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Tax controversies and high net worth individuals


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9 March, 2011

A PDF version of this article can be downloaded below.

Prepare for a changing landscape

A tax controversy – a taxing authority’s examination and challenge of a tax position – could touch a high net worth individual in a number of ways. The individual could come under audit, or a family member, family office, closely-held company or other entity related to the individual could be subject to such a review.

Most Canadians have only limited experience with tax controversies. Traditionally, the Canada Revenue Agency (CRA) has focused primarily on large corporations and specifically identified individual taxpayer issues such as tax shelters deemed abusive. However, the landscape is shifting and the CRA has introduced initiatives that have brought closer attention to high net worth individuals.

The CRA’s greater scrutiny of high net worth individuals is one of a number of initiatives that have resulted from increased international cooperation among revenue authorities. Tax administration is going global – networks, including the Organisation for Economic Co-operation and Development (OECD) and the Joint International Tax Shelter Information Centre (JITSIC), have facilitated information sharing and the creation of international strategies by revenue authorities to combat what is perceived to be abusive tax planning. These coordinated globalized efforts are aimed at ensuring tax compliance both domestically and internationally.

As a result, wealthy 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.

What are the CRA’s recent initiatives in respect of high net worth individuals?

The CRA’s Related Party Initiative (RPI) 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 audit approach involves a cadre of senior auditors from all regions of Canada, including specialists in key technical disciplines. Most significantly, it poses the potential for an audit in one area to open doors to the examination of other related entities and/or individuals.

The RPI is designed to provide a closer review of certain issues associated with wealthy individuals, including matters related to partnership income, trusts, corporations, joint ventures, private foundations, personal bank accounts, interests in foreign assets, and complex planning techniques that achieve a reduction in taxable income.

In addition, the CRA is taking a closer look at the use of trusts in tax planning generally for all levels of income earners.

How will these initiatives change the scope and volume of audit activity?

The CRA’s investigative activity can be expected to be far-reaching. Some high net worth individuals have already received a lengthy questionnaire, in excess of 20 pages. This questionnaire 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, and
  • financial statements for all years under review for 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, and
  • copies of tax planning documents.

Rather than assigning a CRA auditor to review a specific tax return and identifying an audit risk for a particular individual or entity, under this new model the CRA is employing more experienced auditors from across the country, and a taxpayer’s audit risk will be based on his or her entire range of financial interests.

What should taxpayers know about new transaction-based reporting requirements?

Information reporting requirements are expanding. Regimes to combat what is considered to be aggressive tax planning have been introduced federally and in Quebec. As these requirements are relatively new, they can be confusing. Failure to comply can be costly.

The federal reporting requirement (not yet enacted but proposed to be generally applicable to transactions occurring after 2010) may apply to any person obtaining a tax benefit from an avoidance transaction (as defined) that bears certain hallmarks, or a promoter or advisor in respect of such transaction. Reporting is due by June 30 of the year following the time of the transaction. A penalty applies for non-compliance.

The Quebec reporting regime features a mandatory disclosure requirement where a transaction bears certain hallmarks and meets a threshold tax benefit ($25,000) or a threshold impact on income ($100,000). This disclosure is due by the taxpayer’s tax return filing deadline for the year of the transaction. A penalty applies for non-compliance. As well, a preventive disclosure may be made within the same deadline in order to avoid the extension of the limitation period and the application of additional penalties where the general anti-avoidance rule is determined to apply to a transaction.

These reporting requirements should be carefully considered when tax planning is undertaken.

What can you do to assess risks and preparedness for facing a tax controversy?

A high net worth individual can and should assess audit readiness periodically. A good starting point is to identify areas of greatest risk. Consideration should be given to the areas of highest priority for the CRA, in consultation with your tax advisor.

Once you have identified any gaps or risks, you should think ahead about the documentation you would provide to a tax authority to support the tax position – and, just as importantly, how you would gather and deliver that information in the short period of time typically allowed for responding to an information request.

In this regard, it is advisable to establish specific procedures for retaining tax-related documents for the minimum statutory period. In addition, there may be some items that you should retain longer; for example, documentation supporting the cost basis of shares or other assets should be maintained in anticipation of future dispositions. As financial affairs grow in complexity, this becomes increasingly important and challenging.

What should you do if your assessment reveals past errors or omissions in filing?

Filing mistakes can be costly. Even so, if your assessment identifies a past mistake, such as a failure to comply with an information reporting requirement that will result in added taxes, interest and/or penalties, it is still in your best interest to file an amended return (or other appropriate documentation) voluntarily rather than waiting for the CRA or other revenue authority to discover the error. Depending on the circumstances, a formal Voluntary Disclosure might be appropriate. This process should be discussed with your tax advisor.

Also, keep in mind that the CRA and the provinces exchange information, so issues affecting one jurisdiction will likely flow to the other. If you self-report an issue in one jurisdiction, you should be prepared to do the same for others as appropriate. Furthermore, in this era of global cooperation and information exchange among revenue authorities, a domestic tax return amendment may have international implications that must be duly considered.

How long do tax controversies typically take to resolve?

Just because you may be required to respond to an inquiry on short order does not mean that you will hear the outcome in a similarly timely manner. In large part, the timeframe will depend on the complexity of the issues involved. However, as noted, the RPI subjects certain taxpayers to a level of audit traditionally reserved for large companies. For taxpayers selected for an audit under the RPI, the time to complete the audit could be up to three years, particularly if technical issues requiring referral to an international specialist or a valuations expert are involved.

What are some keys to managing tax controversy effectively?

Managing a tax controversy can involve much more than simply responding to information requests and following up to determine the status of the examination. Consider the following issues:

  • How will you obtain the necessary information and how quickly? Few individuals have the capacity to handle short-notice, complex information requests without impacting other responsibilities.
  • Which documents will you provide to the auditor? This requires some care to make sure that you are responding to the request with appropriate documentation for the issue being examined – not more and not less. Before handing over data, you should carefully consider the potential direction and implications of the examination and be prepared to respond to the next question that may be asked.
  • Who is best suited to present your argument? In the case of complex matters, there may be some critical decision-making related to who will participate in interviews should they arise. In addition, complex issues may require outside knowledge and experience in order to understand the implications and to articulate the taxpayer’s position.
  • Should you consider involving legal counsel? In certain cases, for example where the circumstances indicate that litigation may ensue, it may be advisable to retain legal counsel and assert privilege over certain documents.
  • To what extent should you communicate with others who may be affected by the outcome of your audit? It must always be remembered that in circumstances where one individual or a related entity is audited, it is essential to communicate openly with others – within family businesses, with advisors, and with related individuals and entities.
  • When is it beneficial to consider a negotiated settlement? This is an important strategic decision and should be carefully considered, after consultation with related parties and advisors.

A high net worth individual can and should assess audit readiness periodically. A good starting point is to identify areas of greatest risk. Consideration should be given to the areas of highest priority for the CRA, in consultation with your tax advisor.

Discover the Deloitte difference

If you are facing a tax controversy, or require help in assessing your audit preparedness, your Deloitte advisor or one of our leaders listed below would be pleased to assist you.

Jim MacGowan
National tax leader, Private Company Services
403-298-5995
Shiraj Keshvani
Tax partner, Tax Controversy
613-751-5293
Heather Evans
Tax partner, Global Wealth and Employer Services
416-601-6472
Curtis Stewart
Partner, Deloitte Tax Law LLP
403-267-0503
Jean-Jacques Lefebvre
Tax partner, Tax Controversy
613-751-5270
 

 

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.