The Canada Revenue Agency's recently announced "postal code project" targets Canada's richest neighbourhoods, to identify non-compliance apparent from discrepancies between residents' tax reporting with their apparent wealth. Even prior to the postal code project, which focuses on any potential high net worth individual, the CRA had enhanced audit activity on high net worth individuals who had entered Canada and obtained permanent residence status ("landed immigrant") for immigration purposes. A wealthy individual who has purchased a home and moved to Canada with his or her spouse and dependent children may have maintained significant personal and economic ties with his or her country of origin. Canadian residents are generally taxable on their world income. Sometimes landed immigrants, rightly or wrongly, have filed tax returns as Canadian residents yet only reported minimal income relative to their net worth, or apparent lifestyle, or reported only their Canadian source income (i.e. they have not reported employment, business or investment income from their country of origin). When the CRA discovers situations like this, for example, through initiatives such as their postal code project, a wide range of possible Canadian tax non-compliance gets red flagged. This typically includes reassessments for unreported income, which are often a combination of newly identified sources of income or unidentified bank deposits coming from offshore accounts.
While each situation is unique, here are ten key important Canadian tax compliance considerations for landed immigrants determining their i) Canadian tax obligations upon immigration to Canada; or ii) optimal response to a CRA audit or reassessment.
1. Landed Immigrant Status for Immigration Purposes versus Residence Status for Tax Purposes
New Canadians are often under the impression that once they obtain their landed immigrant status, they are Canadian residents for tax purposes and must file tax returns in Canada accordingly. Nonetheless, residence for Canadian tax purposes is a question of fact, with status for immigration purposes being only one factor in that determination. In most cases, however, once individuals have immigrated to Canada, they will have likely established the requisite degree of nexus or residential ties to Canada to be considered factual residents for Canadian tax purposes. In exceptional cases, particularly where the children become adults and the landed immigrant begins to sever certain key residential ties with Canada and spend the majority of his or her time in the country of origin, they may no longer be factually resident in Canada for tax purposes. This is regardless of whether they still maintain their landed immigrant status for immigration purposes. The more common exception to Canadian tax residency is where the landed immigrant, who is unquestionably a factual resident of Canada based on his or her residential ties with Canada, is deemed to be non-resident of Canada pursuant to the dual resident provision in subsection 250(5) of the Income Tax Act ("Act").
2. Dual Resident (Subsection 250(5) of the Act)
A landed immigrant can be resident in more than one country at the same time ("dual resident"). Where an individual is a tax resident in Canada as well as a tax resident of another jurisdiction, the final determination of the individual's residence status for Canadian tax purposes may depend on the application of subsection 250(5) of the Act. In brief, if subsection 250(5) applies, it deems a taxpayer who is otherwise a factual resident of Canada to be a non-resident of Canada if, pursuant to the dual residence tie-breaker rule of the applicable tax treaty, the tie is resolved in favour of the other country. A non-resident of Canada is generally only taxable in Canada on certain Canadian source income. This is therefore a critical line of defence where high net worth individuals have significant non-Canadian sources of income, including business, employment or investment income, from their country of origin.
3. Treaty Tie-Breaker Rules
The vast majority of Canada's tax treaties utilize a set of internationally standard tie-breaker rules, including the permanent home test, centre of vital interest test, place of habitual abode test and citizenship test. The permanent home test is the first tie-breaker test. Because the individual usually has a permanent home available to him or her in both states, this test may not resolve the tie. With landed immigrants, particularly once the children have grown up and are no longer attending school in Canada, the parents may gradually spend more time in their country of origin. In addition, with many landed immigrants, the economic ties are often stronger in their country of origin. Consequently, either the centre of vital interest test or the place of habitual abode test (which emphasizes the physical days present in each country) may resolve the tie in favour of the landed immigrant's country of origin.
