TaxBreaks, April 2005

Any debt to the taxman comes first!
Generous financial assistance is rarely used
Did you know that . . .

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Any debt to the taxman comes first!

Taxpayers, beware: if you have not remitted deductions at source to the taxman as required by the Income Tax Act (the Act), your properties, as well as those held as a guarantee by your creditors, are presumed to be held in trust for the government. The following example, Caisse populaire de la Vallée de l’Or v. The Queen (Federal Court, January 2005), is a case in point.

The facts are relatively simple. A numbered company (the Company) took a movable hypothec on a trailer with the Caisse populaire de la Vallée de l’Or (the Caisse) to secure its line of credit in February 1999. Ten months later, the Company sold the trailer for $10,000 and remitted that amount to the Caisse. At that time, however, the Company owed some $6,000 in source deductions from employee salaries to the Receiver General of Canada.

The Canada Revenue Agency (CRA), citing appropriate sections of the Act, claimed the amount owed to it by the Company from the Caisse. The gist of these sections is that any taxpayer holding or withholding an amount from the CRA is deemed, under the Act, to be holding, separate from the taxpayer’s own properties, assets in trust on account for the federal government. In addition, this presumption covers taxpayers’ properties held by a guaranteed creditor, which properties, in the absence of a guarantee, would be those of the taxpayer. If the amounts held are not remitted, the taxpayers’ properties, as well as the properties held by its guaranteed creditor, are presumed to be held in trust for the government. This holds true for “proceeds of disposition” of both these categories of property. In other words, when a debtor fails to pay tax authorities amounts withheld under the Act, the debtor’s properties become pledged to the tax authorities.

The Caisse argued that the CRA could not recover its debt from the sale of the trailer because it had asserted its interests only after the sale was completed.

According to the court, it was necessary to answer three questions to adjudicate this dispute.

1) At the time of sale, was the trailer deemed to be held in trust?

The answer to this first question was, clearly, yes. Since the trailer was the property of the debtor company at the time when the source deductions were made, this property was automatically deemed to be held in trust for the government.

2) Did the amount received by the Caisse following the sale of the trailer constitute “proceeds of disposition” of this property?

In 2002, the Supreme Court of Canada adjudicated in The Queen v. First Vancouver Finance. The Federal Court referred to the following passage of the decision from the highest Canadian court to deal with this question:

“In this way, when an asset is sold by the tax debtor, the deemed trust ceases to operate over that asset; however, the property received by the tax debtor in exchange becomes subject to the deemed trust. As such, the trust is neither depleted nor enhanced; it simply floats over the property belonging to the tax debtor at any given time, for as long as the default in remittances continues.”

The Federal Court also added that the “proceeds of disposition”, which, in this case, was the sale price of the trailer, could also result from a direct sale made by the taxpayer, or from the realization of a guarantee on the part of a creditor of the taxpayer. In the latter case, based on the judgment in P.G. Canada v. National Bank of Canada, (Federal Court of Appeal, 2004) the judge asserted that the creditor of a tax debtor (such as a bank or a Caisse populaire) must therefore use the sale price of a property to pay the Receiver General of Canada, and that doing so must take priority over paying the guarantee.

3) Does the Act indicate an obligation on the part of the Caisse to give priority to remitting to the Receiver General of Canada the amount owed by the Company?

This third question referred directly to the Caisse’s main argument, which was to the effect that the CRA had not asserted its credit when the trailer was sold and its sale price remitted to the Caisse; that is, at a time when its sale price was no longer part of the debtor’s property.

According to the Caisse, the legal certainty of business transactions in general would be challenged if the Court did not accept this argument, as the resulting implication would be that a financial institution could not accept the payment of credit and release a guarantee without first ensuring that all source deductions had been properly remitted. Thus the financial institution might lose all recourse against its debtor.

The Federal Court rejected this argument for two main reasons. First, it did not see such a limit as “temporal” in the actual text of the section of the Act (i.e., a limit that, unlike those existing in other legislation, ceases to apply at any moment during transactions).

Second, the Federal Court declared that the only limit set by jurisprudence in such a case, one affecting third parties and ensuring the legal certainty of business transactions, consisted of an exception where a third party acquires property from a tax debtor during the debtor’s normal course of operations. This would be the case, for example, for a purchase made by a third party in a department store belonging to a company owing source deductions to the government.

In conclusion, the court pointed out that any inequity cited by the Caisse in respect of its business, due to the existence of the deemed trust, could have been avoided if the Caisse had taken the precaution to inform itself of the tax situation of its debtor and made arrangements accordingly.

This decision by the Federal Court only constitutes a subsequent refinement in the interpretation of the principle of a “deemed trust” contained in the Act. As we can see, apart from third parties acquiring property from a tax debtor during the debtor’s normal course of operations, all other parties to business transactions must ensure that their co-contractors have no debts to the taxman.

It is important to remember that such debts may exist not only for source deductions and other deduction or withholding obligations set by the Act, but also, among other things, for goods and services tax (GST) collected and not remitted.

Marc Gravel, Montréal
Yan Boyer, Montréal

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Generous financial assistance is rarely used

In order for Canadian businesses to become and remain more competitive and innovative, the Canadian government has put in place tax incentives to encourage them to conduct scientific research and experimental development (SR&ED) activities. Several Canadian provinces also offer incentive programs with similar objectives.

