Steve: So welcome to the eighth session of our Tax Dispute Resolution monthly updates. Please note that our next session will be in September so hope everyone will enjoy a restful summer off with family and friends. Being lawyers we of course need, again, to start with a disclaimer. While you can take a moment to read this, the essential message is that these webinars cover the topics presented, only generally, and are not intended to provide legal advice since every situation is different and the law is always changing. My name, in terms of speakers today, I'm Steve Novoselac and I serve as Co-leader of Gowling WLG's tax dispute resolution in Canada. I'm joined today by Lesley Kim and Dan Misutka. Lesley joined our firm's National Tax Practice group last September and she practices out of our Calgary office, with a wide ranging tax expertise, including tax dispute resolution. Dan is also a recent addition to our tax dispute resolution team who practices out of our Calgary office. He's a senior tax litigation specialist, having started his career as a Federal prosecutor and tax litigation counsel for the Minister of National Revenue, and since 2004, he has acted on behalf of taxpayers. As we mentioned at our previous webinars, we launched these webinars internally for our firm's national tax practice group over 6 years ago, to present new CRA policies, legislation and case law. Now that we've expanded them to an external audience, we're pleased to see that others are finding them helpful as well to stay to up to date with current developments in tax dispute resolution. Please feel free to submit topics you'd like us to discuss at future webinars and to submit questions throughout with the question feature. Depending on our timing we'll try to answer your questions at the end of today's session and, if not, then we'll respond to you directly and again we're aiming to wrap up today by no later than 12:30. Please note that a copy of today's slides will be available online afterwards.
So in terms of topics for today we have the following three: number one, expanded mandatory disclosure rules for reportable transactions and a new category of notifiable transactions, part 2, practical considerations, which Lesley will discuss. Second, structuring business sales as hybrid transactions and subsection 84(2) case law update, that Dan will present, and third, SRED or SR&ED tax court appeals, a case study, which I'll be discussing. So with that, Lesley, please go ahead and tell us about the practical considerations for these new reporting rules.
Lesley: Thanks, Stevan. So during our last webinar we discussed the draft legislation released by the Department of Finance earlier this year, to broaden existing rules relating to reportable transactions and creating a new class of notifiable transactions aimed at identifying aggressive tax planning strategies. The draft legislation also included enhanced penalties for failing to comply with the mandatory disclosure rules. So today I will briefly review the proposed rules again and discuss some of the results and practical considerations and uncertainties.
The definition of reportable transaction is amended to require only one, versus two, of the following three generic hallmarks in respect of an avoidance transaction or series. A contingent e arrangement pursuant to which an advisor or promotor, or any non-arms length person to the advisor or promotor, is generally entitled to a fee based on the amount of the tax benefit, that is contingent on obtaining the tax benefit or that depends on the number of persons participating in the avoidance transaction or series. Confidential protection prohibiting disclosure of the details of the transaction to any person, or the CRA, is granted to a promotor or advisor by the taxpayer or contractual protection, including any for of insurance, indemnity, compensation or guarantee, is granted to the taxpayer, promotor or advisor in respect of the avoidance transaction or series. In addition, the definition of avoidance transaction is amended to require only one of the main purposes of the transaction or series to be the obtaining of a tax benefit. This represents a lower threshold than the current primary purpose test for a transaction to be an avoidance transaction.
So the draft legislation also creates a new category of notifiable transactions that are subject to the same disclosure obligations as reportable transactions. Notifiable transactions will be designated by the CRA, with the concurrence of the Department of Finance, and will include transactions or series of transactions that are the same as, or substantially similar to, such transactions. Notifiable transactions will be those that the CRA have found to be abusive and transactions that the CRA has identified to be of interest and for which they require more information to determine if the transactions are in fact abusive. If a reportable or notifiable transaction has been identified, an information return must be filed with the CRA 45 days after the earlier of the day the taxpayer becomes contractually obligated to enter into the transaction, and the day the taxpayer enters into the transaction.
So failing to file an information return for reportable and notifiable transactions by the prescribed deadline could result in large penalties. In the case of a taxpayer that's not a corporation, the maximum penalty is equal to the greater of $25,000.00 and 25% of the tax benefit. For corporate taxpayers, having assets that have a total carrying value of 50 million dollars or more, the maximum penalty is equal to the greater of $100,000.00 and 25% of the tax benefit. In the case of a promotor or advisor, the penalties a total of the fees charged in respect of the transaction, $10,000.00 and $1,000.00 for every day that the failure to report continues, up to a maximum of $100,000.00.
