Confidential protection hallmark
Contractual protection hallmark
Reporting and filing requirements
Failure to file
Following similar initiatives by Quebec, the United States, the United Kingdom and Australia, Canada has proposed a regime of mandatory disclosure for certain tax avoidance transactions entered into after 2010, as well as transactions that are part of a series of transactions that began before 2011 but is completed after 2010. On August 27 2010 the Department of Finance Canada released draft legislation to implement the proposed mandatory reporting regime. This update discusses the new reporting rules and highlights their practical implications.
A 'reportable transaction' under proposed Section 237.3 of the Income Tax Act (Canada) is an 'avoidance transaction', as defined for the purposes of Canada's general anti-avoidance rule (GAAR),(1) that is entered into by a taxpayer and satisfies two of the following three hallmarks:
- An adviser or promoter (or a non-arm's-length person) is entitled (either now or in the future and either absolutely or contingently) to a 'fee' that is to any extent:
- based on the amount of, or contingent on obtaining, a tax benefit from the transaction or series; or
- attributable to the number of persons that participate in, or have been given advice in respect of, the transaction or series (or a similar transaction or series).
- An adviser or promoter has 'confidential protection' in respect of the transaction or series.
- The taxpayer, an adviser or a promoter (or a non-arm's-length person) has 'contractual protection' in respect of the transaction or series.
The explanatory notes to the draft legislation confirm that if a series of transactions includes more than one avoidance transaction, and one hallmark is satisfied in respect of one transaction in the series and a different hallmark is satisfied in respect of another transaction in the series, then cumulatively two hallmarks have been satisfied and each transaction in the series is a reportable transaction.
The mere presence of the hallmarks does not necessarily indicate an abuse of the Canadian income tax system; but in the explanatory notes, the Department of Finance contends that their presence "often indicates that the underlying transactions are ones that could be challenged under the existing provisions of the tax law". The intended objective of the tax avoidance reporting regime is to identify to the Canada Revenue Agency certain types of potentially abusive tax avoidance transaction that are not otherwise subject to any specific information reporting requirements under the act. According to the Department of Finance, normal commercial transactions that do not pose an increased risk of abuse would not have to be reported under the new reporting regime, but it does not elaborate on what it considers to be 'normal'.
The terms 'adviser', 'promoter' and 'fee' are defined very broadly in the draft legislation. More than one person may be an adviser or a promoter in respect of a transaction or series of transactions. The explanatory notes also confirm that a person can be an adviser in respect of a transaction or series if that person provides contractual protection, assistance or advice to any promoter or any other adviser in respect of the transaction or series, even though the person does not provide such protection, assistance or advice directly to the person that entered into the transaction or series. However, a person or partnership that provides advice or representation to a person only in respect of an audit or tax dispute in relation to a particular transaction or series, and that was not involved in any of the creation, development, planning, organising or implementation of, or the provision of contractual protection for, the transaction or series, is not an adviser in respect of that transaction or series.
The explanatory notes describe the concept of 'similar' avoidance transactions or series of transactions as broadly including those with the same or a similar structure that are entered into by different taxpayers, when the objective of those transactions or series is to result in similar tax benefits for each of the taxpayers, even if those transactions or series may involve different properties or obligations. For example, the Department of Finance indicates that in a broadly marketed scheme in which different taxpayers acquire and finance property separately, but where the property that each taxpayer acquires is similar in nature and where the financing structure that each taxpayer enters into is similar, the taxpayers' transactions may be considered to be similar avoidance transactions for the purpose of the fee hallmark.
Confidential protection hallmark
The concept of confidential protection excludes standard provisions in tax opinions limiting the adviser's liability solely to the adviser's client and disclaiming liability to any third parties, as long as there is no prohibition on the disclosure of the transaction or series. Further, the Department of Finance has confirmed that the rights of confidentiality of a person that has entered into a transaction against the person's advisers would not trigger the reporting obligation, since under the definition of 'reportable transaction' it is an adviser or promoter that must have confidential protection in respect of the avoidance transaction.
