Canada, tax TaxBreaks, August 2005 newsletter

TaxBreaks, August 2005

Voluntary disclosure: Get it in writing
Principal residence as a tax shelter
A new plan replaces the Québec Stock Savings Plan
Did you know that . . .

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Voluntary disclosure: Get it in writing

In Karia v. Minister of National Revenue, the Federal Court considered whether a taxpayer’s disclosure of previously unreported taxable income to the Canada Revenue Agency (CRA) under the CRA’s voluntary disclosure program satisfied the “voluntary” requirement, given that the taxpayer in question had been charged with fraud by the local police authority. Finding in favour of the taxpayer, the Court concluded that the disclosure satisfied this criterion despite the fraud charge and that the taxpayer was entitled to rely upon the CRA’s original written statement, which could be interpreted to mean that the “no-names” disclosure would be valid once the name of the taxpayer was revealed and all facts verified.

The facts
The taxpayer in Karia had been the subject of a fraud investigation by local police and was finally charged. Before advising him to make his disclosure on a “names” basis, his lawyer enquired of the CRA, in a “no-names” preliminary, whether it would consider a disclosure made under these circumstances to be voluntary. Among the information provided to the CRA, the lawyer revealed that the taxpayer had been charged with fraud by local police, who had indicated to him that they intended to communicate their findings to the CRA.

The CRA confirmed in writing that it would nonetheless consider such a disclosure to be voluntary, subject to any change in the facts presented. Relying on this assurance, the taxpayer subsequently made a disclosure on a “names” basis. The CRA, however, then took the position that the disclosure was not voluntary and thus did not meet the four conditions of the program.

Conditions for a disclosure to be considered valid
The voluntary disclosure program was created to encourage taxpayers to respect the law relating to declaration of revenue and payment of taxes by allowing them to correct or divulge any incomplete or erroneous information provided in previous declarations without penalty or prosecution. Four conditions apply:

The disclosure must be voluntary.
It must be complete.
It must involve a penalty.
It must include information that is at least one year past due. However, the CRA will now accept information relating to periods of under a year, provided that the disclosure is not initiated simply to avoid late filing or instalment penalties.

If the CRA finds the voluntary disclosure satisfies its criteria, it can use its discretion to waive, in part or in full, all penalties that would otherwise apply and forgo prosecution. In certain cases, it may also waive interest or a portion thereof.

The CRA’s official position regarding the first condition above is that a disclosure may not be admissible if it is found that the taxpayer made it in light of knowledge that he or she had been the subject of an audit, investigation, or other enforcement action initiated by the CRA, or by other authorities or administrations with which the CRA has information exchange agreements. This was the argument put forward by the CRA in refusing the taxpayer’s request in Karia.

The Court’s findings
The Federal Court found that the taxpayer had the right to rely upon the CRA’s initial written statement to the effect that the disclosure, if made on a “names” basis, would be accepted as voluntary. The CRA’s argument to refuse the taxpayer’s request was rejected by the Court because there had been no written agreement between the CRA and the police authorities and because the matter was never brought up by the CRA in its communications with the taxpayer.

As well, the Federal Court found that, according to the CRA’s official policy regarding the voluntary disclosure program, the taxpayer must have actual knowledge that the CRA has an information exchange program with another enforcement agency investigating him or her; that the taxpayer “ought to have known” about the agreement is not sufficient.

Consequences
Karia provides an excellent example of the importance of written statements in the context of a “no-names” disclosure. The decision in favour of the taxpayer is welcome, given that the CRA program is largely administrative and does not carry the weight of the law as such. However, the relief provided by this judgment only affects taxpayers who, on an anonymous basis, request written confirmation from the CRA that a disclosure can be considered voluntary before proceeding to a “names” disclosure. The Federal Court’s decision will certainly be useful to other Canadian tax authorities offering similar programs.

Marc Gravel, Montréal
Yan Boyer, Montréal

Principal residence as a tax shelter

In the housing market that we have seen in recent years, the sharp increase in the value of a principal residence represents an interesting tax shelter, given the exemption on capital gains you realize upon the sale of such a residence. At first glance, the rule seems simple: you live in a residence, you sell it and you do not pay tax on the gain made at the time of the sale. We will see that, in certain cases, the rules are much more complex.

