a financial burden that the impoverished community simply could not afford to pay.

7 Waycobah, supra note 5 at para. 21.

public.8 Nonetheless, the Federal Court of Appeal held that it is not unlawful for the CRA to base a decision on its own valid guidelines or decision-making framework, provided that those guidelines are not exhaustive. In the Court’s view, this did not appear to be the manner in which the Assistant Commissioner considered or applied the guidelines in relation to Waycobah’s remission order request.9

UPHILL BATTLE IN REQUESTING A REMISSION ORDER

Although the First Nation was not successful, Waycobah is nonetheless a helpful decision of the Federal Court of Appeal that clarifies any ambiguity that may have previously existed regarding the scope of the CRA’s internal guidelines and the extent of their application to individual cases. The Federal Court of Appeal’s decision in Waycobah also makes it clear that the CRA must consider other factors, circumstances and submissions outside of its guidelines, and which may relate to the broader language of subsection 23(2) of the FAA. This is no doubt of benefit to taxpayers who think that their circumstances may justify a remission order being recommended, but whose circumstances may not otherwise fit squarely within one of the four above-mentioned criteria.

That being said, a Canadian taxpayer has yet to be successful in seeking a judicial review of the CRA’s decision to refuse to recommend a remission order. Both the Federal Court and the Federal Court of Appeal have, in large measure, showed deference to the CRA’s decisions. This highlights the broad discretion that the CRA has in determining whether to recommend that a remission order be granted. Depending on their own individual facts, not all cases will warrant the CRA recommending that tax and/or penalties be remitted. Nonetheless, according to information obtained pursuant to disclosure under the Access to Information Act (Canada), in 2010-2011, the CRA’s Headquarters Remission Committee recommended that taxes and/or penalties be remitted in 14 of 44 total cases.10

While this figure is by no means high, it does indicate that the Committee made positive recommendations for the granting of a remission order in nearly one out of every three cases. The statistic suggests that, in cases where taxpayers face apparently insurmountable tax debts, or legitimately believe that they have received wrong advice or direction from a CRA official, it may well be worth discussing the feasibility of requesting a remission order with their tax advisors.

Rahul Sharma is an Associate in Miller Thomson LLP’s Tax and Private Client Services Groups.

Rahul can be reached at rsharma@millerthomson.com

8 Ibid. at para. 29.9 Ibid. at para. 28.10 Practitioner’s Act, supra note 2.

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CASL’s anti-spam provisions apply to electronic messages that are commercial in character, and “commercial” under CASL refers to anything that “encourages participation in commercial activity”, including: (i) an offer to purchase, sell, barter or lease a product, goods, a service, land or an interest or right in land; (ii) an offer to provide a business, investment or gaming opportunity; or (iii) advertising or promotion of these activities or of a person carrying out or intending to carry out these activities.

In determining whether an electronic message is “commercial”, the Canadian Radio-television and Telecommunications Commission (CRTC), the CASL enforcement regulator, will look at: (i) the content of a message; (ii) the hyperlinks in a message to content on a web site or other database; and (iii) the contact information contained in a message. The test they will apply is whether it is reasonable to conclude, based on the above, that the purpose(s) of an electronic message is to encourage participation in a commercial activity. Under CASL, no expectation of profit is required in order for an activity to be considered commercial in character.

CASL’s prohibition against the unauthorized altering of the transmission data in an electronic message applies if a computer system located in Canada is used to send, route or access the electronic message.

CASL’s prohibition against the unauthorized installation of computer programs applies if a computer system is located in Canada at the relevant time or if the person installing a computer program onto another person’s computer system is either in Canada at the relevant time or is acting under the direction of a person who is in Canada at the time when the direction is given.

CASL also amends the Canadian Competition Act to address fraudulent or misleading practices conducted through electronic messages or web sites. CASL also amends Canada’s private-sector legislation known as the Personal Information Protection and Electronic Documents Act (PIPEDA). PIPEDA now contains prohibitions against the automated collection of electronic addresses (i.e., email harvesting) and the use of any such collected addresses as well as the unauthorized use of computers to collection personal information and the use of any such collected personal information.

