Treaty Shopping

A topical concern in the area of tax avoidance, according to the CCRA, is "treaty shopping", which the CCRA described (somewhat restrictively) as the establishment by a taxpayer of residency in a jurisdiction in order to avail itself of the provisions of a tax treaty with that jurisdiction. Treaty shopping was described in Crown Forest Industries Ltd. v. Canada, [1995] 2 C.T.C. 64 (S.C.C.), as the routing of income through particular states in order to take advantage of treaty benefits that were designed to be given only to residents of the contracting states. The CCRA stated that it would challenge treaty shopping transactions, first, by relying on certain commentary by the Organization for Economic Co-operation and Development to Article 1 (Persons Covered) of the Model Tax Convention on Income and on Capital regarding the improper use of treaties. Second, the CCRA stated that it would seek to apply the general anti-avoidance rule to such transactions. In response to a question about which treaty shopping situations were being examined, the CCRA replied that all such situations were being examined.

Withholding Tax on Interest

The CCRA also stated its views as to the scope of the post-amble to subparagraph 212(1)(b)(vii) of the Income Tax Act. According to the CCRA, the post-amble is broad enough to encompass debts containing provisions for adjustments to the interest rate based on earnings before interest, taxes, depreciation and amortization (EBITDA). The CCRA acknowledged that such adjustments would generally reflect the changing credit profile of the debtor and noted that it had not yet evaluated a "live example". The policy concern, according to the CCRA, is that such adjustments could potentially be used to export profits to non-residents. It is unclear how this concern arises where, for example, the interest rate increases as EBITDA falls, although such adjustments would appear to come within the scope of the CCRA's views.

The CCRA also stated that, in light of the decision in General Electric Capital Equipment Finance Inc. v. R., [2002] 1 C.T.C. 217 (F.C.A.), leave to appeal ref'd (2002), 302 N.R. 194 (note) (S.C.C.), a novation was not required at common law for changes to the terms of a debt to give rise to a new obligation for the purposes of subparagraph 212(1)(b)(vii), although the CCRA acknowledged that the position may be different under civil law. The CCRA noted that it would not regard changes that involve merely deferring interest or amending a security interest as giving rise to a new obligation for the purposes of subparagraph 212(1)(b)(vii).

Partnerships

The CCRA confirmed its position that a salary paid by a partnership to one of its partners would not be deductible to the partnership, on the grounds that a partner cannot have two sources of income from one business. However, remuneration paid by the partnership to a partner for services rendered to the partnership that are not performed in the partner's capacity as a partner (for example, in the course of a separate business of the partner) would generally be deductible, according to the CCRA: see for example 9711923 (1997) (an example cited by the CCRA). The rationale for this position, the CCRA explained, is that a partner, in the capacity of a partner, cannot be an employee of the partnership, because a person cannot enter into a contract with him or herself. It is unclear how this rationale allows a partner to perform services to the partnership in a capacity other than as partner. When asked how this rationale would apply where a partner lends money to the partnership, the CCRA replied that it would be necessary to inquire into the capacity in which the partner loaned the money (for example, in the course of a separate lending business of the partner). The CCRA suggested, in this respect, that taxpayers should structure such loans through a separate entity.

With respect to preference units in a partnership, the CCRA stated that it saw no legal impediment to the use of such preference units but noted that section 103 of the Income Tax Act could potentially apply where the partners have different entitlements. The CCRA would be concerned, it suggested, in circumstances where the allocation formula resulted in losses for some partners and profits for others.

Loss Utilization

The CCRA was also asked whether it still required loss utilization transactions to be "commercially reasonable". The CCRA replied that it would not provide a favourable ruling in respect of such transactions if the amounts or time frames involved were "blatantly artificial". The CCRA stated that a commitment letter could be used to show that the amounts were not blatantly artificial. The CCRA also stated that, in order to provide a ruling, it would require: (i) an explicit summary of the income and losses of all relevant corporations and a history of their affiliation; (ii) an analysis of any loss carrybacks; and (iii) an analysis of the possibility of any losses being refreshed beyond seven years. With respect to the decision in C.R.B. Logging Co. v. R., [2000] 4 C.T.C. 157 (F.C.A.), the CCRA stated that it was not yet prepared to say that the application of the decision should be limited. C.R.B. Logging involved the denial of an interest deduction in respect of an investment by a subsidiary in preferred shares of its indirect parent, where the parent had no source of income other than the operations of the subsidiary. The CCRA stated that it would focus, in such circumstances, on whether the parent has sufficient income from sources other than the subsidiary to pay dividends on the preferred shares. The CCRA observed that, in light of certain court decisions (presumably, Ludco Enterprises Ltd. v. R., [2002] 1 C.T.C. 95 (S.C.C.)), the parent in such circumstances may not need many assets to demonstrate this fact.

