Category: Advocis Forum

Sometimes you can beat City Hall, or rather CRA

As we close out the year and head into RRSP season (I know that term makes some bristle, but it’s a practical reality for many others), here’s an exasperating decade-long battle to mull over.

Where it all began

Back in September 1997, Lindsay Kerr received her Notice of Assessment for her 1996 tax year.  The NOA showed her 1997 RRSP contribution limit to be about four times what it had been in recent years, even though nothing had happened in her employment, income sources or other circumstances that would have explained the jump.  

While she suspected a possible error, Lindsay proceeded to contribute $8,121 into her RRSP in February 2008.  As it turned out, this was far in excess of the $794 she was actually entitled to, though it would be years before this came to full light.  Complicating the arithmetic, and potentially compounding the problem, Lindsay had earlier exercised her prerogative to make a one-time over-contribution of $2,000 so that in total she had made excess contributions of $9,327.

Then Lindsay took a break.  Having no taxes owing in the following years, she did not file tax returns from 1997 to 2002.

The early correspondence

A couple of years on, Lindsay was solicited by CRA to file returns for those missing years.  The letter, received in February 1999, advised her that all taxpayers are required to file an annual tax return in specific situations, none of which applied to her. Specifically, she did not owe any taxes for those years.

Lindsay spoke to CRA on a number of occasions by phone to obtain filing extensions, but eventually she was served with arbitrary tax assessments for 1999 and 2000.  Faced with the prospect of paying taxes she knew she did not owe, in November 2003 Lindsay filed returns for 1997-2002.  As it turned out, indeed there were no taxes owing; in fact, refunds were paid for all the years.

Error discovered, penalty tax assessed

On filing the 1997 return in 2003, Lindsay properly recorded the $794 contribution limit, though there was no paper trail to explain how she came upon this information. 

Still, as a result of this disclosure, Lindsay was assessed the 1% monthly penalty tax for the duration of the over-contribution.  By the time the matter was heard in court in the fall of 2008, she had paid $11,270 in taxes, penalties and interest.

The odyssey: Requesting a waiver

While it would be difficult to say that Lindsay was completely innocent of knowledge of the error, the fact is that she relied on the official documents as she was entitled to do.  On that basis, she applied for a waiver of the penalty tax in September, 2004.

The first CRA response explicitly stated that each individual may make RRSP contributions within the limit “provided on the Notice of Assessment each year.”  A later internal report in 2007 found that CRA “had originally provided an incorrect amount and (it appears) we had never advised the taxpayer, in writing, that her revised 1997 RRSP deduction limit was $794.”

On her second request in September 2005, an administrative review, the content of the denial letter included a comment that “you should have been aware that the amount in Box 52 of your T4 slip is required to be reported on your return.”  Again, the 2007 report found fault: “This statement is of concern because, according to the copy of the 1996 return provided to us by the taxpayer, she did report the correct amount in box 206.”  Box 52 is the pension adjustment to be reported in Line 206: Lindsay entered it correctly; CRA transcribed it incorrectly and then apparently still blamed her for its error. 

On her third request in June 2006, Lindsay specifically asked for a different tax office to handle the review – No doubt there had been some acrimony over the years of wrangling.  That earlier mentioned 2007 internal report was the basis for the ultimate decision in July 2007, at which time Lindsay was again denied, this time on the basis she had not made “reasonable errors” in failing to report the appropriate amounts.  This was despite that the only official record was acknowledged by CRA to be that original erroneous NOA.

Oh, that independent 2007 report?  Despite Lindsay’s request (and CRA’s assurance) for an independent review, it was first approved by an official at the original office before being given to the senior official who wrote to Lindsay.  And to boot, a memorandum obtained from a Privacy Act request revealed that that final writer had some critical misapprehensions of the facts, and appeared to show a bias against Lindsay for not having filed returns in those interevening years … years she was not obligated to file returns.

