More Bite than Bark: Proposed Changes to Tax Laws Look to Empower the CRA

November 20, 2022 Update:

• New draft legislation has delayed the application of the trust reporting rules another year, meaning these rules will apply to trusts with taxation years ending after December 30, 2023.
• Amendments to the draft legislation indicate that the mandatory reporting rules for reportable transactions and notifiable transactions are also delayed and will apply to transactions after 2022.

The Government appears to be focusing its legislative efforts when it comes to increasing tax revenue by empowering the CRA with changes that target tax planning it does not like. There have been significant proposed changes designed to give the CRA more information and power announced by the Federal government in the recent years. In 2022, we saw the introduction of draft legislation and consultation papers as the government prepares to implement some of these changes. In this article, we discuss three proposed changes that we consider most concerning for our clients.

Trust Reporting rules

Now beginning in 2023, most trusts will need to file annual tax returns, regardless if the trust had activity during the year or not.[1] Trust returns are due at the end of March, rather than the end of April, so it is critical to be aware of this new requirement.

The trust returns will now require additional disclosure of information about the settlor, trustees and beneficiaries of the trust, such as names, dates of birth, addresses, tax residency, and social insurance numbers.

These changes have been expected since 2018. However, we were surprised to see bare trusts included in these reporting and disclosure requirements in the drafts of legislation released this year. Historically, from a tax perspective, bare trusts were not considered “trusts” and were excluded from most trust-related reporting and taxation rules. They were instead treated as agencies and flow-through entities for taxation. While the tax treatment has not changed, the draft legislation released this spring and summer will require taxpayers to start filing tax returns for their bare trusts and report their existence.

Bare trusts are used for a variety of transactions and, in many cases, by regular people who do not realize that their actions have created a bare trust. For example, if a parent adds a child as a joint owner to land or a bank account and the intention is the parent still maintains all the control and benefit of the asset, then this is a bare trust. Many parents do this to avoid probate or, simply, for convenience of having their child be able to assist with managing the asset. The inverse also applies, such as when a parent co-signs on an asset so that a child may qualify for financing but, in reality, the parent and the child regard the asset as belonging solely to the child. Bare trusts are also used in commercial transactions, such as where there is a timing gap between when the transaction is effective and when legal title actually changes or if there is another reason to not to transfer legal ownership.

We are concerned that the inclusion of bare trusts in the reporting requirements will result in numerous taxpayers being offside the tax laws. This is especially the case where people creates bare trusts without realizing it or utilize bare trusts for reasons unrelated to tax planning. Failure to file the annual tax return or provide the proper disclosure may result in penalties up to $2,500.

Changes to Reportable Transactions and Notifiable Transactions rules

There are already rules require the person receiving a tax benefit (or someone acting for their benefit), or an advisor, or a promoter to report or notify the CRA of any transaction that falls within certain criteria. The proposed changes increase the number of transactions that fall within these reporting obligations. It is important to note that reporting or notifying does not necessarily mean taxes will be owed. However, these are transactions that the CRA considers at-risk for tax avoidance and therefore wish to obtain further information when these transactions occur.

These reporting obligations apply to the taxpayer, any person who benefits from the transaction, an advisor[2] and a promoter. It will not be sufficient for one person to report the transaction on behalf of everyone.

Under the draft legislation, the penalties for failing to report a reportable transaction or notifiable transaction are:

1. Taxpayers and those who benefit from the transaction (if a corporation with $50M assets or more): Penalty of $2,000 per week of failure to file, up to a maximum of $100,000 or 25% of the tax benefit from the transaction, whichever is greater.
2. Taxpayers and those who benefit from the transaction (in any other case): Penalty of $500 per week of failure to file, up to a maximum of $25,000 or 25% of the tax benefit from the transaction, whichever is greater.
3. Advisors and promoters: Penalty equals the sum of 1) Fees charged for the transactions, 2) $10,000, and 3) $1,000 per day for failure to file, up to $100,000.

Reportable Transactions

Transactions will be “reportable transactions” if they meet the following criteria:

1. It would be reasonable to consider one of the main (but not necessary the only) purposes of the transaction or series of transactions was to obtain a tax benefit.
2. One or more of the following apply:
   1. A promotor or advisor’s compensation is based on the tax avoidance or tax benefit obtained;
   2. A promotor or advisor has confidentiality protection related to the tax treatment of the transaction or transactions;[3] or
   3. The taxpayer or a non-arm’s length person to the taxpayer has contractual protection related to the transaction, such as insurance that will insure against losses if the tax benefit is not obtained or tax avoidance is not achieved.

Most tax planning will meet criteria #1 so it will be important to be aware if the transaction or tax plan may meet any of the criteria set out in #2. If the transaction may or does meet the criteria to be a “reportable transaction”, then an information return must be filed with the CRA by June 30 in the year following the transaction.

