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Volume 19, Number 8, August 2011

Thin Cap CalCulaTion RevisiTed

A recent CRA advance income tax ruling (document no. 2010-0365371R3) revisits the meaning of the words beginning of a calendar month that ends in the year in a thin capitalization calculation (clauses 18(4)(a)(ii)(B) and (C)). The ruling addresses the determination of a corporations paid-up capital (PUC) for the purposes of clause 18(4)(a)(ii)(C) in the case of an amalgamated corporation that arises from an amalgamation that occurs in the middle of a calendar month. The ruling involves a detailed series of transactions designed to restructure a Canadian corporate group owned by a US partnership. For the purposes of the thin cap issue, however, the relevant facts are simple. Several Cancos amalgamate to form a new Canco (Amalco) on an effective date that is assumed to occur mid-month. As a result of the amalgamation, certain interest-bearing debt owing by a predecessor to a specified non-resident shareholder becomes indebtedness of Amalco. Also on the effective date, Amalco issues additional interest-bearing debt to a specified non-resident shareholder. The ruling confirms in part that for the purposes of clause 18(4)(a)(ii)(C), the PUC of Amalcos shares determined immediately after the amalgamation is to be treated as the amount of the PUC at the beginning of the calendar month in which the effective date falls.

In This Issue Thin Cap Calculation Revisited Canadian GST/HST and European VAT E-Invoices Metaphysics for Tax Practitioners: The SCC in Dub and Bastien Estate Finance and Capital Markets ABIL for Personal Guarantee Partnerships and Paragraph 95(2)(n) Eligible Dividend Rates Update Internal Capital Loss GAARed Some Cheques Not Subject to Requirement to Pay Foreign Government Exemption: US Real Estate Income Foreign Tax News 1 2 3 3 5 5 6 8 9 10 11

The ruling is an extension of the CRAs administrative position regarding the meaning of the phrase beginning of a calendar month for the purposes of a thin capitalization calculation for a newly incorporated company. That administrative position was originally announced at the Foundations 2007 annual conference and was subsequently published in Income Tax Technical News no. 38 (September 22, 2008). The ITTN says that in the case of a newly incorporated company, the phrase beginning of a calendar month means the date of incorporation; this interpretation is a slight departure from the CRAs otherwise well-established administrative position that the phrase means the earliest moment on the first day of a calendar month. The recent ruling also seems to override an earlier CRA interpretation (document no. 2002-0136985, September 9, 2002), which suggested that in order for the amalgamated company to have any PUC for thin cap purposes for the month of amalgamation, that event must occur on the first day of that calendar month. The ruling is another helpful CRA administrative development designed to deal with certain anomalies in the thin cap calculation, and will be welcomed by taxpayers and their advisers. When for commercial reasons a transaction happens to close in the middle of a calendar month, this development will presumably eliminate the need for more complicated and costly structuring to ensure compliance with a stricter reading of the thin cap technical requirements. For example, on an inbound acquisition to Canada, the purchaser typically incorporates a Canadian acquisition company, funds it with a combination of debt and equity, acquires a Canadian target, and then amalgamates the acquisition company and the target. A taxpayer should now be comfortable that it can satisfy the thin cap requirements immediately after that amalgamation, even if it occurs mid-month. The CRA, however, has not yet extended the logic of the recent ruling or of its 2007 position on newly incorporated companies to other situations that involve a taxation year that commences or ends mid-month. Shortly after the ITTN was issued, the CRA was asked to confirm a more general propositionthat for the purposes of the thin cap calculation in any particular taxation year, the beginning of the first calendar month that ends in the year is the first moment in that year (not necessarily on the first day of that month), and conversely that the relevant end of the last calendar month in the taxation year is the last day of that year (document no. 2008-028661, October 29, 2008; see also Thin Cap Calculation, Canadian Tax Highlights, March 2009). The CRA did not agree, and concluded that for the purposes of the thin cap calculation, the first

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calendar month in a particular taxation year may have its beginning in a preceding taxation year. Thus, for example, for the purposes of the calculation in respect of a taxation year that begins mid-June, the beginning of the June calendar month is June 1, even though that date does not fall in that particular taxation year. For now, it appears that the CRA will go no further than to accept the proposition that for thin capitalization purposes the beginning of the first calendar month in a taxation year should be the first day of that taxation year only in the context of a newly incorporated or an amalgamated company. Nik Diksic Ernst & Young LLP, New York

The VAT directive lists 15 items that must be recorded on an invoice; member states are allowed to impose certain additional local requirements. The following differences are apparent from a comparison of Canadian and EU requirements: 1) Within the European Union, each invoice must be numbered sequentially and show a number that uniquely identifies the invoice; this is not required in Canada. 2) The suppliers (and in some cases the customers) European VAT number must be mentioned on the invoice; in Canada, only the suppliers business number must be quoted. 3) The VAT directive requires that in the case of an exempt or zero-rated supply, or if the customer is liable for payment of VAT, the applicable provision of the directive or corresponding national provisions must be referred to; no similar condition is required in Canada. 4) In Canada, the terms of payment for supplies of $150 or more must be quoted; this is not required under EU regulations.
E-invoicing is also allowed in Canada, but the ETA has not established unique or specific requirements therefor. Under the VAT directive, e-invoicing is allowed subject to acceptance by the business customer. Moreover, specific VAT requirements are designed to ensure technical security: the authenticity of the origin and the integrity of the content must be guaranteed by means of electronic data interchange (EDI) or advanced electronic signature. The 27 EU member states vary significantly in their approach to both traditional invoicing and e-invoicing, and a number of countries impose penalties if the invoices issued do not meet the invoicing obligations of the particular country. In order to harmonize the current discrepancies between EU member states, a new invoicing directive (Council Directive 2010/45/EU) was adopted by the European Commission for implementation by January 1, 2013. The new directive includes the following important points: (1) The commission confirmed that all 15 requirements listed in article 226 of the VAT directive, including the customers VAT identification, should always be noted on the invoice. (2) A member state will no longer be allowed to impose its local VAT requirements for invoices. (3) E-invoices will be accepted under the same conditions as paper invoices, and a business can determine its own type of business controls to ensure that authenticity of origin and integrity of content are guaranteed. Nevertheless, e-invoicing must still be agreed to by the customer. For a company doing business in Europe, a closer look at EU and local country requirements and a comparison