Judgment for the Applicant    

Incredibly, there were even more twists and turns in this case, but in the end the court was convinced that Lindsay was entitled to the relief she sought.  An order was issued in September ’08 stating that her errors were reasonable, as were her corrective steps, and as a result she was entitled to the return of her $11,270.

Your own resolutions?  Pay close attention to your Notice of Assessment (checkin’ it twice?), keep good written records of your communications with CRA, and maybe hug a judge this new year’s.

2008 An Investor’s Tax Year in Review

Whether you’re inclined to say, “It’s not about the income, it’s about the outcome,” or maybe, “It’s not how you make out, it’s what you take out,” tax is the difference between the top line and the bottom line.

As 2008 comes to a close, here is a look back at the significant tax developments that have occurred over the last year or so.

Federal Budget 2007 – Holdovers 

Pension splitting

Announced in last year’s Budget, pension splitting became a tangible reality in 2008 for pensioners preparing their 2007 tax returns.  The rules allow for up to 50% of eligible pension income to be split over to the pensioner’s spouse.

Apart from potentially shifting income to a lower bracket taxpayer, related benefits may include reducing clawbacks on Old Age Security and the age 65 credit, and doubling up access to the pension credit if the receiving spouse does not already have his or her own eligible pension income.

While the change certainly provides relief for many seniors, there remains a sore spot: For pensioners under 65 to qualify, the income must originate from a registered pension plan (or via a pre-deceasing spouse’s RRSP, RRIF or DPSP).  Indeed, in its submissions this past summer for the 2009 Federal Budget, the Investment Funds Institute of Canada suggested that pension splitting be allowed at age 55 for all registered plans.  This would certainly level the playing field for those not having the benefit of a registered pension plan.

Whatever may happen, this is welcome development, and likely a standing feature of our tax system for the foreseeable future.

RDSPs

The Registered Disability Savings Plan was announced in the 2007 Budget, to be available for deposits beginning in 2008.  These plans will allow for deposits of up to $200,000 to grow tax-sheltered for qualified disabled beneficiaries.  As a further boost, deposits will be augmented by federal matching grants of up to 300% of deposits, as well as free bond money being available based on family net income.

Unfortunately, to date no plans have been able to be put in place as the financial service industry awaits necessary administrative details from the federal government.  During an informational program attended by the writer in late spring, a representative from Human Resources and Social Development Canada (HRSDC) stated that those details will be delivered by December, 2008, so we may see plans made available by early 2009.  

RRIF conversions

The end of 2008 will also see the end of the transitional period related to the move of the commencement of mandatory RRIF withdrawals from age 69 to age 71.  In 2007 and 2008, these rules allowed for RRSP or RRIF re-contributions for certain age 70 and 71 individuals.  In 2009, we will again simply need to be aware that those RRSP annuitants attaining age 71 in the calendar year must convert their RRSP to a RRIF, purchase an annuity or cash their RRSP.

Federal Budget 2008

TFSAs

By far the most significant development of the last year was the announcement of the new Tax-Free Savings Account.  In this writer’s opinion, it is in fact the biggest change in how Canadians will manage money since the creation of the RRSP in 1957, and time may prove it out to be even bigger yet.  

As stated in the Budget document, “This flexible, registered, general-purpose account will allow Canadians to watch their savings – including interest income, dividend payments and capital gains – grow tax-free.”

Beginning in 2009, each Canadian resident taxpayer age 18 or older will be entitled to place up to $5,000 annually into a TFSA account.  This limit will be indexed annually, but will only increase when the resulting figure rounds up to the next $500 level.  Unused contribution room may be carried forward indefinitely.

In contrast to the RRSP/RRIF regime where deposits are pre-tax and withdrawals are taxable, the TFSA receives after-tax funds and withdrawals are 100% tax-free.  (Of course both types of plans allow tax-sheltered accumulation.)  The additional benefit of the TFSA structure is that the non-taxable withdrawals have no effect on income tested tax credits, nor do they contribute to the clawback of Guaranteed Income Supplement or Old Age Security.