II. WHY SHOULD CASL MATTER TO YOU AND YOUR ORGANIZATION?

Individuals and organizations will want to ensure that they are CASL compliant because non-compliance may lead to significant consequences and penalties, including:

1. Administrative Monetary Penalties (AMPs):

CANADA’S ANTI-SPAM LEGISLATION (CASL) IS COMING INTO FORCE ON JULY 1, 2014: WHY YOU SHOULD PAY ATTENTION AND SOME SUGGESTIONS FOR COMPLIANCE PREPARATIONBy J. Andrew Sprague, Associate, Miller Thomson LLP

In December 2013, the Government of Canada announced that the anti-spam provisions of Canada’s anti-spam legislation (CASL)1 will come into force on July 1, 2014, and that CASL’s provisions relating to computer programs will come into force on January 15, 2015.

I. WILL CASL APPLY TO YOU AND YOUR ORGANIZATION?

CASL’s broad scope and reach means that it impacts every individual and every organization that engages in commercial activities in Canada.

CASL contains a number of prohibitions, including:

1. the sending of commercial electronic messages without consent and without meeting certain prescribed form and content requirements;

2. the altering of transmission data in an electronic message without consent; and

3. installing computer programs without express consent.

CASL’s prohibition against the sending of unsolicited commercial electronic messages applies if a computer system located in Canada is used to send or access an electronic message.

Under CASL, the definition of what is considered a commercial electronic message is very broad and includes electronic messages such as email, text messaging/SMS, instant messaging, social networks (Facebook®, LinkedIn®, etc.), and other online services (e.g., web forums, portals).

1 The official name is An Act to promote the efficiency and adaptability of the Canadian economy by regulating certain activities that discourage reliance on electronic means of carrying out commercial activities, and to amend the Canadian Radio-television and Telecommunications Commission Act, the Competition Act, the Personal Information Protection and Electronic Documents Act and the Telecommunications Act (S.C. 2010, c. 23).

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(a) A fine of up to $1,000,000 per violation for individuals;

(b) A fine of up to $10,000,000 per violation for any other person (i.e., any legal entity that is not an individual);

2. Corporate officers and directors being held personally liable for corporate violations;

3. Vicarious liability arising for violations committed by employees or agents;

4. A private civil right of action (including the possibility of class-action lawsuits); and

5. Reputational risks.

Liability under CASL also extends to any person who aids, induces, procures or causes to be procured a prohibited act.

Fortunately, CASL permits a due diligence defence against claims of non-compliance. I believe that if individuals and organizations take proactive steps to set up appropriate policies, procedures, and processes relating to the activities prohibited under CASL, and properly enforce them, such individuals and organizations may be able to use their efforts as an aid to a due diligence defence, and such efforts may be a factor in determining liability or damage awards arising out of a CASL non-compliance claim.

III. NEW CONSENTS ARE REQUIRED

Consents to receive commercial electronic messages can be express or implied under CASL. Unlike Canadian privacy laws that permit “opt out” consent for less sensitive types of information, such as receipt of marketing information, this form of consent is not sufficient under CASL for the receipt of marketing information by electronic means.

IV. EXEMPTIONS FROM ANTI-SPAM PROVISIONS

One or more exemptions from compliance with CASL’s anti-spam provisions may be available to individuals and/or organizations, depending on their particular circumstances.

Messages sent:

1. by a business to an existing customer;

2. internally within a business;

3. in regard to a legal obligation or a legal right;

4. to respond to an inquiry or a referral;

5. within an existing “family relationship” or “personal relationship”;

6. where there is an “existing business relationship”; or

7. where there is an “existing non-business relationship”,

may be exempted under CASL if all of the necessary criteria are met. Other exemptions may also be available.

V. NEXT STEPS

While developing their CASL compliance strategies, there are a number of steps that individuals and organizations can take.

Step 1: If an individual or organization has not already done so, he, she or it should conduct an audit/gap analysis to collect information about his, her or its current electronic communication practices.

Step 2: Once an individual or organization has completed an audit/gap analysis of his, her or its current electronic communication practices, the next step should be to consider CASL’s requirements and assess what changes might be required to an individual’s or organization’s current policies, procedures, practices, processes, and/or computer systems and networks in order to ensure that the individual or organization is CASL compliant.