Canadian GsT/hsT and euRopean vaT e-invoiCes

Canadian businesses are increasingly moving toward the implementation of global e-invoicing practices. However, affected parties should be aware that satisfaction of the Canadian GST/HST documentation rules may not be sufficient to meet the more stringent European invoicing requirements. Providers of e-invoicing services typically offer global B2B (business-to-business) solutions that maximize cost savings through the adoption of a single invoicing model across all borders. However, when a Canadian business ventures into Europe, in order to avoid inconvenience, administrative costs, and embarrassment, and also tax penalties, it is essential that e-invoicing comply not only with local GST/HST requirements but also with the VAT rules. For Canadian GST/HST purposes, the Excise Tax Act (subsection 169(4)) and the Input Tax Credit Information GST/HST Regulations list the prescribed information that a business customer needs to prove its right to claim input tax credits (ITCs). For a purchase of $150 or more, the required information includes the name and GST registration number of the supplier, the total amount of consideration and the tax paid or payable, the recipients name, the terms of payment, and an identifying description of each supply. This information need not be contained in one document, and it is not necessary to issue an invoice, provided that there is other acceptable supporting documentation. In Europe, by contrast, article 220 of the VAT directive (Council Directive 2006/112/EC), applicable to the 27 member states of the European Union, provides that for VAT purposes the supplier must issue an invoice to a business customer. In certain circumstances, an invoice must also be produced for the supply of goods to end consumers (such as physical goods ordered over the Internet).

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of the similarities and differences relative to the Canadian GST/HST rules may prevent penalties arising from noncompliance with e-invoicing requirements both now and after 2012. Audrey Diamant and Ulrika Laurence PricewaterhouseCoopers LLP, Toronto

M eTaphysiCs foR Tax pRaCTiTioneRs: The sCC in d ub and basTien esTaTe

There are many elusive distinctions in taxation law. Some are more elusive than othersfor example, the place where intangible property is located for the purpose of determining eligibility for the exemption from taxation under section 87 of the Indian Act. In two decisions released on July 22, 2011, Bastien Estate (2011 SCC 38) and Dub (2011 SCC 39), the SCC wrestled with the intricate question, Where is interest located? Section 87 of the Indian Act exempts an Indians personal property from taxation when that property is situated on a reserve. In Bastien Estate, Mr. B, a status Indian belonging to the Huron-Wendat Nation, invested profits from his moccasin-manufacturing business in term deposits at a caisse populaire situated on the Wendake Reserve. The CRA challenged the tax-free status of the interest on the term deposits because the caisse earns its money through activities in the commercial mainstream. Both the TCC and the FCA held that the interest was taxable. The SCC reversed the lower courts on the basis that the situs that matters for the purposes of section 87 was the location of Mr. Bs interest-earning activity, not the caisses respective locations or its means of generating revenue. Mr. B was merely a creditor of the caisse. Writing for the majority, Cromwell J followed the test prescribed in Williams ([1992] 1 SCR 877) to determine the location of property for the purposes of the Indian Act. The first step of the test is to determine all potentially relevant factors connecting the intangible personal property to a location. The court must then decide the weight to be given to each connecting factor, considering the purpose of the Indian Act exemption and the type of property and its tax treatment. In finding that the interest was exempt from tax, Cromwell J pointed to a number of factors connecting the interest to the reserve: Mr. B lived on the reserve; the certificates of deposit were obtained on the reserve; the interest was payable on the reserve; the caisse populaires only branch was on the reserve; and the principal invested, which gave rise to the interest, was originally earned on the reserve.

In Dub, the situation of the taxpayer (Mr. D) differed from that of Mr. B in three important ways: Mr. D did not live on a reserve; the principal amount invested was not earned on a reserve, according to the trial judges findings; and Mr. D did not spend his interest income on a reserve. Cromwell J gave little weight to Mr. Ds residence, since Mr. Ds own reserve did not have a financial institution. Further, the place where the principal originated was secondary to the place of contracting for the interest income, which was at the on-reserve caisse populaire. Cromwell J gave no weight to the place where the interest income was spent, because it was not relevant to the determination of the location where the interest was earned. The courts analysis is fact-dependent, and other investments may carry a different taxable status under the Williams analysis. Cromwell J said,
Of course, in determining the location of income for the purposes of the tax exemption, the court should look to the substance as well as to the form of the transaction giving rise to the income. The question is whether the income is sufficiently strongly connected to the reserve that it may be said to be situated there. Connections that are artificial or abusive should not be given weight in the analysis. For example, if in substance the investment income arises from an Indians off-reserve investment activities, that will be a significant factor suggesting that less weight should be given to the legal form of the investment vehicle. . . . Cases of improper manipulation by Indian taxpayers to avoid income tax may be addressed as they are in the case of non-Indian taxpayers.

Despite this admonition, and although the outcomes of the cases are clearly fact-driven, the courts decisions were hailed by Konrad Sioui, grand chief of the Wendake Reserve and hereditary chief of the Huron-Wendat Nation, as the most important involving native fiscal rights in Canada over the last 150 years, since the adoption of the Indian Act. Courtney West and Robert McMechan Robert McMechan Professional Corporation, Ottawa

finanCe

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An International Bar Association conference held in London on May 16-17, 2011 examined international tax developments affecting corporate finance and capital markets. Many global developments have been designed with a view to curbing perceived abuses. n France is extending its thin capitalization rules to include guarantees. n A new Irish anti-hybrid rule is intended to deny a section 110 (of the Irish Taxes Consolidation Act, 1997) company an interest deduction for interest that is (1) exempt