The reportable transaction rules, as currently drafted, would require filing for transactions or series of transactions that would not normally be considered aggressive tax planning from the CRAs perspective. Moreover, there is no minimum tax benefit or minimum threshold for advisor and promotor fees where the reporting obligations to apply. I also note that the definition of advisor includes each person who provides any advice with respect to creating, developing, planning, organizing or implementing the transaction or series. As a result, reporting is required by multiple parties, including the taxpayer and each promotor and advisor who provides any assistance or advice regarding the creating or implementing of the transaction or series. This means that multiple advisors in a single accounting firm or law firm could each be required to file an information return in respect of a single transaction. For lawyers, information that is subject to solicitor/client privilege does not have to be reported. But this doesn't necessarily mean that lawyers are not required to file an information return. For example, it was suggested at a recent Canadian Tax Foundation presentation that the scope of the privileged exception is not clear and that lawyers could still be required to report around privileged information. Given this uncertainty, and the potentially large and in some cases disproportionate compliance burden and costs, the CBA CPA Joint Committee recommended its submissions to Finance on the draft legislation that there be a de minimis threshold before the reporting obligations apply; that reporting not be required until the legislation receives Royal Assent and that only one information return be required per firm, versus per individual advisor. We don't know what recommendations, if any, Finance will accept but in the meantime a simple estate freeze, for example, or a non-controversial pre-closing reorganization on the sale of a business, could be caught under the new rules. Under these common scenarios the taxpayer, each accountant who worked on the tax planning, and each lawyer who implemented the plan could all be required to report the transaction or series if even one of the three generic hallmarks are present, with respect to the transaction or series.
As the legislation is currently drafted there are a number of common, innocuous accounting and law firm practices that could fit within one of the three hallmarks for reportable transactions. For example, contingent fee arrangements and fees based on a number of items, such as a set fee per section 85 rollover agreement, could trigger the fee hallmark. Engagement agreements that contain mutual confidentiality clauses, or tax memos providing that contents cannot be passed on to others, could fall within the confidential protections hallmark. Another concern is that most purchase and sale agreements include indemnity for pre-closing taxes, which could fall under the contractual protection hallmark. While there is a carve out for indemnity that is offered to a broad class of person, in the normal commercial context, it's not clear that indemnity that is offered to the purchaser by the vendor would be considered to be an offer to a broad class. Given the potential to material penalties, taxpayers and advisors may err on the side of caution and report any tax plan transactions. This could lead to disproportionately large compliance burdens and excessive costs for routine tax planning.
While penalties for failing to report under the new reporting rules won't apply until the draft legislation receives Royal Assent, reporting obligations already apply to transactions entered into since January 1 of this year. We hope that the Department of Finance addresses some of these issues discussed today so that there's more clarity and certainty at that time. But in the interim, it appears that routine tax planning, and advisor tax practices, could be caught by the new rules. Thank you for your time. That concludes my part of the presentation and my colleague, Dan Misutka, will now discuss structuring business sales as hybrid transactions.
Dan: Hi there. I'm going to speak about a new CRA audit focus on business sales structured as hybrid transactions, and when we talk about hybrid transactions, generally we're talking about an offer to sell a business and an agreement between the buyer and seller to enter into certain restructuring to bring about a situation where the buyer acquires desired target assets, and the seller is able to make use of the capital gains exemption. Historically, the Canada Revenue Agency had attempted to apply subsection 84(2), of the Income Tax Act, to recharacterize the proceeds and disposition received on the share sale part of these transactions as dividend income. But after the Tax Court decision in Geransky the CRA generally respected the structures, however, there's new case law.
Looking first at the provision, generally subsection 84(2) applies where funds or property of the corporation resident in Canada have been distributed, or otherwise appropriated in any manner whatever for the benefit of the shareholders, on a wind up, discontinuance or reorganization of the business. In Geransky the buyer was interested in certain target assets which were moved out of an operating company as part of the pre-closing restructuring, up to the holding company that owned the operating company, and then moved over to a new company, the shares of which were acquired by the buyer. The CRA reassessed to recharacterize the proceeds and disposition received on the sale of the new company shares as dividend income. But on appeal the CRA cited a number of traditional surplus stripping cases in support of the reassessment. However, the Court found, among other things, that the funds or property of the corporation did not end up in the appellant's hands in the course of the reorganization. That is no funds or property were distributed, or otherwise appropriated, by the appellant who sold the shares of the new company.
