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 3: The Most Common Problem Areas
It is useful to identify some of the most common areas where contentious tax issues may arise. Simply knowing that a particular item is tax-sensitive and what to look for can help counsel avoid landmines and use their tax advisors in a timely and cost-efficient manner.
When Value Changes Hands, Think Tax
When value is conveyed from one person to another, tax people think about at least three things:
- Does sales/use tax (i.e., GST/HST) apply?
- Does the transferor realize a gain or profit for tax purposes?
- Is this a value-for-value transaction (and if not has a taxable benefit been conferred)?
In the case of property transfers, any excess of “proceeds of disposition” realized over the property’s “cost amount” generally triggers some form of gain or income for tax purposes.
While in most cases a property’s “proceeds of disposition” will be its fair market value (i.e., assuming two arm’s-length parties negotiating with adverse interests), this is not always so:
- In some cases, the tax statute may deem the “proceeds of disposition” to be more or less than a property’s fair market value (e.g., certain permissible tax-deferred transactions); and
- On non-arm’s-length transactions, the CRA has much greater ability to challenge whether the amount agreed on by the parties really is the property’s “fair market value.”
Counsel should understand that (1) a property’s “cost amount” for tax purposes may be quite different than its carrying value for accounting purposes, and (2) tax advisors will always want to know what a property’s “fair market value” (determined under general valuation principles) is, since that is what typically determines whether a tax gain or loss arises.
Consideration Takes Many Forms
The tax world is generally concerned with value, rather than just cash. This means that when determining the tax consequences of something, everything of value being conveyed needs to be included in the sale price, not just the cash component. Seller liabilities assumed by a purchaser, debts owing to a purchaser that are cancelled or reduced, significant obligations incurred by the payer for the recipient’s benefit, payments made to third parties on behalf of the seller (“constructive receipts”) and similar items of value are all included, which impacts:
- any sales taxes owing;
- the amount included in the recipient’s income for tax purposes (either directly as taxable income or as the amount of the seller’s proceeds of sale for purposes of determining any gain or loss from a disposition of property); and
- the amount (if any) deducted from of the payer’s income for tax purposes (either directly as a taxable deduction, or indirectly as part of the cost basis in any property acquired or expense incurred).
Non-cash consideration is a common source of income and sales tax disputes with the Canada Revenue Agency (CRA).
Employees vs. Independent Contractors
Payroll taxes are an area of frequent disputes between taxpayers and the CRA. This is because a variety of tax-related obligations (e.g., Canada Pension Plan premiums, Employment Insurance premiums, income tax payroll withholding and remittance obligations) apply exclusively in respect of employees, and the distinction between a taxpayer’s employees and other individual service providers (independent contractors) is often difficult to draw.
As a general rule, someone who is an employee under applicable employment law will also be an employee for tax purposes, meaning that the tax people will assume that whatever label has been put on someone for HR purposes is legally accurate. In close calls, the tax cost of being wrong is worth counsel’s extra attention to see what elements of the relationship can be adjusted to achieve the desired employee/contractor status, and ensure all resulting tax obligations are met.
Note that where an employer has failed to withhold and remit amounts as required, the CRA is generally permitted go back as many years as it wants to re-assess taxes, penalties and interest (i.e., no statute-barred limit). For more on this topic, read this article on doing business with and in Canada.
Unlike some other countries, Canada’s income tax system does not include a group or consolidation concept that combines income and losses from different entities into a single tax return. Instead, each legal entity computes its own income separately and pays its own taxes owing.
This means that transactions within a group of related entities (even if all within Canada) cannot be ignored for tax purposes simply because each entity is under common control. In particular, sales tax generally applies to all conveyances of value, and GST/HST audits frequently target related-party transactions.
Tax advisors need to be aware of each intra-group transaction made by each legal entity to accurately determine that entity’s tax liability, and the documentation and pricing of those transactions will matter for tax purposes even if it doesn’t for other purposes.