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from tax in the recipient country by reason of a recharacterization of the debt as equity or (2) not taxable because of a notional deduction in the recipient country. (A singlepurpose company that met certain requirements was able to qualify for a special tax regime under section 110 and avoid Irish tax.) n In the United States, FATCA requires non-US financial institutions (including banks, private equity funds, hedge funds, foreign insurance companies, and even investment vehicles) to enter into an agreement with the IRS to disclose the identities of direct and indirect US investors on pain of a 30 percent withholding tax on US-source interest, dividends, rents, royalties, and proceeds from the sale of instruments that generate US-source interest on dividends. Canada has suggested that the requirements violate Canadian privacy laws and potentially deny banking services to some Canadian residents and citizens or force the payment of steep penalties. The IRS has said that it will delay the law until 2014, but the Canadian finance minister says that Canada will continue to work on a mutually agreeable solution. n The US portfolio interest exception for bearer bonds has been repealed. n For US tax purposes, starting September 4, 2010, a payment made pursuant to a securities-lending, repo, or swap transaction based on a dividend on a US security is treated as a US-source dividend subject to withholding tax on the gross amount. n For US tax purposes, guarantee fees by a non-US person or by a US corporation are US-source and taxable as income that is effectively connected with a US trade or business. n For UK tax purposes, after September 1, 2010, a non-UK corporation may apply for so-called passportholder status in order to avoid a 20 percent UK withholding tax on interest. A residence certificate is required from the local tax authority; a prescribed form is submitted to HMRC. n Spains courts have ruled against taxpayers on dividend-related transactions involving equity swaps, stock loans, forward sales, and similar transactions; those transactions have been disqualified. n The US economic substance doctrine has been codified effective for transactions entered into after March 30, 2010. To be tax-effective, a transaction must change in a meaningful way the taxpayers economic position (excluding federal income tax effects), and the taxpayer must have a substantial purpose (excluding federal income tax effects) for entering into the transaction. A 20 percent underpayment penalty applies if there has been adequate disclosure; otherwise, the penalty is 40 percent. n The US Dodd-Frank Wall Street Reform and Consumer Protection Act and the proposed European Market

Infrastructure Regulation contain additional regulations for swap transactions. n New US foreign tax credit anti-splitter rules suspend credits until related income is recognized. n The US active financing exception to subpart F for interest and fees has been extended to 2011. n The OECD Forum for Tax Administration announced in September 2010 that joint international tax audits may occur in cases such as those involving transfer pricing, permanent establishment issues, complex structures with tax haven entities, hybrid financial instruments, and double-dip leases. n In a UK discussion paper of January 2010, HMRC expressed concern about the risk of artificial diversion of UK profits where a UK companys finance subsidiary is funded through UK capital but no return is earned in the United Kingdom. This situation may arise, for example, when a finance company is funded with equity that has been either raised by the parents UK borrowings (and the parent deducted the related interest expense) or drawn from the corporate groups accumulated UK funds (including excess cash), a tactic that renders those funds unavailable for use elsewhere. n In Germany, tax credits or refunds are to be taken into account in determining the level of tax burden of a CFCs income for its business years beginning after calendar 2010. This rule will affect a German company that uses a Maltese finance company. A CFCs low-taxed income is not taxable in the European Union if the CFC is engaged in a truly economic activity in its country of residence. n In the Netherlands, a foreign finance company does not qualify for the participation exemption if it is subject to an effective tax rate of less than 10 percent. n Proposed US rules expand the anti-conduit financing rules to cover disregarded entities. n The banking crisis has forced banks to increase tier 1 capital, and many existing capital instruments no longer qualify. n For US tax purposes, uncertain tax positions must be disclosed on schedule UTP (form 1120). For 2010, a corporation with total assets of $100 million or more (reduced to $50 million and to $10 million in 2012 and 2014, respectively) must file a schedule UTP with its income tax return if it files a form 1120, 1120-F, 1120-L, or 1120-PC; if it or a related party issued audited financial statements; and if it has one or more tax positions that must be reported on schedule UTP. A requirement to report may be triggered if, for example, a tax reserve is recorded in the corporations audited financial statements. The quantum of each relevant tax position must be reported. Jack Bernstein Aird & Berlis LLP, Toronto

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In MacCallum (2011 TCC 316), the TCC found that the taxpayer could deduct an allowable business investment loss (ABIL) of $56,000 ($112,000 50%) for the net guarantee payment he had made to a bank in connection with his sons companys line of credit. The court concluded that the taxpayer provided the guarantee to support the sons company and, in so doing, to protect and collect $395,000 owing by it to the taxpayers subsidiary. Generally, a taxpayers business investment loss may arise, inter alia, from the disposition to an arms-length person of a debt owed to the taxpayer by an insolvent corporation that was a small business corporation at the time of a windup. A taxpayer may elect to have made a deemed disposition of and a repurchase of a bad debt for no consideration. The ABIL, the deductible portion of a business investment loss, is 50 percent of the taxpayers business investment loss for the year. Provided that one of the purposes of the loan was to gain or produce income from a business or propertythe business purpose testa taxpayer is generally not prevented from deducting an ABIL realized on an uncollectible debt. In MacCallum, the taxpayer (Mr. M) was the controlling shareholder of Holdco, whose wholly owned subsidiary (Subco) operated a trucking business. One of Subcos clients was a CCPC in the construction business (Opco), owned by Mr. Ms son. Opco was a small business corporation. Mr. M was not an Opco shareholder, but he acted as a site supervisor for Opco for no remuneration and was actively involved in its daily operations. In February 1996, Opco entered into a construction contract with the city of Miramichi. Opco used $395,000 of equipment and materials provided by Subco to fulfill this contract with the city; Opco was unable to pay Subco the amount owing, and it remained on Opcos books as an account payable to Subco. A dispute over the contract with the city resulted in excess costs to Opco for materials purportedly over and above the contractually agreed quality, a claim that had been verified for Opco by two independent consulting firms. The dispute left Opco in a difficult position, and it was being pressed by its bank to get its financial affairs in order. In July 1996, Mr. M gave a guarantee for Opcos line of credit with the bank; at the time, both Mr. M and his son fully expected Opcos dispute with Miramichi to be settled in Opcos favour. However, in 2002 Opco was forced to accept a settlement from the city for an amount that was far less than the excess costs it had incurred under the disputed contract: Opcos main expert witness had apparently lost the documentation that supported his calculations. Opco paid Mr. M about $50,000 of the settlement in 2002 in order to assist him with the bank payment needed to settle Opcos line of credit; Opco paid the balance of the settlement to another creditor.
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Mr. M settled Opcos $162,000 line of credit with the bank in 2003; shortly thereafter, Opco ceased operations. Mr. M claimed an ABIL of just over $56,000 in his 2003 tax return50 percent of the amount he had paid the bank as a result of the guarantee ($162,000) net of the $50,000 he had received from Opco in 2002. In 2007, the CRA reassessed Mr. M and denied the ABIL. The TCC noted that Mr. M testified that he signed the guarantee with the bank to earn money from an agreement that it had with Opco (pertaining to the guarantee) and also to keep Opco in business during its ongoing dispute with the city so that Subco could collect the balance owing to it (Opcos account payable to Subco). The TCC stated that transactions among family members that are allegedly made for business purposes are closely scrutinized. The TCC also noted that because there was no written documentation to support an agreement between Opco and Mr. M pertaining to income to be earned from the guarantee, the credibility of Mr. M and his son the only witnesseswas of prime importance. Mr. M and his son made contradictory statements about the terms of the purported agreement; no one else, including the companies controller, was aware of the agreement; and the final payment that Mr. M received from Opco was not in accord with either version of the alleged agreement. The court concluded that there was no such agreement. Although the TCC found that Mr. M and his son had no agreement concerning income to be earned from the guarantee, it noted that the business purpose test requires that one of the reasons for the guarantee must be to earn or produce income, but there is no requirement that that reason must be the guarantees primary purpose. (The court said that, on the facts, Mr. M may have been primarily motivated to assist his son.) The TCC also noted that the ABIL rules do not require a direct link between the income expected to be earned and the debt incurred by the taxpayer, although the connection cannot be too remote. The TCC concluded that Mr. Ms desire to provide the guarantee to support Opcos continued existence and thereby enhance the possibility that Subco could collect the amount owing from Opco was not too remote to meet the business purpose test for an ABIL. Mr. M was thus entitled to deduct the ABIL. Jim Yager KPMG LLP, Toronto