Interest is not deductible on money borrowed to contribute to a TFSA (like RRSP loans), but TFSA account value may be pledged as security for further borrowing.

From a spousal wealth and estate planning perspective, a high rate taxpayer may contribute into a spouse’s TFSA without being subject to the income attribution rules.  Furthermore, at death (or at separation), a TFSA account may rollover to a spouse and remain tax-sheltered in the receiving spouse’s hands.

For many, the most surprising and valuable feature is that when a TFSA holder makes a withdrawal, there is a dollar-for-dollar recovery of contribution room for making future deposits.  

RESP changes

Some of the time limits associated with RESPs have been extended to provide additional flexibility to students.

The time period for allowable contributions to a plan is extended from 21 to 31 years following the year in which the plan is entered into.  Similarly, the termination date for a plan is extended from 25 to 35 years following the opening of the plan.  

The government also relaxed the rules surrounding Educational Assistance Payments.  Rather than requiring that the student be currently enrolled in order to obtain an EAP, an RESP beneficiary may receive EAPs for up to a six-month “grace period” after ceasing to be enrolled in a qualified program.  

Unlocking Federal LIFs

Canadians who have funds “locked up” inside of federal Life Income Funds (LIFs) will now have greater access to their money beyond the current annual maximum withdrawal limits.

Small balance withdrawal – Individuals who are at least 55 years of age with LIFs worth less than $22,450 (to be indexed to the average industrial wage) will be able to wind up their accounts or convert them to another tax-deferred savings vehicle, such as an RRSP or RRIF, in which there are no maximum withdrawal limits.

Financial hardship withdrawal – Any LIF holder, regardless of age, facing “financial hardship” (low-income individuals or individuals with high disability or medical-related costs) can unlock up to $22,450 (also to be indexed).

One-time unlocking – Individuals who are at least 55 years of age may “unlock” up to 50% of their LIF holdings and transfer the funds into another tax-deferred savings vehicle, such as an RRSP or RRIF, in which there are no maximum withdrawal limits.

Interest deductibility – Lipson case

Being able to deduct interest charges on borrowed money is at the heart of both simple and complex tax-assisted investment leveraging. On April 23, 2008, the SCC heard arguments in the Lipson case, with the judgment expected imminently this fall.  

As background, recall the Singleton decision of the Supreme Court of Canada from 2001.  Mr. Singleton withdrew funds from his law partnership, used those funds to buy a house, mortgaged the house, then deposited the mortgaged funds back into the partnership.  The SCC held that the mortgage interest was deductible as the use of the borrowed funds could be traced into a business or income-producing asset.

In Lipson, Jordanna Lipson borrowed money from a bank which she used to purchase some shares of the family investment company from her husband Earl.  Earl used that money to buy a house, mortgaged the house, then used the mortgaged funds to pay off Jordanna’s loan.  The government was successful at both the Tax Court of Canada and the Federal Court of Appeal, arguing that the interest deduction (and other tax benefits originally claimed) could not stand as the series of transactions offended the general anti-avoidance rule, or GAAR.  

Tax practitioners are hopeful that the forthcoming decision will provide some clear principles from the top court to guide those engaged in leveraged investing.  At time of writing, the SCC had not yet handed down its highly anticipated judgment. 

Offside IPPs

In June, CRA issued Compliance Bulletin #5 re-confirming its intention to pursue and prosecute non-compliant registered pension plans, particularly offside individual pension plans.  The bulletin recounts two successful prosecutions occurring at the Federal Court of Appeal in July, 2007: Jordan Financial and 1346687 Ontario.

Both cases involved a pre-retiree’s creation of a corporation and an associated pension plan to receive the value of a public service pension plan entitlement.  The FCA found that neither was a true pension plan, resulting in deregistration and immediate taxation of the originally transferred amounts of $754,513.47 and $564,478.56, respectively.