A landed immigrant with significant income earned outside Canada may substantially benefit if subsection 250(5) applies to deem him or her to be a non-resident of Canada, if this results in the foreign income being subject to tax rates far less than what would be assessed in Canada. However, where families are receiving many of the benefits of living in Canada while the main income earner is not subject to a material level of tax in Canada is often a sensitive matter with the CRA that will cause them to exercise their due diligence before conceding to deemed non-residence status. In addition to adequately supporting that the tie-breaker rules go in favour of the country of origin, the tie-breaker rules in the applicable treaty have to in fact apply. For the treaty tie-breaker rules to apply, the individual has to be a resident of both contracting states for purpose of the treaty. To be a resident of a contracting state for treaty purposes, a person must be "liable to tax" in that state by virtue of a criterion referred to in the treaty. The CRA have provided their views on paragraph 1 of Article 4 of Canada's treaties (i.e. meaning of "liable to tax") in paragraphs 1.41 to 1.45 of Income Tax Folio S5-F1-C1. Consequently, taxpayers relying on subsection 250(5) of the Act should expect to have to provide support to the CRA regarding their tax status in the other jurisdiction (e.g. copies of foreign tax returns and assessments).
4. Taxpayers not bound if they have mistakenly filed tax returns as Canadian residents
Landed immigrants, when filing their initial Canadian tax returns, sometimes were unaware of the dual resident provision in subsection 250(5) of the Act and mistakenly reported themselves as Canadian residents. Regardless of the reasoning behind reporting as a Canadian resident on a tax return, where an individual was a dual resident and subsection 250(5) should have applied to deem him or her to be a non-resident, the individual should be able to amend his or her prior tax returns assuming the taxation years are not statute barred. Where the CRA has reassessed unreported foreign source income to a taxpayer who the CRA assumes, because of the tax returns, is a Canadian tax resident, the application of subsection 250(5) may be a valid argument to have those reassessments overturned by a CRA appeals officer, or if necessary by the Tax Court of Canada or the Canadian competent authority (see #7 below). There is Canadian jurisprudence that supports that taxpayers are not bound by their initial mistaken tax classification as a resident of Canada.
Taxpayers need to consider that if they are successful in amending their tax returns or having reassessments overturned on the basis that they are a non-resident of Canada, and therefore not taxable on non-Canadian source income, this may have other Canadian tax ramifications (see #6 below). Also, the CRA may be limited to how many years they can go back to reassess an amended tax return if those years are statue barred.
5. Foreign Reporting Obligations
Canadian residents have foreign reporting obligations. The most common foreign reporting obligation that may impact landed immigrants is pursuant to section 233.3 of the Act. In particular, Form T1135 - Foreign Income Verification Statement ("Form T1135") must be filed by Canadian resident individuals, corporations and certain trusts that, at any time during the year, owned specified foreign property costing more than $100,000. Form T1135 is due on the same date as the corporation or individual's income tax return. "Specified foreign property" in subsection 233.3(1) of the Act includes, but is not limited to, shares of the capital stock of a non-resident corporation, funds or intangible property situated or held outside Canada, as well as tangible property situated outside Canada. The penalties where taxpayers do not fully comply with their foreign reporting obligations can be onerous.
Landed immigrants who have been assessed, or are about to be assessed by the CRA, for unidentified bank deposits that the CRA are asserting give rise to unreported income, may find themselves in a predicament. For example, landed immigrants, to establish that certain Canadian bank deposits were simply transfers of funds from a foreign bank account holding funds accumulated prior to becoming a resident of Canada, must disclose that account that was not reported on Form T1135. Where taxpayers find themselves in this predicament, or where taxpayers simply have not complied properly with the foreign reporting rules and are exposed to potential significant penalties, they should obtain advice from a Canadian tax advisor (see #10 below).
6. Principal Residence Exemption, Departure Tax and Part XIII Withholding Tax Consequences
Where an individual is a dual resident, subsection 250(5) should have applied to deem him or her to be a non-resident and the taxpayer is considering amending his or her prior tax returns or arguing against a proposed assessment of unreported income by the CRA on that basis, consideration must be given to the impact this change of residence status may have on other Canadian tax matters, including the principal residence exemption, the Canadian departure tax rules and the Part XIII tax system.
Capital gains arising from the sale of a principal residence are generally exempt from Canadian taxation for Canadian residents. Consequently, any determination of non-residence status could impact the formula for computing the principal residence exemption.
Pursuant to the Canadian departure tax rules, when an individual ceases to be a resident of Canada, he or she has obligations under paragraph 128.1(4)(b) of the Act. This provision deems an individual to have disposed of his or her property at its fair market value and then reacquired it for the same amount at the time the individual ceased to be a resident of Canada for tax purposes. This deemed disposition triggers capital gains and losses that accrued prior to becoming a non-resident. Any capital gains would be taxed in the year of the change in residence. Certain types of property are excluded from this deemed disposition, including Canadian real or immovable property.