Step 3: Utilize available resources. The federal government has two CASL/anti-spam web sites that individuals and organizations may find of interest: fightspam.gc.ca and http://www.crtc.gc.ca/eng/casl-lcap.htm.

Step 4: Implementation of the changes required, as determined in Step 3, is a very important and necessary step in becoming CASL compliant.

Step 5: If an individual or organization has not already done so, he, she or it should also review and update his, her or its privacy policies, including his, her or its web site privacy policies (where applicable) and the terms of use/terms of service for his, her or its web site (where applicable).

This article is provided as an information service and is a summary of current legal issues. This information is not meant as legal opinion and readers are cautioned not to act on information provided in this article without seeking specific legal advice with respect to their unique circumstances.

J. Andrew Sprague is an Associate in Miller Thomson LLP’s Business Law, Information Technology Law and Intellectual Property Law Groups.

Andrew can be reached at asprague@millerthomson.com

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the relationship went bad and that the engagement ended at the end of 2004.

The Appellant was subject to a random audit for the years in issue. During the course of the audit, she told the CRA auditor that her fiancé paid for the general household expenses. She refused to provide the name of her fiancé to the CRA. It was her view that this information was part of her private life and should remain private. Additionally, her fiancé refused to give her permission to tell the authorities who he was.

Given the Appellant’s reluctance to provide information, the CRA auditor had little choice but to use some method (in this case, using the cash flow method) to determine the income necessary for the Appellant to maintain her lifestyle during the years under review as a single person. The court concluded that the CRA officer was fair and reasonable and restrained in her use of the cash flow method [para. 21 of the Reasons].

The identity of the fiancé became known at the trial. He was subpoenaed but refused to show. Hence, the court issued a warrant for arrest to bring him to court. Needless to say, Mr.  Garfield, the fiancé, was an unwilling witness and not very forthcoming. Documents produced during the hearing had Mr. Garfield living at a different address than the address identified by the Appellant. In addition, at no time did he report a change to his marital status and he did not claim an equivalent to married deduction in the years in issue. In fact, Mr.  Garfield did not file tax returns for the tax periods under review. Even so, Mr.  Garfield did acknowledge having paid many of the Appellant’s expenses and supporting the Appellant while she was not working.

At the end of the evidence portion of this trial, it was clear that since the Appellant had not adduced any documentary evidence, the Appellant was solely relying upon her viva voce testimony and that of Mr.  Garfield. As the court put it, “the critical issue in this trial is that of credibility of these two witnesses” [para. 23 of the Reasons].

What follows in the Reasons for Judgment is a succinct summation of the judge’s role in determining credibility, and for this reason alone, it is worth repeating. As Deputy Judge Masse stated: “It is trite law that I can accept all of the evidence of a witness, none of [the] evidence of the witness or I can accept some of the witness’ evidence and reject other portions of the witness’ evidence” [para. 24 of the Reasons].

Citing the well-known dictum of Justice O’Halloran of the British Columbia Court of Appeal in Faryna v. Chorny, [1952] 2 D.L.R. 354 (B.C.C.A.) at pages 356-357, Judge Masse reminds us of the challenge facing the trier of fact when making a finding on credibility:

Daimsis v. The Queen, 2014 TCC 118: FINDINGS BASED ON CREDIBILITY: IT IS NOT AS EASY AS YOU MIGHT THINKBy David W. Chodikoff, Editor of Taxes & Wealth Management, Tax Partner, Miller Thomson LLP

This rather innocuous Informal Procedure tax appeal was decided by Deputy Judge Rommel G. Masse. It serves as a good reminder of how a court must make a finding of credibility or the lack of it.

This tax appeal concerned the Appellant’s 2003 and 2004 taxation years. The issue was whether the Appellant had underreported her income for those years.

The Appellant’s theory of her case was simple. Ms. Daimsis, the Appellant, claimed that she had reported all of her income that she earned during those years: those amounts were $4,600 and $24,410 for the 2003 and 2004 taxation years, respectively.

She claimed that most of her living expenses during those years were paid by her fiancé (at the time). Her claim was also that she and the boyfriend/fiancé were then co-habiting.