The Bulletin lists further negative tax consequences that may result from deregistration, including interest and penalties.  As well, notice is given that new applicants may be required to confirm the bona fides of a plan in writing prior to registration being granted.  No doubt this is intended to both dissuade questionable structures and ease later prosecution.

RRSPs in bankruptcy

On July 7, the long awaited amendments to the federal Bankruptcy and Insolvency Act were proclaimed in force.  The amendments give RRSP, RRIF and DPSP type plans the same protection that is afforded to registered pension plans in bankruptcy, with the exception that deposits made within a year of the bankruptcy will be available to creditors.

Prior to the amendments, a bankrupt with an RPP could carry it out of bankruptcy, but protection for RRSPs, RRIFs and DPSPs depended on the law of the province where the bankrupt was located.  These amendments assure that there is a base level of consistency across the country, though stronger creditor protection may be available in some provinces, including the additional protection within insurance based plans where an appropriate beneficiary designation is in force.

Charities

Redeemer Foundation 

On July 31, the Supreme Court of Canada issued its judgment in the Redeemer Foundation case.  Redeemer was seeking judicial review to resist a CRA request to disclose donor lists.  The SCC held that CRA may indeed use its audit powers to obtain a donor list, and further may use that list to identify and audit those donors.

ICAN

On August 9, CRA revoked the charitable status of International Charity Association Network.  ICAN failed to provide adequate documentation for $464M of charitable receipts it issued in 2006.  In its press release announcing the revocation, CRA stated that it is “reviewing all tax shelter-related donation arrangements, and it plans to audit every participating charity, promoter and investor.”  

Snapshot – Current brackets and rates

Absent a further Fall Economic Statement by the incoming federal government or any of the provinces, the three exhibits below summarize the tax brackets and rates we will be using to report our taxes next April (or June if you run a business).   

A few brief notes:

Whereas in 2007 we saw a mid-year downward adjustment of the lowest bracket from 15.5% to 15%, we end 2008 with the same federal rates that we began with

The graph format in Exhibit 2 provides a side-by-side visual comparison of how a taxpayer moves up through to top marginal rates, with as few as 6 brackets in Alberta and as many as 10 in BC, Ontario and Nova Scotia

Exhibit 3 shows that the top marginal rate on eligible dividends is below the rate on capital gains in four provinces in 2008, though those eligible dividend rates will generally rise through 2012 according to the federal schedule and provincial adjustments

Exhibit 1 – Federal tax brackets and rates – 2008

Basic amount to 9,600        0%

9,600 to 37,885                15%

37,885 to 75,769              22%

75,769 to 123,184           26%  

123,184 to +                    29%

Exhibit 2 – Combined federal/provincial tax brackets, 2008

[Graphic not rendered]

Exhibit 3 – Top marginal tax rates, 2008

Province                                    Interest / foreign income    Taxable capital gains    Eligible/Ineligible dividends 

British Columbia                                43.7%                                   21.9%                        18.5% / 31.6%

Alberta                                                39.0%                                   19.5%                       16.0% / 26.5%

Saskatchewan                                     44.0%                                   22.0%                        20.4% / 30.8%

Manitoba                                            46.4%                                   23.2%                        23.8% / 37.4%

Ontario                                               46.4%                                   23.2%                        24.0% / 31.3%

Quebec                                               48.2%                                   24.1%                        29.7% / 36.4%

New Brunswick                                 47.0%                                   23.5%                        23.2% / 35.4%

Nova Scotia                                       48.3%                                   24.1%                        28.3% / 33.1%

Prince Edward Island                        47.4%                                   23.7%                        24.4% / 33.6%

Newfoundland & Labrador               45.0%                                   22.5%                        28.1% / 33.3%

Putting the charitable back into giving

For years CRA has pursued tax schemes it sees as abusing the charitable tax credit rules.  Two recent high-profile cases seem to indicate that the agency may be gaining some traction in its efforts. 