Finally, any change in classification from a Canadian resident to a non-resident triggers the possible application of Canada's Part XIII withholding tax system on certain Canadian source passive income (e.g. interest, dividends, royalties, rent, etc.). If amended tax returns are needed, the impact this would have on failure to withhold assessments on payments made in the period the taxpayer erroneously filed as a Canadian resident must also be considered.
7. Mutual Agreement Procedure vs. Notice of Objection vs. Tax Court of Canada
Where landed immigrants are involved in a tax dispute with the CRA and the issues involve the application of the treaty tie-breaker rules, or Canada's taxing rights on income earned from the landed immigrant's country of origin, consideration should always be given to filing a competent authority request under the Mutual Agreement Procedure ("MAP") article of the applicable tax treaty. The MAP is provided by the treaty and does not impact a taxpayer's domestic notice of objection or Tax Court of Canada appeal rights. While the most effective dispute resolution mechanism to deploy should be determined on a case by case basis, notice of objection rights should always be protected first. Notices of objection can be held in abeyance while a resolution of the tax dispute is pursued under the MAP.
8. Exchange of Information Article in Tax Treaties
Landed immigrants, especially dual residents, involved in a tax dispute with the CRA must also bear in mind the Exchange of Information ("EOI") article in a tax treaty. For example, if a dual resident taxpayer is disputing a CRA assessment of unreported income (e.g. unidentified Canadian bank deposits) on the basis that the deposits were transfers from offshore accounts that were earned or accumulated prior to becoming a Canadian resident, the CRA's competent authority has the ability to request information on those foreign assets or income streams from the foreign tax authority (i.e. the competent authority of its treaty partner) through its powers under the EOI article. Landed immigrants must also be aware that any information provided to the CRA in defence of their filing position or reassessment can be forwarded to the other competent authority under the EOI, which may bring to light areas of tax non-compliance in that foreign jurisdiction.
9. Gross Negligence Penalties and Burden of Proof
Where the CRA has reassessed significant amounts of unreported income, subsection 163(2) of the Act provides for gross negligence penalties that are often assessed as well. Landed immigrants being assessed by the CRA on their unidentified Canadian bank deposits often have gross negligence penalties assessed simply because the CRA have not been provided satisfactory answers to the source of such deposits. Canadian courts have held that gross negligence involves a neglect beyond a failure to use reasonable care. In other words, there is generally a burden of proof on the CRA to establish that the taxpayer acted with a high degree of negligence tantamount to intentional acting or indifference as to compliance. There are many cases where landed immigrants, despite being assessed gross negligence penalties by the CRA on unreported income, did not act with the degree of negligence required to support such penalties.
10. Voluntary Disclosures Program
Landed immigrants who filed tax returns as Canadian residents may not be in a position to argue that they are deemed non-residents of Canada pursuant to subsection 250(5). If so, they may have been non-compliant with reporting their world income and/or other foreign reporting obligations. Where these taxpayers have not already been contacted by the CRA for a possible audit and they have an exposure to non-compliance and gross negligence penalties if audited by the CRA, they should give immediate consideration to applying for penalty, interest and potential criminal prosecution relief under the CRA's Voluntary Disclosure Program ("VDP"), especially in light of the CRA's announced changes that once implemented will significantly restrict the application of the VDP.
The Canadian Government has invested one billion additional dollars to tackle tax evasion and perceived abusive tax avoidance. The CRA has touted these enhanced resources, along with increased collaboration and cooperation with their international partners, "to detect and CRAck down on tax cheats and ensure that those who choose to break the law face the consequences and are held accountable for their actions". Landed immigrants need to understand the Canadian tax compliance considerations to determine their Canadian tax obligations upon immigration to Canada or, if they are already in the CRA's cross-hairs, their optimal response to a CRA audit or reassessment.
Footnotes
[] The CRA's Income Tax Folio S5-F1-C1, Determining an Individual's Residence Status, provides more information regarding determining an individual's residence status for tax purposes.
[] The CRA's guidance on how to apply to the Canadian competent authority under the MAP is available in Information Circular 71-17R5 Guidance on Competent Authority Assistance under Canada's Tax Treaties.