In contrast, the Minister of National Revenue (the “Minister”) alleged that the Appellant was less than cooperative and provided very little information, including refusing to identify her co-habiting fiancé. As a result, the Minister had little choice but to have the auditor perform a cash flow analysis in order to make an estimation of the Appellant’s “real” income for her 2003 and 2004 taxation years. This analysis resulted in the Minister issuing a Notice of Assessment for the Appellant’s 2003 taxation year, increasing her reported income by $24,412, as well as a Notice of Reassessment for her 2004 taxation year, increasing her income by an amount of $16,034. The Appellant filed Notices of Objection and, with the exception of some minor adjustments, the Appellant continued the appeal process to the Tax Court of Canada.

There were three witnesses in this Appeal: the Appellant, the Canada Revenue Agency (the “CRA”) auditor, and the former fiancé.

At trial, the Appellant explained that during the relevant time period she was engaged to be married and cohabiting with her fiancé. She stated that her fiancé wanted her to stay at home and he wanted to be the provider. She claimed that her fiancé paid all of her living expenses. She said that he was making a good living and would support her. The Appellant claimed that

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TAXES & WEALTH MANAGEMENT MAY 2014

CASES OF NOTEKossow v. R., [2014] 2 C.T.C. 1, 2013 CarswellNat 4557 (F.C.A.), leave to appeal refused 2014 CarswellNat 1530, 2014 CarswellNat 1529 (S.C.C.) — Near J.A., Gauthier J.A., Evans J.A. — Tax — Income tax — Tax credits — Charitable donations — Whether genuine gift — The taxpayer, Ms. Kossow, made purported donations to, and received charitable tax receipts from, a foundation in the amounts of $50,000, $60,000 and $50,000 in the 2000, 2001 and 2002 taxation years, respectively. The donations were funded by 20 percent cash from the taxpayer and 80 percent from a 25-year, non-interest bearing loan provided to the taxpayer by an initiatives funding program. The taxpayer claimed donation tax credits in respect of the donations. The Minister reassessed the taxpayer, and disallowed 80 percent of the donation tax credit claimed for 2000 and 2001, and disallowed the entire tax credit for the 2002 taxation year. The taxpayer’s appeal was dismissed by the Tax Court judge who found that the taxpayer did not make a gift within the meaning of section 118.1 of the Income Tax Act. The judge held that the interest-free loans constituted significant benefits that the taxpayer received in return for making her donations. The taxpayer’s appeal to the Federal Court of Appeal was dismissed. The Federal Court of Appeal concluded that the taxpayer received a significant financial

If a trial Judge’s finding of credibility is to depend solely on which person he thinks made the better appearance of sincerity in the witness box, we are left with a purely arbitrary finding and justice would then depend upon the best actors in the witness box. On reflection it becomes almost axiomatic that the appearance of telling the truth is but one of the elements that enter into the credibility of the evidence of a witness. Opportunities for knowledge, powers of observation, judgment and memory, ability to describe clearly what he has seen and heard, as well as other factors, combine to produce what is called credibility, and cf. Raymond v. Bosanquet (1919), 50 D.L.R. 560 at p. 566, 59 S.C.R. 452 at p. 460, 17 O.W.N. 295. A witness by this manner may create a very unfavourable impression of his truthfulness upon the trial Judge, and yet the surrounding circumstances in the case may point decisively to the conclusion that he is actually telling the truth. I am not referring to the comparatively infrequent cases in which a witness is caught in a clumsy lie.

The credibility of interested witnesses, particularly in cases of conflict of evidence, cannot be gauged solely by the test of whether the personal demeanour of the particular witness carried conviction of the truth. The test must reasonably subject his story to an examination of its consistency with the probabilities that surround the currently existing conditions. In short, the real test of the truth of the story of a witness in such a case must be its harmony with the preponderance of the probabilities which a practical and informed person would readily recognize as reasonable in that place and in those conditions. Only thus can a Court satisfactorily appraise the testimony of quick-minded, experienced and confident witnesses, and of those shrewd persons adept in the half-lie and of long and successful experience in combining skilful exaggeration with partial suppression of the truth. Again a witness may testify what he sincerely believes to be true, but he may be quite honestly mistaken. For a trial Judge to say “I believe him because I judge him to be telling the truth”, is to come to a conclusion on consideration of only half the problem. In truth it may easily be self-direction of a dangerous kind.