Credits and refunds
The federal credit rates range between 20% and 35%, and the Québec rates range between 17.5% and 35%, depending on the type of qualifying business satisfying the conditions. Examples of expenses that qualify are salaries and subcontracts (Québec and federal), primary materials, capital expenses, equipment rentals, and general expenses (federal): such expenses must be directly attributable to SR&ED activities and are subject to certain rules.

In essence, the SR&ED program allows taxpayers to claim cash refunds and/or tax credits in relation to eligible SR&ED work carried on in Canada.

Even though the Canada Revenue Agency, which is responsible for the administration of the SR&ED program, processes approximately 11,000 SR&ED claims representing $1.5 billion of tax credits each year, we firmly believe that many taxpayers are not claiming the SR&ED tax credits to which they are entitled, or are not maximizing their present claims.

Businesses that carry on eligible activities may claim SR&ED tax credits. As such, this program is aimed at the manufacturing sector, engineering and science consulting firms, laboratories, and inventors.

It should be noted, however, that partnerships cannot claim SR&ED tax credits, but rather must allocate them to their members on the basis of each member’s proportionate share in the partnership.

Eligible activities
For income tax purposes, SR&ED activities are defined as a systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis and that falls into one of the following categories:

• Basic research - Work undertaken to advance scientific or technological knowledge without a practical application in view.
• Applied research - Work undertaken to advance scientific or technological knowledge with a practical application in view.
• Experimental development - Work undertaken to achieve a technological advancement in order to create, or improve even slightly, materials, products, or processes.

For most companies, most SR&ED claims are related to experimental development activities. Listed below are examples of projects that could qualify for the program, projects that are more specifically related to the environment industry:

• Developing or improving wastewater treatment processes.
• Developing or improving technologies used to rehabilitate contaminated soil.
• Adapting a water filtration technology under specific weather conditions.
• Developing or improving pumping equipment.
• Adapting existing technology to a different application.
• Developing or improving an air treatment system.
• Using a new product in a recycling process in order to improve its features.

• Support work - Work that directly supports and is commensurate with the needs of basic or applied research, or experimental development. Such work includes only the following: engineering; design; operations research; mathematical analysis; computer programming; data collection; testing; and psychological research.

Even if a project and its activities fall within one of the above-mentioned categories, the project and related activities will qualify for the SR&ED tax incentives only if all of the following three criteria are met: scientific or technological advancement, scientific or technological uncertainty and scientific and technical content.

Generally, only SR&ED activities carried out in Québec (Québec credit) and in Canada (federal credit) will qualify. In this regard, the eligible work may be performed either by the taxpayer directly, or on the taxpayer’s behalf by another party.

All in all, SR&ED credit programs are excellent financing tools that your company can use to outclass the competition. Have you been taking full advantage of them?

Michel Lefebvre, Montréal
Denis Dumas, Longueuil

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Did you know that . . .

• Tax return filing deadline extended. Because April 30 falls on a Saturday, you have until May 2, 2005, or later (June 15 if you or your spouse or common-law partner carried on a business) to file your federal income tax return for 2004 (and, if applicable, your Québec return). If you file late, you face penalties of 5%, plus 1% for each complete month of delay up to 12 months, on the balance owing. In addition, you have to pay interest on the balance owing, calculated from May 3, 2005.
• Prescribed interest rates for the second quarter. The prescribed interest rates that apply for federal income tax purposes for the second quarter of 2005 are the same as those in effect during the first quarter. The rates in effect from April 1 to June 30, 2005, are: 7% on overdue taxes, Canada Pension Plan contributions and Employment Insurance premiums; 5% on overpayments; 3% on taxable benefits for employees and shareholders from interest-free or low-interest loans. In Québec, these rates are, respectively, 7%, 1.65% (was 1.5% in the first quarter) and 3%.
• Voluntary disclosure can be beneficial. If you owe money to the tax authorities because you neglected to file a return for one or more tax years, you can make a voluntary disclosure and pay only the tax due, plus interest. You will not have to pay the penalties that would otherwise be required. Your disclosure needs to be complete and to include information that is at least one year past due. In addition, you must contact the Canada Revenue Agency (or Revenue Québec, if applicable) before an audit or investigation is commenced.
• Request a review of your Notice of Assessment. If you disagree with a Notice of Assessment that you receive from the Canada Revenue Agency (CRA), you can make a request on the CRA’s Web site to have the Notice reviewed. A CRA agent will review your request and send you a response within weeks. You will be contacted if any additional information is needed to process your request.
• Phasing out the excise tax on jewellery. As announced by the Minister of Finance, Ralph Goodale, in the February 23, 2005, federal budget, the excise tax payable by manufacturers and importers of jewellery was reduced to 8% from 10%, effective February 24, 2005, on the following goods: clocks and watches, articles of all kinds made in whole or part of natural shells and semi-precious stones, jewellery (including diamonds and other precious and semi-precious stones for personal use or adornment) and goldsmiths’ and silversmiths’ products. This tax will be eliminated gradually over the next four years until the rate reaches zero in 2009.
• Parking space paid for by an employer. According to the Canada Revenue Agency, there is no taxable benefit for an employee whose employer provides a parking space, provided the employee is required to use his vehicle for employment-related travel three or more days out of a five-day work week.

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