Contractual protection hallmark
'Contractual protection' in respect of a transaction or series of transactions means:
- any insurance (other than standard professional liability insurance) or other protection that protects a person against a failure of the transaction or series to achieve any tax benefit, or pays for or reimburses any expense, fee, tax, interest, penalty or similar amount that may be incurred by a person in the course of a dispute in respect of a tax benefit from the transaction or series; and
- any promoter's undertaking that provides assistance to a person in the course of a dispute in respect of a tax benefit from the transaction or series.
Contractual protection does not include an advance income tax ruling obtained by a person for whom a tax benefit could result from the transaction or series. However, it could include situations in which a taxpayer would be entitled to be compensated for any fees incurred in the course of an audit, an objection to an assessment, reassessment or determination or a court appeal of an assessment in respect of a tax benefit which could result from an avoidance transaction or series of transactions.
The second form of contractual protection deals with situations where a promoter provides an undertaking to assist a person in the course of a dispute in respect of a tax benefit from a transaction or series of transactions, even if the promoter does so for free. The Department of Finance has indicated that this kind of contractual protection would include situations where the promoter offers to provide relevant documentation and guidance to challenge an assessment or to file an appeal of a court decision in respect of the transaction or series.
Reporting and filing requirements
Every person for whom a tax benefit arises from a reportable transaction and every adviser or promoter entitled to a fee caught by the hallmarks must file a prescribed information return providing full and accurate information about each reportable transaction.(2) The Canada Revenue Agency has yet to issue the prescribed information return. While the reporting obligation under Section 237.3(2) applies on a transaction-by-transaction basis, Section 237.3(3) deems a person's filing obligation to have been satisfied in respect of each transaction in a series of transactions if the person files a single information return reporting the entire series of transactions.
The filing deadline for the information return is on or before June 30 of the calendar year following the year in which the transaction first became a reportable transaction in respect of the person. However, for a transaction that is part of a series of transactions that began before 2011 but is completed after 2010, the information return will be deemed to be filed by the filing due date as long as it is filed before the end of 2011.
Proposed Section 237.3(12) of the draft legislation provides that the filing of an information return in respect of a reportable transaction is not an admission by the filer that the GAAR applies in respect of any transaction, or that any transaction is part of a series of transactions. However, the wording of Section 237.3(12) provides no protection against a filing constituting an admission that a transaction is an avoidance transaction or part of a series that includes an avoidance transaction, which raises significant concerns as discussed below.
There are several points to note about the filing requirements. First, different participants in a series of transactions may have different reporting obligations and in different years. Second, where the reporting obligation involves a series of transactions, the filing of an information return by one person may or may not satisfy other persons' reporting obligations. Therefore, persons involved in a series of transactions that includes a reportable transaction must carefully consider their individual reporting obligations to ensure that they are properly satisfied. This is especially important since any penalty for failure to file in respect of a reportable transaction is jointly imposed on taxpayers that benefit from the transaction, persons acting for (or for the benefit of) such taxpayers, and promoters and advisers involved in the transaction in certain circumstances.
In general, every person that fails to file an information return in respect of a reportable transaction within the prescribed timeframe will be jointly and severally, or solidarily, liable to pay a late-filing penalty equal to the total of all fee entitlements of all advisers and promoters (and non-arm's-length persons) in respect of the transaction or series to the extent that such fees meet the conditions of either the fee hallmark or the contractual protection hallmark. Liability for the penalty is subject to a due diligence defence. Further, in the case of advisers and promoters only, there is a monetary limit on the penalty equal to the total fee entitlement of that particular adviser or promoter (and any non-arm's-length person) in respect of the reportable transaction or series of transactions.
In addition, if the penalty (or any penalty interest) is not fully paid and any taxpayer for whom a tax benefit arises from the reportable transaction has not satisfied the required reporting obligation, the GAAR will be deemed to apply to the reportable transaction as a result of the rule in proposed Section 237.3(6). However, to the extent that the tax benefit sought would otherwise be permitted under the GAAR, a taxpayer may still obtain the tax benefit if the taxpayer files late the required information return with the minister and pays any outstanding penalty and interest.