The trial Judge ought to go further and say that evidence of the witness he believes is in accordance with the preponderance of probabilities in the case and, if his view is to command confidence, also state his reasons for that conclusion. The law does not clothe the trial Judge with a divine insight into the hearts and minds of the witnesses. And a Court of Appeal must be satisfied that the trial Judge’s finding of credibility is based not

on one element only to the exclusion of others, but is based on all the elements by which it can be tested in the particular case.

In addition to this “jurisprudential lens”, Judge Masse stated that he (supposedly like any other judge) must assess the credibility of the witnesses: “making use of human experience, the knowledge of the human condition, the knowledge that memories fade with time and the fact that human beings are most imperfect creatures” [para. 24 of the Reasons].

A thoughtful analysis of the oral evidence of the two central witnesses follow, with the conclusion that on balance the issue of credibility is resolved in favour of the Appellant.

The value of the case is its reminder that the judge’s job of determining credibility is one of balancing a variety of factors and placing the proper weight on those various elements. It is a very difficult task. Thankfully, more often than not, trial judges get it right.

David W. Chodikoff is an editor of Taxes & Wealth Management. David is also a tax partner specializing in Tax Litigation (Civil and Criminal) at Miller Thomson LLP.

David can be reached at 416.595.8626 or dchodikoff@millerthomson.com

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ON THE RADAR

Lottery Commissions

In document 2014-0522731M4 dated May 8, 2014, the CRA outlined its revised administrative position regarding payments to lottery ticket retailers. Before 2014, the CRA’s position outlined in IT-404R, Payments to Lottery Ticket Vendors, was that any prize lottery ticket retailers received in a year from a provincial lottery corporation for selling a winning ticket was not taxable. However, generally, prizes a taxpayer receives by virtue of carrying on a business are taxable, as explained in IT-334R2, Miscellaneous Receipts.

Repeated concerns over the years prompted the CRA to review its position and, upon  review, the CRA concluded that treating prizes paid to lottery ticket retailers as non-taxable led to inconsistent treatment between taxpayers and was no longer sustainable. Consequently, the CRA cancelled IT-404R on December 31, 2013. Therefore, since January 1, 2014, lottery ticket retailers must include in their income the amount or value of any prize they receive in a year from a provincial lottery corporation for selling a winning ticket, because these amounts are received as part of their normal business activity. As with any business income, taxpayers must report all taxable amounts received in a year on that year’s income tax and benefit return.

The CRA’s new position does not affect the taxation of any prize the holder of a winning lottery ticket receives. Those who win a prize in a lottery will continue to receive such prizes free of tax.

Unclaimed Interest Expense

In document 2014-0521341E5 dated May 8, 2014, the CRA was asked whether a taxpayer can claim an interest expense in a taxation year subsequent to the taxation year in which the interest was paid.

Paragraph 20(1)(c) of the Income Tax Act provides a deduction in a taxation year for interest paid in the year or payable in respect of that year on funds borrowed for the purpose of earning income from a business or property; however, it does not permit a taxpayer to claim a deduction for interest paid in a previous taxation year on an income tax return for a subsequent year. When a taxpayer wishes to claim an interest deduction for a previous taxation year in respect of which a return has already been filed, the taxpayer may request a reassessment of the previous year’s tax return.

A taxpayer may carry forward non-capital losses (which may have resulted in whole or in part from interest deductions) from previous years in certain circumstances in accordance with paragraph 111(1)(a) of the Act.

benefit as the recipient of long-term, interest-free loans; the benefit did not come from the donee but from the lender as a result of the taxpayer’s participation in the donation program. The Judge was correct in finding that the taxpayer did not make a gift. The taxpayer’s application for leave to appeal to the Supreme Court of Canada was dismissed on May 15, 2014.