Definition of principal residence and conditions
A house, a condominium, a mobile home, a houseboat, a share in a co-operative housing corporation, an apartment in a duplex or rental property: all these can be considered as a principal residence. This also includes the subjacent land of one half-hectare or less; for a larger area, the excess must be justifiable as necessary for the use and enjoyment of the residence. You must be a Canadian resident for each year in which your residence is designated as your principal residence. As long as you meet the requirements for Canadian residency, it is not necessary for this residence to be located in Canada: a residence that you occupy for a short period of time each year, such as a cottage or condominium in Florida, is eligible.

The taxpayer’s intention counts
At the time of purchase, the taxpayer must intend to “ordinarily inhabit” the property. If the intention is to resell in the near future, the property may be considered as goods in inventory and not as a capital property. In this case, not only does the gain not qualify for the tax exemption, it is fully taxable! This situation mainly targets those who work in real estate (such as brokers, builders and architects) and who are involved in quick buy-and-sell transactions (e.g., one transaction per year over a three-year period).

Capital gain exemption – General rule
The capital gain realized upon the sale of the property will not be taxable if the property qualifies as a principal residence for all the years after 1971 in which you have owned it. The formula for calculating the exemption is

1 + the number of tax years that you designate after 1971
during which the property is your principal residence and
during which you are a resident of Canada
__________________________________________________ X capital gain
the number of years after 1971 during which you own the
residence.

Both the numerator and the denominator include the complete years in which you acquired and disposed of the property; the additional year addresses overlapping situations in which you possess a new principal residence at the same time as you have not yet sold the former one. The law provides that the above fraction cannot exceed 1, thus cancelling any inappropriate result arising from the addition of the extra year.

In most cases, members of the same family unit (including the owner, the spouse and minor children) who own only one principal residence during the relevant period can benefit from the federal principal residence exemption simply by not declaring the sale in their income tax return. For more complex situations, the federal T-2091 form must be completed. In Québec, the TP-274 form is required in all cases.

Complex situations
Owning two residences at once. Members of the same family unit are owners of a city residence and a country cottage. When you sell one of the properties, you must choose whether to designate, partially or in full, the years of ownership of the property as your principal residence, bearing in mind that the years thus designated are then rendered unavailable for the same treatment when you come to sell the second property. Therefore, the following factors must be taken into account:

Which property has increased more in value?
Which property is likely to increase more in value in the future?
Are there available or possible capital losses that could be deducted against the capital gain that occurred at the time of the sale of the property?

Two residences acquired prior to 1982. Before 1982, two taxpayers from the same family unit (e.g., two spouses) could claim the principal residence exemption on their respective properties. After 1981, the regulations changed and only a single principal residence per family (taxpayer, spouse and minor children) is allowed.

When one of the two properties is sold, the designation of principal residence can be made without complication for years prior to 1982. However, as stated above, for years subsequent to 1981, the choice of principal residence in terms of one of the two properties signifies that the years designated will not be usable at the time of the sale of the second property.

In addition, the legislation allows taking into account the value of the property at December 31, 1981 versus its value at the time of the sale.

Election of $100,000 in capital gains in 1994. Add to all this that taxpayers could elect to be exempted from $100,000 in capital gains on their property in 1994 and you have all the pieces of the puzzle!

A few tips

If you and your immediate family have only one principal residence, you can sleep at night!
If you purchase and then quickly resell several residences within a short period of time, proceed with caution.
If you, or you and your immediate family, own two principal residences, you should analyze the choices available when selling either of the two properties.

Sylvain Monarque, Laval
Mélanie Méthot, Laval

A new plan replaces the Québec Stock Savings Plan

In its 2005-06 budget presented on April 21, 2005, the Québec government announced the termination of the Québec Stock Savings Plan (QSSP), following the moratorium on this plan since June 12, 2003. Henceforth, no investment or public offering will be recognized as part of the QSSP. Moreover, any rights to a deduction under the former QSSP must be exercised no later than December 31, 2005.