paRTneRships and paRaGRaph 95(2)(n)

Finance issued a welcome comfort letter dated May 26, 2011 that recommends the expansion of paragraph 95(2)(n) to include partnerships for the purposes of excluded property and interaffiliate dividends.

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Paragraph 95(2)(n) was enacted in 2007 as an expansion of the qualifying interest (QI) test (paragraph 95(2)(m)) and foreign affiliate status. Assume that a particular Canadian-resident corporation does not have the necessary QI in a particular non-resident corporation (or it is not the Cancos FA), but a related Canco does have a QI (or FA status) in respect of the non-resident. In that case, paragraph 95(2)(n) deems the particular Canadianresident corporation to have the requisite QI (and FA status) for specified purposes (paragraphs 95(2)(a) and (g), subsections (2.2) and (2.21), element A of the FAPI definition, and the companion surplus regulations). As currently drafted, paragraph 95(2)(n) provides relief only if both the tested taxpayers are Canadian-resident corporations, but not if one or both of them are partnerships. Assume that Canco wholly and directly owns Cansub, which in turn wholly and directly owns FA 1. Canco also wholly and directly owns another Canadian subsidiary, and together they are partners in a partnership that wholly and directly owns FA 2. In the absence of the partnership, Canco would have a QI in each FA, and the attribution from Canco under paragraph 95(2)(n) would flow so that Cansub would have a QI in FA 2, and FA 2 would be an FA of Cansub. However, the partnership fractures the attribution of Cansubs QI and FA status in FA 2 because Cansub, a corporation, cannot be related to a partnership. Thus, the partnership cannot recharacterize as ABI any of FA 2s property income earned from FA 1 under paragraph 95(2)(a), because paragraph 95(2)(n) does not apply: FA 2s income remains property income and FAPI to the partnership. (In addition, FA 2s loan receivable from FA 1 is not excluded property.) This FAPI result is generally viewed as phantom FAPI: the problem can be cured by a payment from FA 2 of a current-year dividend in an amount equal to the FAPI, which entitles the partnership to an offsetting deduction under subsection 91(5). From the partners perspective (assuming that each had at least a 1 percent interest), FA 2s income can be recharacterized as ABI, and thus the FA 2 dividend out of that income is exempt surplus. The comfort letter considers a fact pattern in which a partnership is 98.2 percent owned by a Cancos FAs. The partnership wholly owns FA 4, which in turn owns 9 percent of a non-resident corporation (Forco). Canco has an economic interest in Forco that exceeds the 10 percent ownership threshold: Canco owns 11 percent of Forco through FA 5, a wholly owned subsidiary. On the facts, paragraph 95(2)(n) does not apply, and thus the stock of Forco is not excluded property to FA 4 (such as on a disposition), and any dividends received by FA 4 are FAPI and included in the partnerships income. (Element A(b) of the FAPI definition as currently enacted does not eliminate a dividend received by FA 4 because Forco is not

an FA of the partnership.) Finance has confirmed its support for fixing both these results for FA taxation year-ends ending after the announcement date of enabling legislation, with an option for the taxpayer to elect earlier application for year-ends ending after 2010. The comfort letter does not fix the phantom FAPI situation that is described above. In the situation described in the comfort letter, however, if Forco was a CFA and received recharacterizable property income from FA 5, that income, when allocable to the FA partners, is considered ABI to them and not FAPI pursuant to paragraph 95(2)(z). That provision does not appear to eliminate phantom FAPI that arises on Forcos gain from a disposition of the asset that gave rise to that property income or on FA 4s gain from a disposition of the Forco stock where that asset taints the Forco stock so that it is not excluded property. (The phantom FAPI could be relieved by the payment from FA 4 of a dividend to the partnership.) Paul L. Barnicke and Melanie Huynh PricewaterhouseCoopers LLP, Toronto

eliGible d ividend R aTes updaTe

Federal eligible dividend changes (shown in table 1) increase personal taxes on eligible dividends in all provinces and territories until 2012. The increase in federal tax rates on eligible dividends is intended to ensure that the combined corporate and personal tax on active business income earned through a corporation roughly equals the tax payable by an individual who earns that income directly. Table 2 shows provincial and territorial dividend tax credit rates for eligible dividends; table 3 shows the top combined federal-provincial and federal-territorial marginal tax rates on eligible dividends; and table 4 shows the tax saving or cost if after-tax corporate income is paid out as a dividend instead of the pre-tax amount being paid out of the corporation as a deductible salary expense. After 2011, the top federal marginal tax rate is19.29 percent on eligible dividends (table 1) and 19.58 percent on non-eligible dividends. Although the difference in those
Table 1 Federal Gross-Up, Tax Credit, andRates on Eligible Dividends
2010 2011 percent 41 16 .4354 17 .72 38 15 .0198 19 .29 After 2011