Dealing with Non-Residents
Whenever a Canadian resident deals with non-residents of Canada, a variety of additional and potentially expensive tax issues come into play. Withholding taxes are typically the most important of these, which create an obligation on a Canadian payer to withhold and remit to the CRA a percentage of the payment made to a non-resident.
Payments to non-residents that carry this obligation include:
- payments of dividends, royalties, and (in some cases) interest;
- payments relating to services to be performed in Canada (whether or not by a non-resident); and
- payments to acquire “taxable Canadian property” (e.g., land in Canada, shares of certain corporations that derive their value primarily from Canadian land, etc.).
There is no time limit for the CRA to re-assess the Canadian payer who fails to withhold on these payments to non-residents for the un-withheld amounts, plus interest and penalties. For more on this topic, read this article on payments from Canada.
A host of other tax issues may arise when the non-resident is also someone not dealing at arm’s length with the Canadian taxpayer (e.g., within a multinational group). These include:
- voluminous “transfer pricing” requirements (see below);
- rules governing debts owing between Canadians and non-arm’s length non-residents (cash pooling arrangements are a particular problem area); and
- time limits for actually paying deductible expenses incurred to non-arm’s length non-residents.
It is always good practice to alert your tax advisors whenever transactions with non-residents are involved, no matter how benign they seem.
For multinational groups, transfer pricing is often the single biggest demand on tax resources and source of conflict with tax authorities. Transfer pricing rules protect a country’s tax base by imposing the “arm’s-length standard” on transactions within the group. Put simply, Canada’s transfer pricing rules ensure that Canadians do not pay too much for goods and services they receive from, or receive too little for goods and services they provide to, non-residents with whom they do not deal at arm’s length.
Transfer pricing rules obligate the Canadian taxpayer to carefully consider how to price transactions with non-arm’s length non-residents, make sure fair market value consideration is received and paid, and then document in a timely manner the reasons why a particular pricing methodology was used (“contemporaneous documentation”).
Failure to do so exposes the taxpayer to significant re-assessment for extra income, withholding tax on any excess value conferred on the non-arm’s length non-resident, penalties and interest. These amounts can be enormous, so ensure your tax advisors are aware of all such transactions so that can they take steps to ensure compliance with transfer pricing rules. For more on this topic, read this article on Canadian subsidiaries.
Dealing with the CRA
The extent of counsel’s involvement in dealing with the CRA will depend on whether in-house tax capacity exists and how much external advisors are used. Many CRA–taxpayer disputes arise from a lack of understanding about the taxpayer’s business or its legal relationships (i.e., commercial law), which is understandable since tax auditors are external non-lawyers. Counsel can often be helpful in explaining these to tax auditors so that they apply the tax laws from the right commercial-law starting point.
Sophisticated taxpayers manage their relationships with tax authorities. Involve experienced tax counsel at the outset to develop an audit management plan and decide which battles to pick. CRA personnel are professionals doing a difficult job, and there is nothing gained from being needlessly uncooperative.
Properly handled, over-broad information demands can be narrowed appropriately to the circumstances. Provide what you can when you can (this keeps the audit moving), ask for extensions as early as possible, and explain what other materials you can’t or won’t provide.
CRA audits need to be actively managed, and there are right ways and wrong ways to do it.
Webpages & Public Filings
The CRA uses a variety of sources to obtain information about taxpayers that may be of interest. Corporate webpages are a window into your organization, and you should assume that a CRA auditor will review anything publicly available online to identify items of interest and verify the content against what the taxpayer has said in its tax filings. The same applies to filings on websites such as SEDAR, which contain management circulars, press releases and similar documents filed by public companies.
Giving your tax advisors the opportunity to review such material before it gets posted online is a wise practice, and can avoid an unfortunate or unhelpful choice of wording that triggers a lengthy and time-consuming inquiry (or worse) from the CRA.
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.