Tax law is a strange and mysterious world for many people, even most lawyers. The law is constantly changing, the concepts are challenging and the results are often counter-intuitive, making it a source of frustration for those forced to deal with it. Many businesses treat Tax (which is really just another area of law) as a completely separate department from Legal, making it that much more difficult to integrate the work of the two.
In over 30 years of practice, I have had the privilege of working with many in-house legal and tax departments, and have seen what works well and what could be improved. To help businesses and their legal groups get the most out of their tax advisors (internal and external) in a productive and cost-efficient way, I am sharing a series of three articles with tips and best practices. (Click on the links below for the other two articles.)
Part 1: How Tax Works
There are some fundamental principles underlying Canada’s tax system that are very helpful to set out at the beginning because they act as a lens through which the tax world should be viewed. Understanding these makes understanding tax much easier.
Tax Is Not Accounting
The courts have made very clear that tax liability is determined using the tax statute and not accounting rules. While the accounting treatment of a particular transaction or payment often agrees with the tax treatment, this is not necessarily so and should not be assumed. Some of the core concepts underlying accounting (e.g., the conservatism principle requiring less certainty to recognize liabilities than income) do not exist in tax statutes. Moreover, in many cases tax provisions have been written with specific policy objectives in mind that are not part of the accounting world.
While it is certainly useful to know how accounting rules treat a particular item, you can never assume that the tax treatment corresponds with the accounting for it: they are separate sets of rules with different objectives.
Lawyers and Accountants
While tax lawyers and tax accountants may both very knowledgeable about tax, their training and perspective are not the same and there are important differences to be aware of, including the following:
● Accountants cannot give tax law advice on a privileged basis, and you should assume that tax authorities can and will see their work product and communications;
- Accountants will have a much better understanding than lawyers as to the accounting implications of different tax alternatives (which are often especially important for public companies);
- Accountants generally see much greater volume of work in the compliance/filing area (e.g., tax returns, election forms, etc.) and in most cases can handle this more efficiently than lawyers;
- Lawyers will generally have a much better understanding than accountants of the non-tax legal rights and obligations (e.g., commercial law) that serve as the basis for applying tax statutes, and are also more experienced in statutory interpretation and document drafting; and
- Accountants typically seek to limit their liability for incorrect advice under the terms of their engagement (usually to a maximum based on fees paid), which lawyers are generally unable to do.
Things Don’t Exist “For Tax Purposes”
Tax law is best thought of as an overlay of specific rules in the tax statutes that apply to whatever legal rights, obligations and relationships the taxpayer has created under non-tax (i.e., commercial, securities, employment) law. In Canada, there is generally no such thing as creating something “for tax purposes”: if you create a lease under commercial law, it’s a lease for tax purposes too. (There may be special tax rules about how leases get taxed, but you still start from the fact it’s a lease.)
Anyone who says they’ve done something “for tax purposes” either is referring to the motivation for (rather than the legal effect of) a transaction or doesn’t understand how Canada’s tax system works.
Documentation Evidences Legal Relationships
Since tax applies to the parties’ legal rights and obligations, establishing what they are is essential. In re-assessing a taxpayer, the Canada Revenue Agency (CRA) is allowed to make whatever plausible assumptions it wants, and the onus is on the taxpayer to refute them.
As a practical matter, this means that it is hard for a taxpayer to prove anything that hasn’t been suitably documented. While verbal agreements can be legally binding, they are difficult to establish as an evidentiary matter, and the CRA can be expected to challenge anything that isn’t written and signed, with the taxpayer bearing the onus of convincing a court otherwise.
Counsel should ensure that material legal relationships have been properly documented, and treat this an opportunity to clearly articulate the parties’ rights and responsibilities in a way that supports what the parties are trying to achieve.
There is Nothing Wrong with Tax Planning
With the exception of a few specific provisions in the tax statute, a taxpayer’s purpose in entering into a particular course of action is generally irrelevant to the tax results. In fact, the Supreme Court of Canada has explicitly stated that:
- “taxpayers have the right to order their affairs to minimize tax payable” (Jean Coutu Group Inc. v. Canada, 2016); and
- “Unless the Act provides otherwise, a taxpayer is entitled to be taxed based on what it actually did, not based on what it could have done, and certainly not based on what a less sophisticated taxpayer might have done.” (Shell Canada Ltd. v. Canada, 1999).
Tax planning within the rules is perfectly fair (CRA auditors sometimes need to be reminded of these authorities), and it is usually worth some effort to explore better versus worse ways of achieving a given commercial result from a tax perspective.