Dividend gross-up . . . . . . . . . . . . . . . . . . . . 44 Federal dividend tax credit (on grossed-up dividend) . . . . . . . . . . . . . 17 .9739 Top federal rate a . remains 29% . . . . . . . . . . . . . . . . . . . . . 15 .88

a The table assumes that after 2011, the top federal marginal income tax rate

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Table 2

Provincial and Territorial Eligible Dividend Tax Credit Rates on Grossed-Up Dividends
2010 10 .00 10 .83 11 .00 12 .00a 11 .32 8 .85 6 .11 6 .40 10 .50 11 .90 11 .00 10 .83 2011 percent 10 .00 10 .31 11 .00 12 .00a 11 .00 11 .50 8 .85 5 .82 6 .40 10 .50 11 .90 11 .00 15 .08 10 .00 9 .76 11 .00 12 .00a 11 .00 11 .50 8 .85 5 .51 6 .40 10 .50 11 .90 11 .00 15 .08 After 2011

Table 4 Integration: $10,000 ABI Subject to Tax at the General/M & Pa Corporate Income Tax Rate, Dividend Versus Salary Saving/(Cost)b
2010 (43) (14) (5) 27 2011 (52) (37) (10) 100 2012 dollars (47) (88)c (1) 145 (47) (88)c (1) 145 (47) (88)c (1) 145 2013 2014

Alberta . . . . . . . . . . . . . . . . . . . . . . . . . . British Columbia . . . . . . . . . . . . . . . . . . Manitoba . . . . . . . . . . . . . . . . . . . . . . . . New Brunswick . . . . . . . . . . . . . . . . . . . Northwest Territories . . . . . . . . . . . . . . . Nova Scotia . . . . . . . . . . . . . . . . . . . . . . Nunavut . . . . . . . . . . . . . . . . . . . . . . . . . Ontario . . . . . . . . . . . . . . . . . . . . . . . . . Prince Edward Island . . . . . . . . . . . . . . . Quebec . . . . . . . . . . . . . . . . . . . . . . . . . Saskatchewan . . . . . . . . . . . . . . . . . . . . Yukon . . . . . . . . . . . . . . . . . . . . . . . . . .

Alberta . . . . . . . . . . British Columbia . . Manitoba . . . . . . . . New Brunswick . . .

Newfoundland and Labrador . . . . . . . . . 9 .60 or 11 .00b

Newfoundland and Labrador . . . (162) / 551d (164) / 548 Northwest Territories . . . . . . Nova Scotia . . . . . . Nunavut . . . . . . . . . Prince Edward Island . . . . . . . . . Quebec . . . . . . . . . Saskatchewan . . . . 158 (603) (405) 171 (602) (439) (104) / 21 (358) (88) (120) / 33

(152) / 546 (152) / 546 (152) / 546 178 (588)e (462) (61) / 27 (344) (55) (111) / 39 178 (588)e (462) (8) / 27 (344) (55) (111) / 39 178 (588)e (462) 27 (344) (55) (111) / 39

Ontario . . . . . . . . . (190) / (43) (359) (108) (115) / 42

a According to New Brunswicks 2010 T1 individual tax return (and confirmed by a

New Brunswick Finance official) . Legislation is forthcoming . b The lower rate applies before July 1, 2010 and the higher rate thereafter .

Yukon . . . . . . . . . . (319) / 696 112 / 1,183 f 125 / 1,176 f 125 / 1,176 f 125 / 1,176f
a When two amounts are shown, the second applies to M & P . b The table assumes that the individual is taxed at the top marginal income tax rate

Table 3

Top Combined Federal, Provincial, and Territorial MarginalTax Rates on Eligible Dividendsa
2010 15 .88 21 .45 25 .09 19 .19 2011 percent 17 .72 23 .91 26 .74 20 .96 20 .96 21 .31 34 .85 25 .72 28 .19 27 .33 31 .85 23 .36 19 .29 26 .11 28 .12 22 .47 22 .47 22 .81 36 .06c 27 .56 29 .54 28 .70 32 .81 24 .81 After 2011

Alberta . . . . . . . . . . . . . . . . British Columbia . . . . . . . . Manitoba . . . . . . . . . . . . . . New Brunswick . . . . . . . . .

Newfoundland and Labrador . . . . . . . . . . . . . 22 .79 or 20 .77b Northwest Territories . . . . . Nova Scotia . . . . . . . . . . . . Nunavut . . . . . . . . . . . . . . . Ontario . . . . . . . . . . . . . . . Prince Edward Island . . . . . Quebec . . . . . . . . . . . . . . . Saskatchewan . . . . . . . . . . Yukon . . . . . . . . . . . . . . . . 19 .81 33 .37 23 .64 26 .57 25 .70 30 .68 21 .64 18 .80

(shown in table 3) . Levies other than federal, provincial, and territorial income tax; the employer portion of provincial health tax; and the employee portion of Northwest Territories and Nunavut payroll taxes are not considered . Thus, for example, CPP contributions are not considered . Different results may arise in special circumstances, such as for mutual fund corporations . c If British Columbias HST regime survives the HST referendum held from June to August 2011, the provinces general and M & P income tax rate will increase from 10 to 12% on January 1, 2012; in that case, after 2011, the amount is (236) . d If the eligible dividend was paid before July 1, 2010, the amounts are (299)/396 . e If Nova Scotia tables a budget surplus in the 2012-13 fiscal year, the provinces top income tax rate will decline after 2011; in that case, after 2011, the amount is (512) . f The table assumes that Yukons top combined eligible dividend tax rate (table 3) for 2011 is 14 .28% (federal rate of 17 .7162% plus Yukon rate of 3 .4348%) and after 2011 is 15 .93% (federal rate of 19 .2927% plus Yukon rate of 3 .3617%) .

