Mandatory disclosure rules
The Income Tax Act ("ITA") currently includes disclosure obligations for "reportable transactions." However, the Canada Revenue Agency ("CRA") is finding that they are not "sufficiently robust" to respond quickly to tax risks associated with aggressive tax planning strategies.
In order to address these perceived concerns, the Department of Finance ("Finance") announced changes to the mandatory disclosure rules in the 2021 Federal Budget, including with respect to uncertain tax treatments in a corporation's financial statements. Finance released draft legislation ("Draft Legislation") to implement the changes on February 4, 2022, which includes:
a) changes to the existing "reportable transaction" rules;
b) creating a new class of "notifiable transactions"; and
c) enhanced penalties for failing to comply with the reporting requirements for reportable and notifiable transactions.
While the Draft Legislation has not yet received Royal Assent, the new reporting requirements apply to transactions entered into in 2022.
"Reportable transaction" is currently defined to mean an "avoidance transaction" entered into for the benefit of a taxpayer and each transaction that is part of a series of transactions that includes the avoidance transaction having two out of three generic hallmarks:
- a contingent fee arrangement pursuant to which an advisor or promoter, or any non-arm's length person to the advisor or promoter, is entitled to: (i) a fee based on the amount of the tax benefit, (ii) that is contingent on obtaining the tax benefit, or (iii) that depends on the number of persons participating in the avoidance transaction or series or who have been provided access to advice or opinions with respect to such transaction or series;
- an advisor or promoter in respect of the avoidance transaction or series obtains "confidential protection" in respect of the transaction or series from the taxpayer. "Confidential protection" generally means the prohibition of the disclosure to any person or to the CRA , of the details or structure of the transaction or series; and
- a taxpayer, or an advisor or promoter, has or had "contractual protection" in respect of the avoidance transaction or series. Contractual protection includes:
- any form of insurance or other protection, indemnity, compensation or guarantee that protects the taxpayer against failure of the transaction or series or pays for or reimburses any expense, fee, tax, interest or penalty that may be incurred by the taxpayer, in respect of a dispute over the tax benefit from the transaction or series; or
- any form of undertaking by a promoter, to provide assistance to the taxpayer in respect of a dispute over the "tax benefit" from the transaction or series.
For the definition of reportable transaction, a "tax benefit" has the meaning given to the term under the general anti-avoidance rule (GAAR) and includes the reduction, avoidance or deferral of tax, including under a tax treaty and includes a tax refund.
Pursuant to the Draft Legislation, a reportable transaction will only require one of the generic hallmarks to be present, representing a significantly lower threshold for the disclosure requirements under the ITA . However, in the case of contractual protection, the Draft Legislation introduces an exemption for contractual protection that is offered in the "normal commercial transactions" context to a wide market.
The definition of "avoidance transaction" is also amended to require only one of the main purposes of the transaction or series to be the obtaining of a "tax benefit. This effectively means that none of the main purposes of the transaction or series can be to obtain a tax benefit. This also represents a lower threshold than the current primary purpose test under the GAAR" applicable for a transaction to be considered an avoidance transaction for purposes of the reportable transaction rules.
The draft legislation creates a new category of "notifiable transactions" that are subject to essentially the same disclosure obligations as reportable transactions.
Notifiable transactions will be designated by the CRA with the concurrence of Finance and they will include transactions that the CRA has found to be abusive and transactions that the CRA has identified to be of interest and for which they require more information to determine if the transactions are in fact abusive.
The CRA released a sample list of the following six notifiable transactions:
- manipulating "Canadian-controlled private corporation" ("CCPC") status to avoid anti-deferral rules applicable to investment income;
- straddle loss creation transactions using a partnership;
- avoidance of deemed disposition of trust property;
- manipulation of bankrupt status to reduce a forgiven amount in respect of a commercial obligation;
- reliance on the purpose test in section 256.1 of the ITA to avoid deemed acquisition of control; and
- back-to-back arrangements.
Notably, the list includes the manipulation of CCPC" status. A corporation that is not a CCPC is not subject to the refundable tax on investment income under the ITA . Therefore, so called "non-CCPC planning" has become a popular structure for tax deferral purposes and generally involves Canadian individuals incorporating a non-resident corporation or continuing a Canadian corporation to another jurisdiction.
However, the 2022 Federal Budget may have effectively rendered this type of planning moot with the introduction of the concept of a "substantive CCPC," to eliminate the tax deferral for corporations that are controlled by Canadian resident individuals.
If a reportable or notifiable transaction is identified, an information return must be filed with the CRA 45 days after the earlier of:
a) the day the taxpayer becomes contractually obligated to enter into the transaction; and
b) the day the taxpayer enters into the transaction.
It is concerning to note that the deadline may have already passed for some transactions that were already entered into this year, notwithstanding that the Draft Legislation has not yet received Royal Assent.
It is also concerning that reporting is required by multiple parties and could require multiple advisors within a single firm to each file an information return in respect of a single transaction.
Given the uncertainty, and the potentially large and, in some cases, disproportionate compliance burden and costs, the CBA/CPA Joint Committee on Taxation recommended in its submissions to Finance on the Draft Legislation that reporting not be required until the legislation receives Royal Assent. It also recommended that only one information return be required per firm versus per individual advisor.
Failure to report
Failing to file an information return for reportable and notifiable transactions by the prescribed deadline could result in significant penalties, subject to a due diligence defence, as well as other unfavourable consequences.
In the case of the taxpayer, the penalty is generally calculated at the rate of $500 per week that the return remains unfiled, up to the greater of $25,000 and 25% of the tax benefit.
If the taxpayer is a corporation and the carrying value of its assets is $50 million or more, the penalty is calculated at a rate of $2,000 per week that the return remains unfiled, up to the greater of $100,000 and 25% of the tax benefit.
In the case of a promoter or advisor, the penalty is the total of: (i) the fees charged in respect of the reportable or notifiable transaction, (ii) $10,000, and (iii) $1,000 for every day that the failure to report continues, up to a maximum of $100,000.
While the filing requirements apply as of 2022, the penalties for failing to file an information return will not apply until the Draft Legislation receives Royal Assent.
In addition to penalties, in the case of reportable transactions, if the information return is not filed and it results in a penalty that remains unpaid, the tax benefit arising from the transaction is denied. Under the current rules, the misuse and abuse test described in the GAAR must be met for the tax benefit to be denied. However, under the Draft Legislation, this requirement has been removed.
Finally, the normal reassessment period will not start until the required information return is filed with the CRA .
Given the lower threshold for a transaction to fall within the definition of reportable transactions, even routine tax planning could potentially get caught, since such planning invariably results in a tax benefit. Moreover, taxpayers, promoters and advisors may feel compelled to err on the side of caution and report all such transactions, since the penalties for failing to report a reportable or notifiable transaction are potentially very significant, resulting in materially increased compliance costs for taxpayers.