In terms of the new audit activity that I've spoken about, we've seen the CRA apply subsection 84(2) to hybrid transactions and cite this MacDonald decision from the Federal Court of Appeal. It's important to note that MacDonald did not involve the sale of a business reorganized to allow for a hybrid sale, however, the Federal Court of Appeal in MacDonald focused on the words, "in any manner" in subsection 84(2) to hold that the liquidated assets of the professional corporation in issue ended up in the shareholder's hands by circuitous means. More recently the decision of the Tax Court in Foix is of some concern to certain commentators because it did involve a hybrid reorganization, undertaken to allow the vendors to make use of their capital gains exemption. Bear in mind, however, that the Court found in Foix that there were was an original agreement to allow the vendors to distribute excess corporate cash, which agreement was carried through into the hybrid reorganization. Such that the Court felt that the purchasers became the instruments and intermediaries, through which the distribution of corporate cash took place for the benefit of the shareholders, following the reorganization that allowed for the hybrid sale.
In terms of takeaways from the case law, first of all, the decision in Foix does not mean that hybrid sale transactions are now automatically subject to subsection 84(2). We have seen some audit activity recently where this seems to be the underlying reassessment position of the CRA. Some identifiable amount of property or funds must be made, and some evidence that this identifiable amount is distributed, or otherwise appropriated by the shareholders of the corporation in question. In any type of share sale, even the share sale portion of a hybrid sale transaction, there is the value of the shares sold on the corporation will be tied to the value of the underlying corporate assets. This does not equate to a distribution or appropriation of corporate funds or property within the meaning of subsection 84(2). Moreover, even if you can identify a distribution or appropriation of corporate funds, some intention to minimize tax that would otherwise arise on the distribution or appropriation must also be present. The circuitous means, for lack of a better word, for the distribution or appropriation. So if you or your clients are faced with an 84(2) assessment, reassessment or a proposed reassessment in relation to a hybrid transaction, take a hard look at the facts and don't be afraid to ask for advice. Those are my comments and I will turn this over to Stevan for comments on the SRED case law.
Steve: Thanks very much, Dan. So our third topic today is SRED Tax Court of Canada Appeals - a case study. But for this topic I'll first discuss some general considerations, then a recent case study and finally some practical considerations. So in terms of general considerations, the Courts will apply well established five part test for determining eligibility of SRED expenditures. Number one, was there a technological risk, or uncertainty, which could not be removed by routine engineering or standard procedures? Second, did the person claiming to be doing SRED formulate hypotheses specifically aimed at reducing or eliminating that technological uncertainty? Third, did the procedure adopted accord with a total of discipline of the scientific method, including the formulation testing and modification of the hypotheses? Fourth, did the process result in a technological advancement? And, fifth, was there a detailed record kept, as the work progressed, of the hypotheses tested and the results? Continuing on with some further comments on general considerations, certainly one of the most important strategic ones is obtaining expert testimony. It can be highly problematic not to retain an expert or to have a proposed expert that does not get qualified by the Court to testify. Experts have an overriding duty to resist the Court impartially on matters relevant to the area of expertise. This duty overrides the expert's duty to the taxpayer. The expert must be independent and objective, and not merely an advocate for the party, and must be seen to be such by both the CRA and the Court.
So now for the case study. The case study today is a case called National R&D and The Queen. The Tax Court decision that was upheld by the Federal Court of Appeal. The sole issue was whether expenditures incurred on a certain project were SRED eligible. The only witness in the case who testified before the Tax Court was the sole shareholder and president of the appellant. He had conducted all of the subject activities himself pertaining to this project with a student helping as well. He was accepted by the Tax Court as a litigant expert so that allowed him to provide both opinion testimony as well as his own first hand fact testimony. The appellant had also retained an expert, however, the Tax Court did not qualify the appellant's proper expert witness. On the main substantive issue of determining SRED eligibility, the Tax Court held that only the first of the five part test, that I discussed a few moments, was met and that the appellant failed to meet the other four criteria. The SRED expenditures were accordingly denied eligibility and the Federal Court of Appeal upheld these decisions.