14 .28 to 17 .72d 15 .93 to 19 .29d

a The table assumes that after 2011, the top combined federal, provincial, and

territorial marginal income tax rates remain at 2011 levels . b The lower rate applies before July 1, 2010 and the higher rate thereafter . c If Nova Scotia tables a budget surplus in the 2012-13 fiscal year, the provinces top income tax rate will decline after 2011; in that case, the top combined rate on eligible dividends will fall to 32 .42% . d The rate that applies depends on the level of the taxpayers other income; the higher rate applies if the taxpayer has no other income .

top federal rates is only 0.29 percentage points, an individual subject to tax at the top marginal rate will still generally prefer to receive eligible dividends rather than non-eligible dividends because of the continued significant differences in provincial and territorial top marginal tax rates between eligible and non-eligible dividends. In British Columbia and Nunavut, eligible dividend tax credit rates are decreasing until 2012 because they are linked to the federal gross-up for eligible dividends, which is decreasing until 2012 (table 1). The same result would have occurred in New Brunswick, Nova Scotia, and Prince Edward Island, but those provinces eligible dividend tax credit rates have been maintained at 2009 levels, retroactive to 2010: New Brunswicks legislation is forthcoming, but the provinces

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2010 T1 individual tax return confirmed the proposed 12 percent eligible dividend tax credit rate for the 2010 taxation year; Nova Scotias Bill 27, Financial Measures (2011) Act, received royal assent on May 19, 2011; and Prince Edward Islands Bill 26, Income Tax (Dividend Tax Credits) Amendment Act, received royal asset on December 9, 2010. The same result also would have occurred in the Northwest Territories, except that its Bill 17, An Act To Amend the Income Tax Act, which received royal assent on March 4, 2011, increased its eligible dividend tax credit rate starting in 2011 to 11.5 percent (the rate in effect before 2010). Newfoundland and Labradors Bill 9, An Act To Amend the Income Tax Act, 2000 no. 2, which received royal assent on June 24, 2010, increased the provinces eligible dividend tax credit rate to 11 percent for eligible dividends paid after June 30, 2010; and starting in 2011, Yukons Bill 92, Act To Amend the Income Tax Act (2010), which received royal assent on November 9, 2010, increases its eligible dividend tax credit rate to 15.08 percent. Donald E. Carson and Ruby Lim PricewaterhouseCoopers LLP, Toronto

inTeRnal CapiTal loss GaaRed

In Triad Gestco Ltd. (2011 TCC 259), the TCC applied GAAR to a series of reverse estate freeze transactions between a corporation and a trust that resulted in an $8 million capital loss, which the CRA had considered to be artificially created to offset an $8 million capital gain realized in the same taxation year. A taxpayers loss on the disposition of property to an affiliated person is deemed to be nil. When the transactions were undertaken in 2002, the definition of affiliated persons in subsection 251.1(1) did not include a trust, and thus the CRA was forced to rely on GAAR to deny the taxpayers capital loss claim. In 2005, the definition was amended to include a trust, thus ensuring that the stoploss rules apply to fact patterns similar to the Triad Gestco transaction. In 2000, the taxpayer (Mr. C) undertook an estate freeze to have a family trust own certain shares held in his wholly owned corporation, Opco. Mr. C was the trustee of the family trust and his children were its beneficiaries. In December 2001, Opco realized a capital gain of approximately $8 million on the sale of some of its assets. In January 2002, Opco redeemed some of its shares owned by Mr. C; Opco elected to have the resulting dividend of more than $4.5 million deemed paid to Mr. C to be paid out of its capital dividend account, and thus the deemed dividend was not taxable to him. That same month, Mr. C subscribed for $3 million of class E preferred shares of

Opco. In July and August 2002, the following series of transactions was undertaken to cause a reverse freeze in Opco: (1) Opco incorporated a new corporation (Subco); (2) Opco transferred approximately $8 million in assets to Subco in exchange for $8 million of Subcos common shares; (3) a trust (Mr. Cs trust) was created, and settled by an unrelated party, with Mr. C as its sole beneficiary; (4) Subco paid a $1 stock dividend to Opco by issuing 80,000 class E voting preferred shares, which had a low paid-up capital and an $8 million redemption value and FMV (thus shifting value from the commons to the preferred shares); and (5) on August 29, 2002, Opco sold its Subco common shares to Mr. Cs trust for their then current FMVa nominal amountand thus realized a capital loss of almost $8 million. Because Opco had an August 31 year-end, it was able to apply the capital loss arising on the sale of Subco commons to Mr. Cs trust against the capital gain realized from its December 2001 asset sale. The CRA reassessed Opco to deny the $8 million capital loss on the basis that it resulted from a series of avoidance transactions within the meaning of GAAR (section 245). Generally, for GAAR to apply to a transaction (or series of transactions) it must be shown that the transaction resulted in a tax benefit, was an avoidance transaction not arranged primarily for bona fide purposes other than to obtain a tax benefit, and was an abuse or misuse of the Act. The CRA argued that the transactions in issue went beyond the ambit of permissible estate planning and were undertaken primarily to create an artificial capital loss to offset a capital gain that had been made in the same taxation year. The tax benefit was the reduction of the tax otherwise payable by Opco on the $8 million capital gain realized in its 2002 taxation year. The CRA noted that other options were available to undertake a reverse freeze without creating adverse tax consequences or a capital loss; for example, the Subco common shares might have been transferred to Mr. C, his spouse, or a company controlled by either of them. However, the CRA claimed that the Subco common shares owned by Opco were transferred to Mr. Cs trust because that transfer would not cause the denial of the latent capital loss that had been created on those shares. The CRA argued that the transactions were undertaken to achieve an outcome that the stop-loss rules and other specific anti-avoidance provisions, found notably in subparagraph 40(2)(g)(i), seek to prevent. Further, the recognition of artificial losses realized within the same economic unit is contrary to the object, spirit and purpose of those provisions. Opco argued that the reverse freeze transactions were undertaken not to obtain a tax benefit, but to ensure that any future growth of Subcos assets would accrue to Mr. C through Mr. Cs trust. This access to future growth was