Value is Value
There is no such thing as “value for tax purposes”: when interpreting and applying Canadian tax law, taxpayers and the CRA are both required to use the same definition of “fair market value” that applies generally. Tax advisors are not valuators and have no particular insight as to what the “fair market value” of any particular property is but are definitely interested in what that amount is. Where the amounts are significant, getting qualified valuation advice is desirable and worth the cost to forestall a CRA challenge to the taxpayer’s estimate of value.
Categories and Labels Matter
Not all amounts are taxed the same way. Dividends are taxed differently from business income, which is taxed differently than royalties, which are taxed differently than employment income. Which category an amount falls into matters greatly. This means that it is essential to:
- involve your tax advisors to identify the tax differences of one type of payment versus another; and
- make sure that the amount in fact meets whatever legal tests are required for it to have the desired legal character.
While the label the parties put on something in the documentation is not determinative (i.e., calling a sale a lease does not make it a lease), as a practical matter the description used in the documentation certainly matters. The importance of this was shown recently in a sales tax case where the appeal court split 2-1 on whether the subject matter of the transaction was a property or a service (which had much different tax consequences).
Put simply, different forms of property, services or payments fall into different categories under tax statutes and are taxed differently, so descriptive wording matters. Ensuring that the text is drafted with the desired tax result in mind makes it far more likely to achieve that result. It is hard to overstate the importance of getting tax law advice on choosing the optimal legal character of a payment, and drafting the documents that will both evidence the parties’ respective legal rights and obligations and characterize the subject matter.
Legally Effective Transactions
Parties that fail to create the legal rights, obligations and relationships they were hoping for will not typically get the tax results they intended. While commercial law is not the CRA’s strong suit, they have access to lawyers in the Department of Justice (the CRA’s legal counsel) and are perfectly entitled to confirm that the taxpayer has done what it intended to do as a matter of non-tax law, be that establishing a trust or partnership, issuing shares, creating a debt or taking any other legal step.
The courts have made very clear that the CRA is obligated to apply the tax statutes to the taxpayer’s actual legal relationships; that also means that the taxpayer bears the cost of any deficiencies (i.e., “I meant to create a trust” generally isn’t good enough). Counsel should ensure that the intended steps are in fact legally effective in order to achieve the desired tax result.
Acting Consistently with the Documents
Having appropriate documentation is a necessary but not necessarily sufficient element of achieving the desired tax results. Taxpayers must actually conduct themselves in a manner consistent with the documentation they rely on to established the legal rights, obligations and relationships they claim exist. Relying on a foreign director of a corporation to establish its tax residence in a particular country likely won’t work if that person really makes no independent decisions and simply follows instructions from someone in Canada, viz. a director in name only.
If someone doesn’t respect their own documentation, the CRA and the courts likely won’t either, and for this reason counsel needs to make sure that people are acting in accordance with it (and alert the tax people if they are not).
Where Purpose Matters
There are a small number of tax provisions whose text specifically refers to a taxpayer’s purpose in doing something. These include the “general anti-avoidance rule” (GAAR), a remedy of last resort for the CRA where a taxpayer does something that complies with the letter of the tax statute but has a tax avoidance motive and constitutes an abuse or misuse of the rules. It is generally helpful from a tax perspective to memorialize and document the non-tax purposes of the taxpayer’s actions, as the GAAR cases involving commercially motivated transactions done in a tax-effective way are much friendlier to taxpayers than those involving tax-driven transactions.
Rectification and rescission are equitable common-law remedies that are available in limited circumstances to correct or reverse transactions where the parties’ intent is not accurately described in the relevant documentation or an unjust result occurs due to a mistake by one or both parties. In either case, it can be extremely helpful to express the parties’ purposes and intentions for entering into the relevant transactions in the document recitals in order to facilitate a later claim for such relief if needed.
CRA Statements are Not the Law
The CRA frequently takes positions that are simply not legally correct. Some of these are instances of genuine interpretational uncertainty where a court could reasonably decide either way. In others, the CRA has developed an administrative policy that reflects what the CRA wishes the law says, rather than what it does say. While it is always useful to know what the CRA’s stated position is in order to understand the likelihood of an audit challenge, it is important not to accept every CRA statement at face value.
Steve Suarez is Partner at BLG. He works exclusively on income tax matters, focusing on mergers and acquisitions, inbound and outbound investment, corporate restructurings and audit management, and tax dispute resolution. He is also the creator of www.businesstaxcanada.com, a website that describes Canadian business tax issues for non-tax people.