While this is heartening from the perspective of protecting the integrity of legitimate charitable fundraising, these developments may also foreshadow a dark cloud of privacy issues for potential charitable donors generally.

ICAN

International Charity Association Network (ICAN) was audited in 2007 with respect to its 2006 operating year.  CRA auditors were particularly interested in whether ICAN  may have been receiving property for which tax receipts were issued in amounts far in excess of the value of the property, sometimes called ‘buy low, donate high’ arrangements.

ICAN failed to provide adequate documentation for $464M of charitable receipts it issued in 2006.  According to CRA, this is almost five times the total charitable receipts issued by the United Way of Greater Toronto in the same year.  While the United Way had over 200 staff, ICAN managed its activity level with only 16 employees.

On August 9, 2008, CRA revoked the charitable status of ICAN.

In its press release announcing the revocation, CRA stated that it is “reviewing all tax shelter-related donation arrangements, and it plans to audit every participating charity, promoter and investor.”  Clearly, those participating in and facilitating questionable donation structures have been put on notice by CRA.  

Interestingly, this press release followed closely on the heels of a win by CRA at the Supreme Court of Canada a week earlier in the Redeemer case.

Redeemer Foundation

Redeemer Foundation operated as a charity offering forgivable loans to finance the education of students at an affiliated college. CRA became concerned that some donations to the program were not valid charitable donations because the donors’ contributions were made solely to finance the education of their own children.  The donation structure enabled donation credits for the parents and tuition credits for their student children – an early education in double-dipping, one might say.

In 2003, a CRA auditor orally requested documentation from Redeemer, included a donor’s list.  While the information request was in support of the audit of Redeemer itself, CRA proceeded to contact certain donors to advise them that their donation deductions would be disallowed, and all were reassessed accordingly.

In 2004, a similar CRA request was made with respect to later tax years but Redeemer refused on the basis that CRA must first obtain a Federal Court order.  Income Tax Act section 231.2(2) specifically precludes a request for “information or any document relating to one or more unnamed persons unless the Minister first obtains the authorization of a judge.”

In 2005, Redeemer applied for judicial review of the original request, looking to have the donor list returned and the donor audits effectively rescinded.  

Eventually the case made its way to the Supreme Court of Canada (SCC), which issued its judgment on July 31, 2008, holding that CRA could obtain a donor list and use it to perform donor audits:

Redeemer had to maintain donor records as part of its normal course of operations.

The provision of such information to CRA on an audit is a legitimate and necessary part of verifying the bona fides of charitable activities.

It would be unworkable if judicial authorization was required whenever an audit of a charity entails a possibility that its donors might be investigated and reassessed.

A donor can reasonably expect that a donation will be examined if the registered charity is audited and that a claimed tax credit will be non-compliant if the charitable program is not valid. 

Three of the seven Supreme Court judges dissented, expressing the concern that the audit powers over the charity could and were being used improperly.  Specifically, CRA had indicated as early as the year 2000 that it intended to reassess the Foundation’s donors.  By its verbal request to the charity in 2003, CRA was able to circumvent the taxpayer protection rule and judicial scrutiny in s.231.2(2) to identify and reassess those donors.

A chilling effect on donations?

Bearing in mind that both these cases involved aggressive donation schemes, one is nevertheless left to wonder what effect the combination of these two cases might have on potential charitable donors generally.  

In the face of an active CRA with a bolstered audit tool, potential donors may be inclined to keep the chequebook in pocket for fear that they may be exposed to unwanted scrutiny, remote though that possibility may be.  Hopefully not, for charity’s sake.

Perhaps the best defense for both donors and charities is to be aware of the types of questionable schemes that may be targeted by CRA, and steer clear of them.  

For more information on CRA’s informational outreach efforts to donors and charities, see www.cra.gc.ca/donors.