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necessary because the annual income generated by the class E preferred shares that Mr. C held in Opco ($180,000) was not sufficient to meet his needs. Opco further argued that the transactions were not avoidance transactions because they were undertaken for the non-tax purpose of providing Mr. C with the growth in the Subco assets, they had economic substance, and they were legally effective. The TCC agreed that a tax benefit existed because Opco was not required to pay any tax on the capital gain that it realized in its 2002 taxation year. The court concluded that the stock dividend paid by Subco, the creation of Mr. Cs trust, and the sale by Opco of Subcos common shares to Mr. Cs trust were avoidance transactions because their primary purpose was to obtain a tax benefit: thus, the entire series of transactions was an avoidance transaction. The TCC agreed with the CRA that a reverse freeze could have been accomplished in other ways without creating a capital loss, and concluded that the only reason the transactions were arranged in this manner was to obtain the tax benefit. The TCC noted that it was difficult to accept that Mr. C absolutely needed to have access to the future growth of Subcos assets, given that he had just received a $4.5 million capital dividend and had reinvested only $3 million of it in Subcos class E shares, an investment that generated a monthly dividend of $15,000. The TCC also noted that Subcos assets generated very little income and Mr. C had not tried to access those funds. The TCC viewed the 2005 amendment to section 251.1 as a clear indication that the results of the transactions were contrary to the Acts object, spirit, and purpose. The transactions constituted abusive tax avoidance because they potentially defeated the underlying rationale of the capital loss provisions in the Act and were thus subject to GAAR. Paul Hickey KPMG LLP, Toronto

soMe Cheques noT subjeCT To RequiReMenT To pay

The CRA regularly issues requirements to pay (RTPs) to banks under section 224, but rarely does an RTP attract the attention of the SCC. In Canada Trustco Mortgage Co. v. Canada (2011 SCC 36), the SCC split 4-3 on a rather complicated technical question of the applicability of an RTP to a cheque drawn on the tax debtors trust account and payable to him, and then delivered for deposit to a joint account at the same institution. Despite the split decision, the SCCs judgment provides some certainty; but both the majority and minority judgments also provide future litigants with ample material to argue subsequent

cases on this issue or any issue that involves the clearing of cheques. Under section 224, if the minister has knowledge or suspects that any person is or will be liable within one year to pay monies to a tax debtor, the minister can require the person to pay the monies to the receiver general. This liability attaches to monies only when [they] become payable and therefore cannot attach to funds sitting in a bank account, but it can attach to those funds when the taxpayer attempts to withdraw them from the bank account for his or her own use. In Canada Trustco Mortgage, the tax debtor was a lawyer who had both a trust account and a joint account with another lawyer at Canada Trustco Mortgage (Trustco). The minister became aware that the tax debtor was drawing cheques on the trust account for deposit in the joint account. The cheques were payable to the tax debtor personally, but they were delivered to Trustco with instructions in writing on the back that stated Dep to and the joint account number. The minister issued three RTPs to Trustco, which declined to pay the funds, and then assessed Trustco for failure to comply with the RTPs. At the TCC, the minister admitted that the RTP could not apply to the funds on deposit in either the joint account or the trust account. The issue was whether the funds were subject to the RTP while in transit between the two accounts because the tax debtor was named on the cheque as the payee. The TCC (2008 TCC 482) said that the RTP was effective against the tax debtor qua holder of the trust account (not qua the cheques payee), and the FCA (2009 FCA 267) unanimously upheld the decision in two sentences. The SCC majority decision set aside the lower courts decisions and concluded that Trustco was not liable at any time to pay monies to the tax debtor and thus had not failed to comply with the RTPs. The majority decision focused on the following points: (1) the instructions written on the cheque must be taken into account; (2) the Bills of Exchange Act and the common law regarding cheques must be considered; and (3) there is a difference between delivery of a cheque for deposit and its presentment for payment. The majority said that the delivery of a cheque to Trustco, with the endorsement that it be deposited into the joint account, was only a delivery of a cheque, not a presentment for payment. Trustco then took on the role of a collecting bank and was responsible to the joint account holders for presenting the cheque to the paying bank (the bank of the drawer-payer). Trustcos crediting of the joint account before presentment of the cheque is a commercial reality and is governed by the contract with the joint account holders: that contract provided that the amount of any instrument previously cashed, negotiated,

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or credited but subsequently unpaid or unsettled could be debited from the account. Once Trustco received delivery of the cheque and then credited the joint account, it acquired all the rights and powers of a holder in due course pursuant to the Bills of Exchange Act, and it could present the cheque to the drawers bank (which in this case was also Trustco) for payment. The majority concluded that at no time during this process was Trustco liable to make a payment to the tax debtor. The minority disagreed with the majority on two narrow points and arrived at a different conclusion: the minority said that (1) on delivery of a cheque the bank collects the funds as agent for its principal, and it is never the holder of the cheque; and (2) funds deposited into a joint account remain payable only to the payee while the funds are in transit. The minority rejected the formalistic analysis of the cheque-clearing system, and it rejected the banks reliance on the section of the Bills of Exchange Act that granted it the rights and powers of a holder in due course as having no relation to [that sections] purpose. In conclusion, the minority expressed concern about the majority judgment, citing potentially dangerous repercussions of a restrictive interpretation of garnishment powers when applied, for example, to family maintenance. Interestingly, the minority did not comment on the deposit instructions on the cheque, and said that their analysis dealt exclusively with the circumstances in which a tax debtor draws a cheque in favour of him- or herself, and not a third party. The minority did not offer an explanation for this approach and did not give the legal justification for not considering these instructions. It is interesting to speculate whether the minority analysis would differ if the cheque had been endorsed over to a third party rather than for deposit in a joint account. Robert G. Kreklewetz and John Bassindale Millar Kreklewetz LLP, Toronto

Code section 892 exempts a foreign government from

US tax on income derived from stocks, bonds, and other

foReiGn GoveRnMenT exeMpTion: us Real esTaTe inCoMe

Prices in the US real estate market have been dragged down through perhaps two dips over the last five years. New affordability and the prospect of US population increases of at least 3 million people annually for the foreseeable future may suggest that the time is ripe to invest in US real property. Foreign governments may also benefit from the US income tax exemption on real estate investments, but qualification for the exemption is highly fact-dependent. (The exemption applies similarly to certain international organizations.)