Due diligence defence
The proposed due diligence defence exempts a person from liability for a penalty for failure to file the required information return if the person has exercised the degree of care, diligence and skill to prevent the failure to file that a reasonably prudent person would have exercised in comparable circumstances. The existing jurisprudence on similar due diligence defences generally applies a reasonable person test, taking into account all of the relevant facts and circumstances.
The explanatory notes confirm that if, for example, an adviser, acting reasonably, determines that a reportable transaction, in respect of which the adviser provided advice and is entitled to a fee that satisfies either the fee hallmark or the contractual protection hallmark, is part of a series of three transactions, the adviser will have satisfied his or her reporting obligation if a full and accurate report is filed in respect of the three transactions that make up that series even if, unknown to that adviser, those three transactions were actually part of a larger series of transactions.
Despite the Department of Finance's assertion in the explanatory notes that the draft legislation addresses the issues raised by the tax community regarding the proposed tax avoidance reporting regime, "particularly when the proposed regime is considered as a whole", significant concerns remain. The proposed regime has very wide application as a result of the use of broadly drafted defined terms which determine its application to a particular transaction or series of transactions. Although the Department of Finance has attempted to assuage some of the concern by commenting in the explanatory notes that normal commercial transactions that do not pose an increased risk of abuse would not have to be reported under the new reporting regime, that statement is of little practical benefit without further guidance on the kinds of transaction that the department would consider to be 'normal'.
Concerns have also been raised about the imposition of the reporting requirements on legal advisers, particularly its potential to affect adversely the protection afforded to a client by solicitor-client privilege and to conflict with the duty of 'undivided loyalty' owed by a lawyer to his or her client. This is a serious issue that the Department of Finance should address.
Further, as noted above, the wording of Section 237.3(12) provides no protection against a filing constituting an admission that a transaction is an avoidance transaction. Presumably, a taxpayer could include a statement with the information return that the filing is for protective purposes only and does not constitute an admission that a transaction is an avoidance transaction, but explicit protection should be added to Section 237.3(2). Similarly, it is unclear whether the due diligence defence in Section 237.3(11) will be of any benefit where a person reasonably concludes that the transaction is not a reportable transaction since it expressly applies only to reasonable efforts to "prevent a failure to file".
It is hoped that the Department of Finance will resolve these and other outstanding concerns by revising the draft legislation before its enactment.
The introduction of these new reporting rules is likely to increase the costs associated with planning and implementing transactions for taxpayers. Some of the issues that taxpayers and their advisers will now need to think about in the course of planning and implementing transactions include:
- whether there are any reportable transactions or series of transactions that include a reportable transaction;
- the specific reporting obligations that the taxpayer, advisers and promoters have in respect of the transactions or series;
- whether reporting is required under one or both of the federal and Quebec legislation;
- how to ensure the adequate disclosure of information among taxpayers, advisers and promoters to enable them to make the foregoing determinations;
- whether to obtain an agreement among taxpayers, advisers and promoters to ensure complete and consistent reporting of a reportable transaction or series; and
- whether to obtain additional legal opinions (eg, as to whether there is a reportable transaction, whether there is a series that includes a reportable transaction or whether a particular person has a reporting obligation).
For further information on this topic please contact Pamela Cross at Borden Ladner Gervais LLP 's Ottawa office by telephone (+1 613 237 5160), fax (+1 613 787 3558) or email ([email protected]). Alternatively, contact Stephanie Wong at Borden Ladner Gervais LLP's Toronto office by telephone (+1 416 367 6000), fax (+1 416 367 6749) or email ([email protected]).
(1) An 'avoidance transaction' under the GAAR in Section 245 of the act is a transaction that would result, or is part of a series of transactions that would result, in a tax benefit (a reduction, avoidance or deferral of tax), unless the transaction has been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit.