May 2011

A PDF version of this article can be downloaded below.

The CRA places more scrutiny on high net worth individuals
Creditor proofers, beware the smoking gun!
Selling a business: enjoy your cake and icing too
Partnership filings for all…well, at least most

Welcome to our spring 2011 edition of Privately Speaking — Tax Insights, bringing tax ideas and guidance to the owners and managers of private companies in Canada. As the Canadian economy continues to strengthen, my colleagues look at four very interesting tax issues. I invite you to share this release with anyone who will be interested to learn about a raised CRA focus on high net worth individuals, a recent court decision affecting how assets are protected from creditors, tips on selling your business, and changes to tax filings for partnerships.

The authors, our editorial team (noted in the margin) and your local contacts are all pleased to discuss these issues or any other tax matters that concern you. Please feel free to contact any one of us.

Enjoy the newsletter,

Jim MacGowan, National Tax Leader, Private Company Services

The CRA places more scrutiny on high net worth individuals

By Lorn Kutner

A tax controversy occurs when the tax authority (e.g., the Canada Revenue Agency (CRA)) challenges a taxpayer’s position. Because the CRA’s audit focus has historically been on large corporations and specific taxpayer issues, most Canadians have never experienced a tax controversy. However, the landscape is shifting and the CRA has introduced initiatives that bring closer attention to high net worth individuals.

This heightened scrutiny results from increased international cooperation among revenue authorities. Simply put, tax administration is going global. Networks, including the Organisation for Economic Co-operation and Development and the Joint International Tax Shelter Information Centre, have facilitated information sharing and the creation of international strategies by revenue authorities to combat what is perceived to be abusive tax planning.

In Canada, this approach has taken the form of the CRA’s Related Party Initiative (RPI), which is focusing on individual taxpayers with a net worth of more than $50 million and/or with a complex structure of related entities. The CRA’s investigative activity under the RPI can be expected to be far-reaching. Some high net worth individuals have already received a 21-page questionnaire that probes many aspects of a taxpayer’s wealth, and requests:

• Information on associations with unlisted companies, private trusts, partnerships, joint ventures and other entities, foreign and domestic
• Information on personal bank or investment holdings, foreign and domestic
• Organizational charts showing the relationships among all entities noted

Additional information may be requested, including:

• Copies of board of directors meeting minutes and the corporate minute book
• Copies of correspondence with legal and accounting firms used by the corporate group
• Copies of tax planning documents

An audit in one area may open doors to the examination of other related entities and/or individuals. Rather than assigning a junior CRA auditor to review the audit risk for a particular individual or entity, under this new model the CRA is employing more experienced auditors who will look at a taxpayer’s entire range of financial interests to assess audit risk. As a result, high net worth individuals not only face a higher probability of involvement in a tax controversy, but may also encounter a lengthier and more complex audit process.

Whether a taxpayer is involved in a simple inquiry or an extended examination, the response must be timely and provided with due care. Managing a tax controversy is as much an art as it is a science and it involves a host of considerations. This process can quickly become a burden that exceeds the expertise and the resources of an individual or a family office. Consider the following issues:

• How will you obtain the necessary information and how quickly?
• Which documents will you provide to the auditor?
• Which information or documents should you not provide to the auditor?
• Who is best suited to present your argument?
• Should you involve legal counsel?
• To what extent should you communicate with others who may be affected by the outcome of your audit?
• When is it beneficial to consider a negotiated settlement?

Interacting with the CRA with respect to a tax controversy will never be enjoyable. Nonetheless, you should not be concerned if your affairs are properly executed and adequately documented. Consider contacting your Deloitte tax specialist prior to any contact with the CRA to ensure that your planning is sound and the documentation is appropriate. Certainly, if you do receive an inquiry from the CRA please contact us to assist with your response and guide you through the process.

Lorn Kutner is a tax partner in the Greater Toronto Area.

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Creditor proofers, beware the smoking gun!

By Dallas McMurtrie

Asset protection is a common concern for private companies and their shareholders. Entrepreneurs who have spent years building their businesses want to ensure that their capital is protected for retirement and in many cases, for future generations to enjoy. Often planning is undertaken to protect these assets from creditors. A recent court decision in British Columbia illustrates the ability of the courts to defeat arrangements motivated by “creditor proofing”. The case of Abakhan & Associates Inc. (trustee for Botham Holdings Ltd., a bankrupt) vs. Braydon Investments Ltd. is causing tax practitioners and their clients to take notice; and it’s not even an income tax case.  The facts are numerous and the transactions complicated. However, the following summarizes the relevant points.