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Daimsis v. The Queen, 2014 TCC 118, 2014 CarswellNat 1352 (T.C.C. [Informal Procedure]) — Masse D.J. — Tax — Income tax — Administration and enforcement — Audits — Audit methodology — The taxpayer reported $4,600 in income on her 2003 income tax return and $24,410 on her 2004 return. The Minister initially accepted the returns as filed. During a subsequent audit, the taxpayer advised the auditor that her former fiancé paid all the expenses, but refused to provide more than the fiancé’s first name, so the auditor conducted a cash flow method audit based on the taxpayer’s lifestyle and declared income. The Minister adjusted the taxpayer’s income by adding $24,412 to her 2003 income and $16,034 to her 2004 income. The Minister later allowed the taxpayer’s objections in part, and reduced her adjusted 2003 income by $4,568 and 2004 income by $1,583. The taxpayer’s appeal to the Tax Court of Canada was allowed. The reassessments were referred back to the Minister for reconsideration and reassessment on the basis that, during the relevant period, the taxpayer was living with her fiancé in a common law relationship, her fiancé was paying all the taxpayer’s living expenses, and the taxpayer reported all her income. The evidence was that, from 2003 to the end of 2004, the taxpayer was engaged to marry her fiancé, who was living with the taxpayer and paying all her living expenses. The evidence of her fiancé, who was brought to court under arrest for failing to respond to a subpoena, confirmed that he and the taxpayer lived together and that he supported the taxpayer during 2003 and 2004. While the auditor was fair and reasonable in using of the cash flow method to assess the taxpayer, and while the taxpayer failed to adduce documentary evidence to demolish the Minister’s assumptions, the fiancé never filed tax returns from 2002 up to 2005 and clearly had something to hide, which was consistent with his warning the taxpayer not to disclose anything about him to anybody. As the fiancé had no interest in the outcome of the case, no reason to favour either party, and no opportunity to collaborate with the taxpayer, their testimony that he paid her living expenses was accepted and the credibility issue was resolved in favour of the taxpayer. It was more likely than not that the fiancé and taxpayer cohabited throughout most of 2003 and part of 2004, and that the fiancé paid all of the taxpayer’s living expenses when she could not afford to do so.

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TAXES & WEALTH MANAGEMENT MAY 2014

normally be determined by reference to the cost of the inventory to the taxpayer for income tax purposes less the amount of any compensation received (such as insurance), if any. Where the property is capital property, the comments in paragraph 9 of IT-185R should be taken into account.

Where virtual currencies are acquired as gifts, IT-334R2, Miscellaneous Receipts, provides that an amount received as a gift is not subject to income tax in the hands of the recipient. However, where an individual receives a “voluntary payment” or other valuable transfer or benefit from the individual’s employer, the amount of the payment or the value of the transfer or benefit must generally be included in the individual’s income pursuant to subsection 5(1) or paragraph 6(1)(a) of the Act. Similarly, “voluntary payments” or other transfers or benefits received by a taxpayer in respect of, or in connection with, a business carried on by the taxpayer, must be included in the taxpayer’s income from that business.

With respect to whether barter transaction rules apply when one type of virtual currency is exchanged for another type of virtual currency, IT-490, Barter Transactions, provides that in the case of goods bartered by a taxpayer for other goods or services, the value of those goods must be brought into the taxpayer’s income if they are business-related. As such, an exchange of one type of virtual currency for another in such circumstances would trigger a disposition for income tax purposes.

Virtual Currencies (Bitcoins)

In document 2014-0525191E5 dated April 23, 2014, the CRA provided its views regarding the income tax treatment of various transactions involving virtual currencies such as bitcoin.

Where a taxpayer mines bitcoin in a commercial manner, in computing the taxpayer’s income from the business for a taxation year, the value of property described in the inventory at the end of the year must be determined. Section 10 of the Income Tax Act and Part XVIII of the Income Tax Regulations set out the rules pertaining to the valuation of a taxpayer’s inventory for this purpose. In most cases, either of the following two methods of valuing inventory is available: (1) valuation of each item in the inventory at the cost at which it was acquired or its fair market value at the end of the year, whichever is lower; or (2) valuation of the entire inventory at its fair market value at the end of the year.

Whether a virtual currency such as bitcoin is held as inventory or as a capital property is a question of fact. Where such property is lost or stolen, IT-185R, Losses from Theft, Defalcation, or Embezzlement, provides that a loss of trading assets through theft, defalcation, or embezzlement is normally deductible in computing income from a business if such losses are an inherent risk of carrying on the business and the loss is reasonably incidental to the normal income-earning activities of the business. The amount of the taxpayer’s loss would