Prepaid Income

The CCRA clarified its position with respect to prepaid income, indicating that if a prepaid amount can be included in income under both paragraph 12(1)(a) and subsection 9(1) of the Income Tax Act, the CCRA will allow the taxpayer to include it under paragraph 12(1)(a) in order to claim a reserve under paragraph 20(1)(m). If, however, the amount can be included only under subsection 9(1), then the CCRA will take the view that a reserve is not available under paragraph 20(1)(m). The CCRA noted, however, that amounts would be included only under subsection 9(1), and not under paragraph 12(1)(a), where: (i) there was substantial performance at the time of prepayment; (ii) the prepayment may be retained, regardless of whether the goods or services are delivered or performed; or (iii) subsection 9(1) provides a more accurate picture of income.

Shareholder/Manager Remuneration

The CCRA confirmed, with respect to shareholder/manager remuneration, that it would generally not challenge the reasonableness of a bonus paid to a shareholder/manager that reduces the income of a Canadian controlled private corporation (CCPC) to the applicable business limit for the small business deduction. However, the CCRA emphasized that the remuneration must be paid from earnings from an ongoing active business and not, for example, from the proceeds of a sale of assets outside of the ordinary course of business, from funds derived from operations prior to becoming a CCPC, or from intercorporate dividends or management fees received within a complex corporate structure. The CCRA reserved the right, in such situations, to consider all of the relevant facts before accepting the deductibility of the bonus.

Pre-judgment Interest on Wrongful Dismissal Awards and Settlement Amounts

In a departure from existing policy, the CCRA announced that beginning in 2004 pre-judgment interest on wrongful dismissal awards and settlement amounts would generally be taxable, based on the principle that the taxation of pre-judgment interest should follow the taxability of the underlying award or settlement amount. Currently, wrongful dismissal awards and settlement amounts are generally taxable as retiring allowances. This announcement represents a change of position from earlier CCRA views: see for example 2003-0003555 (March 26, 2003), 2002-0179835 (April 10, 2003), 9912315 (June 10, 1999), 9824873 (1998). The CCRA stated that it would maintain existing administrative concessions that allow for the non-taxation of pre-judgment interest on awards or settlement amounts in respect of personal injury and death.

Foreign Tax Credits and Social Security Taxes

The CCRA also announced that beginning in 2004 it would no longer regard social security taxes as income or profit taxes paid to a foreign jurisdiction for the purposes of establishing eligibility for foreign tax credits under section 126 of the Income Tax Act. This position differs from earlier CCRA interpretations with respect to German and French social security taxes: see 9317296 (March 11, 1994) and 9820787 (April 28, 1999), respectively. The rationale for this change of position, according to the CCRA, is that the payer of a social security tax obtains a specific economic benefit, such that the tax cannot be said to be levied for a "public purpose", which is a prerequisite for a tax to be considered an "income or profits tax". The CCRA referred to the decision in Yates v. R., [2001] 3 C.T.C. 2565 (T.C.C. [Informal Procedure]) on this point. The CCRA indicated, however, that it would continue to regard United States social security taxes as eligible for the foreign tax credit, based on the provisions of the Canada-U.S. tax treaty.

Farm Losses

The CCRA confirmed that it would continue to apply its policy of comparing a taxpayer's farming income with other income in order to determine the taxpayer's chief source of income in the context of determining the deductibility of farm losses. The CCRA also stated that it would consider factors such as time spent and capital invested, as well as the actual and potential profitability of the operations in making this determination.

Other Developments

It is also of note that in a speech at the conference the new Commissioner of the CCRA indicated that the CCRA's current priorities include examining the strategic use of bankruptcy and insolvency statutes to compromise the tax liabilities of financially distressed companies. In addition, the Department of Finance indicated that proposed new legislation with respect to cross-border share for share exchanges would take longer than expected to prepare.