Botham Holdings Limited (BHL) owned approximately $20 million of real estate assets. Sometime in 2005, its management decided to enter into a new business venture, the leasing of automobiles with a third-party. The plan was to purchase a portfolio of leases from a failed auto business. In order for BHL to receive tax benefits from the new venture, the business was structured as a partnership with BHL as a general partner.

BHL’s management sought professional legal and tax advice from a respected law firm. Among other things, the management did not want to risk BHL’s real estate assets in the event that the new venture failed. The advisors proposed a complicated series of transactions whereby the real estate assets were transferred on a tax-deferred basis to a holding company owned by the shareholders of BHL (the “BHL – Braydon Transaction”). This transaction was completed on October 31, 2005.

Unfortunately, the new business venture failed, and the partnership and BHL were placed into bankruptcy in May of 2007. By that time, creditors were owed in excess of $20 million. In an attempt to recover additional funds for creditors, the plaintiff (the bankruptcy trustee) argued that the BHL – Braydon Transaction was a fraudulent conveyance within the meaning of the Fraudulent Conveyance Act (British Columbia) (the Act). In short, a fraudulent conveyance under that Act is a transfer made with the intention of having the effect of hindering or impairing the right of a creditor and others. Interestingly, the term “creditors and others” has a broad interpretation; specifically, the original judgment indicated that the term “creditors and others” in the Act includes present creditors, future creditors and those who may become creditors of a debtor.

Based on the evidence, the court found that the BHL – Braydon Transaction was a fraudulent conveyance. What was this evidence? The court cited a planning letter for the BHL – Braydon Transaction that was entered into evidence. The letter from BHL’s legal counsel to BHL indicated that one of the objectives of the BHL – Braydon Transaction was to “…ensure that BHL’s real property and other assets are not exposed to its new leasing venture”. The plaintiff also introduced several of statements made by BHL’s management from discovery in court. In particular, the management agreed that one of the objectives as stated in that letter was to ensure that BHL’s real estate assets were not at risk as a result of the new venture. Therefore, the court found that the intent of the transaction was to defeat BHL’s creditors.

The court’s decision was affirmed by the British Columbia Court of Appeal. The Supreme Court of Canada has declined to hear the case. While this case was decided on British Columbian law, it may apply to other provinces with similar legislation.

This case should be a concern to taxpayers who undertake transactions with the purpose of shielding assets from creditors who may or may not be in existence at the time of the transaction. Private companies often have holding companies in their corporate structures with arguably that purpose in mind. Caution and care must be exercised when drafting documents that state the intention of transactions. These documents may end of up in court and act as an unintended witness; the smoking gun.

Dallas McMurtrie is a tax senior manager in Vancouver.

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Selling a business: enjoy your cake and icing too

By Tony Fimognari and Justin Abrams

Selling your business should be an exciting and satisfying experience, but it should never be rushed. To ensure that your transaction runs smoothly and is financially rewarding, here are a few tips to consider:

Plan early
Don’t wait for an offer to fall on your desk before you consider the possibility of selling your business.

Well before you intend to let go of the reins, consider introducing holding companies or family trusts into your corporate structure to facilitate tax deferrals. A well-planned corporate structure can allow you to multiply the $750,000 lifetime capital gains exemption (LCGE) among family members to share this incentive and to take advantage of lower income tax brackets and graduated tax rates.

Tax planning techniques can rarely be implemented or effective when contemplated at the eleventh hour.

Communicate your goals to your advisors
Your business and personal goals can significantly affect the amount of after-tax proceeds resulting from a transaction.

For example, when the business is sold, do you want access to the cash immediately, or would you like to invest the proceeds and defer tax to a future date? If you don’t require an abundance of cash in the short-term and/or you want to re-invest the after-tax sale proceeds within the corporate group, the use of holding companies as sales vehicles can provide a significant deferral of personal tax.

If increased cash flow is your primary objective, consider refinancing your current debt arrangements or incurring new debt to access cash without having to partially or fully sell your business.

It is critical to convey these goals to your financial and tax advisors up front as this will allow them to structure your deal in a way that best benefits you.

Deal structure
A common misconception is that vendors always prefer to sell the shares of a business rather than to structure the transaction as a sale of its assets. In reality, such a decision should be based on your circumstances. Furthermore, reductions to corporate tax rates in recent years have significantly altered traditional schools of thought in this area.