Notifiable Transactions

The CRA designates certain types of transaction as “notifiable transactions”. While this appears to give some certainty, the categories are fairly broad. These include, but are not limited to:

1. Situations where the “Canadian-controlled private corporation” status has been manipulated to avoid the anti-deferral rules for investment income, such as continuing the corporation out of Canada or having a non-resident hold voting control through “skinny voting shares”.
2. Avoiding the deemed disposition on trust property, such as indirectly transferring the property to another trust.
3. Reliance on the purposes test under section 256.1 to avoid a deemed acquisition of control.

If a transaction is a “notifiable transaction”, then the taxpayer or person who benefits from the transaction must file within 45 days following the earliest of:

1. the day the person becomes contractually obligated to enter into the notifiable transaction;
2. the day that the person enters into the notifiable transaction; or
3. for a person who is simply benefiting from the notifiable transaction (but is not actually entering into it), then the day that the notifiable transaction is entered into.

For advisors and promoters, their deadline is linked to the person that they are advising or having promoted the tax plan to. In other words, whatever deadline applies to their client will also apply to them.

Our concern for both “reportable” and “notifiable” transactions is that many transactions fall within their broad definitions. Similar to our concerns with bare trusts being reportable, this broad scope will likely capture many unsuspecting taxpayers or their advisors (accountants or lawyers), particularly when the tax planning is not considered “aggressive”.

Expansion of the General Anti-Avoidance Rule (“GAAR”)

The GAAR is used by the CRA to recharacterize transactions that are otherwise compliant with tax legislation but they consider “abusive”; it is recharacterized so the tax avoidance that is attempted is thwarted. Currently, GAAR requires three criteria to be met:

1. There must be a tax benefit realized;
2. There was a tax avoidance transaction; and
3. The avoidance transaction was a misuse or abuse of the Income Tax Act.

If the CRA has not already “approved” a type of transaction through its publications, then there is certainly a GAAR risk if the proposed transaction aims to limit taxes. However, so far, the Courts have kept the application of the GAAR fairly limited and it has remained a high bar for the CRA to meet. In the proposed changes, the CRA intends to expand (or, “strengthen” as it is framed in government publications) the GAAR by altering the criteria. These proposed changes were set out in a consultation paper released in the summer and was open for consultation until Sept. 30, 2022. At this stage, we are now waiting for further government releases and/or draft legislation

One of the proposed changes is to amend the definition of “tax benefit” to include tax attributes that may result in a future deferral or reduction of tax. Currently, the tax benefit must actually be realized before the CRA could apply GAAR. Our obvious concern is that the existence of a potential future benefit does not mean the taxpayer will actually implement a transaction that will result in the deferral or reduction in tax. There are also many tax attributes that give rise to tax deferrals or avoidance that are not inherently abusive.

Another proposed change is to include “choice” in the definition of “transaction”. Currently, GAAR applies when a transaction itself is determined to be an avoidance transaction. In a recent case, the members of a deposit insurance corporation (the taxpayer) were assessed by another deposit insurance corporation and the members were required to pay. The taxpayer was required to provide funds to the members to cover this assessment. The taxpayer chose to pay members a dividend instead of a “return of amounts previously assessed”. The dividend would pass tax-free to the members[4] and would allow the taxpayer to claim a deduction for the amount paid to the second deposit insurance corporation. In contrast, if the taxpayer instead paid the members a return of amounts previously assessed, those amounts would have been taxable to the members.[5] The CRA argued this was subject to GAAR. The Court disagreed and determined that the choice to pay the funds as dividends was not, in itself, an avoidance transaction because it was a choice, not a transaction. Since the second criteria could not be met, it could not be subject to GAAR.

By expanding the definition to include “choices”, this mean the choice to effect a transaction one way instead of another may be considered an “avoidance transaction”. This broadens the definition significantly. There is a long-standing principle that taxpayers have the right to organize their affairs in a manner that minimizes tax (called the Duke of Westminster’s principle). Our concern is that this expanded definition will erode this principle and implies that a taxpayer should not try to minimize their taxes, even when their choices are both within the wording of the tax laws.

Lastly, we are also concerned with the proposed lowering of the purpose threshold required for a transaction to be considered an “avoidance transaction”. Currently, an avoidance transactions requires “avoiding tax” to be the primary purpose of the transaction. The proposed change has suggested that “avoiding tax” should only be one of the purposes or a material purpose of the transaction. This can also have far-reaching implications as most, if not all, tax planning involves the reduction or avoidance of tax as one of the purposes.

Overall, expanding the GAAR will significantly increase uncertainty when it comes to tax planning.

Conclusion

The 2022 Budget indicated that the CRA intends to increase audits to recoup what they consider to be tax revenue loss due to tax avoidance. While the above changes do not increase tax rates, they do encourage and require extensive disclosure of information to the CRA and increase the scope of transactions that may subject taxpayers (or their advisors) to audits and penalties.