After abolishing the QSSP, the government planned to introduce a new stock savings plan for small and medium-sized enterprises (SMEs) called “SME Growth Stock”. Although this new plan is largely based on the former QSSP regime, it is different in that it is geared to smaller-sized Québec corporations, is simpler than the QSSP and is subject to tighter application criteria. The new plan will apply beginning April 22, 2005, and will end on December 31, 2009.

The plan’s appeal for SMEs
SME Growth Stock consists essentially of an arrangement between an individual and a broker or an investment fund, under the terms of which the individual entrusts the co-contractor with the custody of his eligible securities that will not be included in any other plan.

The new plan is geared at Canadian corporations

whose assets are less than $100 million;
whose senior management is in Québec;
which paid more than half of the salaries to its employees of an establishment located in Québec during its last taxation year ended before the date of the receipt of the final prospectus;
which, throughout the twelve months preceding that date, had at least five full-time employees who were not insiders or persons related to them;
which had no more than 50% of the value of its property consisting of investments.

An eligible issuing corporation that makes a public offering of shares under the new plan will be required to take the necessary measures to have its shares listed on a Canadian stock exchange. In addition, this plan will be limited to common shares with an unrestricted voting right, and must have been covered by a favourable advance ruling by Revenue Québec.

Through the new SME Growth Stock, the government aims to stimulate and facilitate public growth and expansion financings of Québec SMEs by enabling them to increase their size and improve their position in their market segments. Consequently, corporations benefiting from SME Growth Stock should be able to make public offerings, whereas in the past, the interest shown by investors was insufficient, and therefore they will have easier access to the financing sources essential to their development.

The plan’s appeal for investors
In order to attract investors, the rules of SME Growth Stock allow investors to deduct 100% of the adjusted cost of the acquired eligible securities. This cost is determined without taking into account the costs for borrowing, brokerage, custody or other similar relevant expenses. However, this deduction will be limited to a maximum of 10% of the individual’s total income for the investment year.

In addition, to avoid having to include as income the adjusted cost of the eligible securities that have been disposed of, an individual investor will be obliged to hold the eligible securities having an adjusted cost at least equal to the amount deducted at December 31 of the year of acquisition as well as on December 31 of the three subsequent taxation years. In order to ensure that the capital injected into a particular market segment remains invested for the duration of the plan, the concept of “coverage deficiency amount” will be introduced, meaning that all the shares included in the plan and being disposed of must be replaced within 21 days and not only by December 31, as was the case with the QSSP.

All in all, the new SME Growth Stock seems to compensate for the main shortcomings of the former QSSP regime. Despite the fact that it is still too early to determine its success, the partners participating in the project should reap its benefits. In fact, if the new plan’s objectives are reached, eligible SMEs in Québec should be in a position to have easier access to financing sources in order to grow and expand their business, and the tax consequences related to this plan should please the various investors.

Guy Laroche, Sherbrooke
Annie Lemoine, Sherbrooke

Did you know that . . .

Prescribed interest rates for the third quarter. The prescribed interest rates that apply for federal income tax purposes for the third quarter of 2005 are the same as the rates in effect during the first half of 2005. The rates in effect from July 1 to September 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, the respective rates are 7%, 1.55% (1.65% in the second quarter) and 3%.
Changes to Québec’s drug insurance plan. Starting July 1, 2005, individuals in Québec who are age 65 or older and receive the maximum amount of the federal Guaranteed Income Supplement are entitled to free prescription drugs under Québec’s Public Prescription Drug Insurance Plan. On the same date, the annual premium for many individuals under the plan rose by 5.4% and the deductible amount that people have to pay in a pharmacy for their first purchase of the month increased to $11.90.
Revocation of advance tax rulings from the CRA. An advance income tax ruling is not binding on the Canada Revenue Agency (CRA) if there has been a material omission or misrepresentation in the statement of relevant facts or proposed transactions submitted by the taxpayer or the taxpayer’s representative. The taxpayer will be notified in writing if a ruling is being revoked, according to a statement made by the CRA at the last annual conference of the Canadian Tax Foundation.

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