A share sale can allow you to use your LCGE and allows the purchaser to assume operations with little to no disruption to the day-to-day activities of the business. If it is important to you to retain a partial interest in the business, a share sale may allow this.

An asset sale on the other hand can be used as a negotiation tool as a potential purchaser will benefit from the increase to the cost of the assets, which creates tax deductions to offset future income.

Earnouts and reverse earnouts
An “earnout” is a future milestone (e.g., gross revenue) that, if it occurs, alters the purchase price. The tax treatment of an earnout can vary significantly depending on how the deal is structured. In most cases, where an earnout provides additional proceeds when conditions are met, unless specific CRA guidelines are met, these proceeds will have to be included on account of income by the vendor, resulting in a higher effective tax rate.

Alternatively, a reverse earnout should be considered, whereby proceeds are payable upfront to the vendor and are returned by the vendor if certain specified events fail to materialize. A reverse earnout generally results in capital gains treatment to the vendor, providing for a more tax-efficient result.

All things considered, a myriad of tax planning options exist to meet the objectives of both the vendor and the purchaser. Explore the alternatives before committing to a deal structure; the dollar impact to both parties is usually quite significant.

There are several simple planning methods and critical factors that are often overlooked. Common items include:

• Consider the extraction of safe income within the corporate group prior to, or in conjunction with, a share sale. Safe income is a complicated concept but generally is considered to be the after-tax retained earnings of a corporation. Depending on which company is being sold within the group, the capital gain realized on the sale can be reduced to the extent that there is safe income available in that company.
• Take advantage of existing tax attributes. For example, if there are companies within the corporate group that have losses, a capital dividend account, refundable dividend tax on hand balances, high paid-up capital or assets with an accelerated write-off percentage, such as software or manufacturing processing , planning should be undertaken to maximize the amount of tax that can be sheltered via such “tax-friendly” attributes.

Overall, selling a business is a complicated and often stressful endeavour in its own right. Years of hard work and sweat are invested in building the business; designing the appropriate divestiture strategy is often the icing on the cake!

Tony Fimognari is a tax senior analyst and Justin Abrams is a tax manager. Both are in the Greater Toronto Area.

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Partnership filings for all…well, at least most

By Patricia McDougall

Beginning in 1989, Canadian partnerships or partnerships carrying on business in Canada were required to file an annual partnership information return; federal Form T5013. However, an exemption to this was generally granted by the Canada Revenue Agency (CRA) to partnerships with fewer than six partners where no partner was itself another partnership.

On September 17, 2010, the CRA announced changes to this exemption that emphasize financial criteria over the number of partners. The CRA’s new administrative policy applies to Canadian partnerships with Canadian or foreign operations or investments, and partnerships with fiscal periods ending after December 31, 2010 carrying on a business in Canada. These partnerships must file a Form T5013 for each fiscal period of the partnership if:

• At the end of the fiscal period, the partnership has an absolute value of revenue plus an absolute value of expenses of more than $2 million, or assets valued at more than $5 million, or
• At anytime during the fiscal period, the partnership:
• Has a corporation or trust as a partner
• Is a tiered partnership where it has another partnership as a partner or is itself a partner in another partnership
• Invested in flow-through shares of a principal-business corporation that incurred Canadian resource expenses and renounced those expenses to the partnership, or
• Is requested by the Minister of National Revenue to file form T5013

To determine whether a partnership exceeds the $2 million absolute value threshold, total gross revenues are added to total expenses (without regard to the positive or negative sign). The figures used in the formula are taken from the partnership’s financial statements and expenses include depreciation.

The cost amount of all the tangible and intangible assets of the partnership before accumulated depreciation is used to determine whether the partnership has exceeded the $5 million in assets requirement.

The CRA can assess penalties and interest to a partnership and its partners where form T5013 is filed late, where there is a failure to file form T5013, or where information slips are delivered late to the recipients.

With this change, we expect that many more partnerships will need to file form T5013 starting in 2011. Furthermore, the CRA indicates that there will be changes to the 2011 version of the form. To learn more about the CRA’s new administrative policy and the various versions of form T5013, visit www.cra.gc.ca/partnership or consult with your Deloitte tax advisor.

Patricia McDougall is a tax senior manager in Ottawa.

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This publication is produced by Deloitte & Touche LLP as an information service to clients and friends of the firm, and is not intended to substitute for competent professional advice. No action should be initiated without consulting your professional advisors. Your use of this document is at your own risk.