domestic securities. A foreign government is defined as an integral part or a controlled entity of a foreign sovereign, but little IRS guidance is available to flesh out that definition. The uncertainty is exacerbated by the structural and philosophical differences between the US and other nations governments. However, the few IRS publications that do exist make it clear that a division of a foreign sovereign that is created to promote the general welfare of its citizens (such as a branch empowered to legislate or a workers compensation board) is considered to be an integral part of the foreign sovereign. A corporation created by a foreign sovereign to manage its workers compensation fund qualifies as its controlled entity. A foreign government thus defined may enjoy a section 892 exemption, but not all its US-source income qualifies: generally, only income from stocks, bonds, or other domestic securities is eligible. The United States is willing to forgo tax on income derived from passive investments but not from a commercial activity if the foreign government competes with US businesses. Even the slightest amount of commercial activity can taint all the US-source income that a foreign government earns, such as commercial activity by a controlled entity of a foreign sovereign (deemed to be a controlled commercial entity, which does not benefit from a de minimis exception); however, in the case of an integral part of a foreign sovereign, only the income from the commercial activity is not eligible for the exemption. Suppose that a provincial government in Canada creates a department and authorizes a government official to appoint a board to manage a fund to compensate injured workers. The department collects annual premiums from employers, invests the premiums as a pooled fund, and distributes amounts to workers who are injured on the job. This department, a typical workers compensation board, is considered an integral part of the provincial sovereign and thus a foreign government. Accordingly, income from the boards investments in the US stock market or in US bonds is US-tax-exempt; the eligibility for the exemption of its income derived from US real property is a more complicated matter. Temporary regulations under section 892 provide that outright ownership of commercial real property constitutes a commercial activity. Although it may be possible for a workers compensation board to invest in US real property through an intermediary and still qualify for the exemption, a more detailed structural analysis is required. An entity such as a partnership (including an LLP) is disregarded for section 892 purposes; if the board invests in an LLP as a limited partner, it is treated as owning the US real property directly, and income earned thereon does not qualify for a section 892 exemption.

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In contrast, a US corporation created and wholly owned by the board is not disregarded for these purposes, but other rules are triggered. A US real property holding corporation (USRPHC) in which a foreign government owns a controlling interest is, per se, a controlled commercial entity, and income derived therefrom is not eligible for the section 892 exemption. A USRPHC is a corporation that holds US real property interests worth more than 50 percent of the FMV of (1) all the corporations real property assets wherever located, plus (2) all other assets used or held in a trade or business. At first blush, it seems that the board could load up the corporation with non-US real property to avoid USRPHC status; but regardless of the asset test, a controlled entity that has any commercial activity is deemed to be a controlled commercial entity. Under the current law, it is not clear whether the ownership of even a small interest in US real property by a controlled corporation taints all of its income as commercial. Furthermore, the IRS has stated its intention to challenge the income tax treatment of US real property investments held by controlled intermediaries. Notice 2007-55 states the IRSs intent to use FIRPTA to challenge transactions in which a foreign government claims a section 892 exemption for distributions from a REIT that disposes of real property interests. The IRS has also said that it intends to publish regulations to clarify that a transaction that uses separate foreign-governmentcontrolled entities to invest in US real property is not tax-exempt. However, Notice 2007-55 also acknowledges that the current temporary regulations permit income from a non-controlling interest in a corporate intermediary to qualify for exemption. In one example given in those regulations, income from a USRPHC investment is section 892-exempt if the foreign government does not have a controlling interest: when a foreign government does not control the corporation, the makeup of its assets is not relevant to the determination of the foreign governments section 892 exemption. Thus, if the workers compensation board owns a non-controlling interest in a US corporation that invested in US real property, that corporation is not a controlled commercial entity because the board does not control it, even if its investments and activities are otherwise commercial. As a result, the board can invest indirectly in US real property and enjoy a US tax exemption on rents and gains, but it must be willing to be a minority owner. Given the uncertainties surrounding some of the rules and their interplay with other rules, the risk of an IRS challenge is unavoidable for a foreign government that claims a US section 892 tax exemption when the underlying income arose from US real property investments. Government departments and international organizations

The editor of Canadian Tax Highlights welcomes submissions of ideas or of written material that has not been published or submitted elsewhere. Please write to Vivien Morgan at vmorgan@bellnet.ca.

Published monthly Canadian Tax Foundation 595 Bay Street, Suite 1200 Toronto, ON M5G 2N5 Telephone: 416-599-0283 Fax: 416-599-9283 Internet: http://www.ctf.ca ISSN 1496-4422 (Online)

must take care when structuring these investments, but with proper planning they may enjoy a US income tax exemption and also take advantage of what may be historically low real estate prices. Chris Murrer Hodgson Russ LLP, Buffalo

foReiGn Tax news

United Kingdom
HMRC has published draft legislation dealing with tax avoidance through the use of tax treaties. HMRC welcomes

views on the approach taken in the draft legislation, on whether the tests formulated achieve the required object, and on whether there are any perceived unintended consequences. Comments should be sent to Tom Matthews (tom.o.matthews@hmrc.gsi.gov.uk) by September 22, 2011. A tax information and impact note will be published in autumn 2011, taking into account the comments received. A final draft version will also be published in the autumn, and interested parties will then have further opportunity to comment.

United States
The IRS Large Business and International Division issued a directive with guidance for examiners and managers on the codified economic substance doctrine, which lists (1) facts and circumstances that tend to show that the application of the doctrine to a transaction is likely not appropriate or that it may be appropriate; (2) if the examiner determines that the doctrine may be appropriate, a series of queries that the examiner must answer before seeking the approval of the director of field operations (DFO) to apply the doctrine; and (3) procedures to obtain DFO approval. Vivien Morgan Canadian Tax Foundation, Toronto

2011, Canadian Tax Foundation. All rights reserved. Permission to reproduce or to copy, in any form or by any means, any part of this publication for distribution must be obtained in writing from Michael Gaughan, Permissions Editor, Canadian Tax Foundation, 595 Bay Street, Suite 1200, Toronto, ON M5G 2N5; e-mail: mgaughan@ctf.ca.

In publishing Canadian Tax Highlights, the Canadian Tax Foundation and Vivien Morgan are not engaged in rendering any professional service or advice. The comments presented herein represent the opinions of the individual writers and are not necessarily endorsed by the Canadian Tax Foundation or its members. Readers are urged to consult their professional advisers before taking any action on the basis of information in this publication.

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