In terms of the results from the case, in deciding firstly not to qualify the appellant's expert witness, the Court stated that the proposed expert report did not comply with the Tax Court of Canada rules, or the expert's code of conduct. Also that the requirements of impartiality and independence were not satisfied. Further, that the report was an improper opinion on the application of the law to the facts. This is a commonly seen problem in SRED cases, where the expert provides an opinion on whether the subject expenditures qualify, which is impermissible because that constitutes the legal issue the Court must determine. Finally, the proposed expert did not pass the final or gatekeeper stage of the analysis in determining whether to allow expert testimony, where the Court balances the probative value of the proposed testimony with the potential prejudicial effects.
So then turning to the substantive issue, the Court addressed each of the five criteria for determining eligibility of SRED expenditures. Now I'm not going to today go through the Court's analysis on each of the five criteria, but rather, focus on the third one. That is, did the procedure adopted accord with the total discipline of the scientific method, including the formulation, testing and modification of hypotheses? The appellant argued that this requirement should not be applied and this included arguing that essentially that the scientific method is different from the engineering method. Now the Court rejected this argument and upheld the scientific method criteria for essentially four reasons. First, the Court pointed out that it had previously considered and rejected this argument and that it was not inconsistent with CRA guidance, although the Court did acknowledge that CRA guidance was not binding on the Court. Second, the Court explained that setting out its own understanding of legislation and jurisprudence was not an improper exercise of judicial legislation, putting it this way as a quote that appears on the slide.
"Parliament and the legislature rely on the Courts to give definition amplitude and precision to statutory language as required by the circumstances of the case."
So the criteria could not be successfully challenged on the basis that the Court had interpreted it too broadly. Third, the Court of Appeal held that the Tax Court had adopted a restrictive approach to what constituted the scientific method and properly applied the criteria, that criteria, within the context of the appellant's business environment. Fourth and finally, the Court stated that there was no proven distinction between the scientific method and the engineering method, and in considering this issue, the Court took issue with the manner in which this argument was being put forward, or the manner in which it was supported. Because to support that assertion that this distinction existed, the appellant sought to merely rely on an article contained in its book of authorities. Now book of authorities typically contains copies of legislation provisions, court decisions and legal articles that support the arguments being made to the court. So the Court called this an impermissible attempt to establish, through the back door, a fact that should be a matter of evidence at trial and further clarified that if there is a critical distinction in the methodology used in the applied, as opposed to natural sciences, then the appellant is required to establish that fact in evidence. So essentially this evidence would need to be adduced through experts.
So now finally for a few practical considerations. This case illustrates the critical importance of retaining an independent subject matter expert who's properly qualified. The technical leads, who actually worked on the projects in issue, are typically subject matter experts, however, having an independent expert is much more compelling, both in terms of negotiating with the CRA and for presenting your case in court if the settlement is not achieved. In our experience, we found that leading experts are available at a reasonable cost and, in the right case, can be a distinction between scientific research versus experimental development and that the two concepts have effectively been conflated, especially relating to documentary requirements. We have experience working with expert opinion evidence, supporting the proposition that there is a long established and fundamental difference between scientific research and experimental development, and that these concepts have sometimes been mistakenly merged, which can in effect operate to prejudice taxpayers.
Finally, we'll note that SRED Tax Court appeals can be appropriate for contingency fee arrangements since they seek tax credits. This can make it financially feasible for taxpayers to retain experienced counsel to pursue these claims.
So in conclusion I hope this has been a helpful discussion of some of the issues relating to SRED Tax Court of Canada appeals. So thank you very much for your attention and now turning to see whether we have any questions. We have one here that will be addressing Lesley's topic. The question is, what can we do to mitigate the risk that a transaction will be subject to the mandatory disclosure rules?
Lesley: Okay. So it's a tough one because there isn't a lot of guidance yet, but one of the things that you could do is make sure that your advisors aren't charging fees based on a per item or per client type of basis, or on a contingency basis based on a tax benefit, but rather that they charge on an hourly basis. You want to make sure that you review your engagement agreements carefully to make sure that you're not triggering the confidential protection hallmark. Importantly, there's a due diligence defense. So if you fail to report because you've determined that the transaction wasn't reportable, you should keep records of how you came to that determination, conversations that you had with your advisors, and things like that to support your conclusion that the transaction wasn't reportable.
Steve: Thanks very much, Lesley. We have another question relating to Dan's topic. Having regard to the newer case law, in particular the Foix decision and MacDonald case, do you feel that the previous decision in Geransky is still good law?
Dan: Yes, I do, actually. I think really these decisions, they often turn on the facts and people tend to get a little bit freaked out sometimes when something happens, in relation to an area that they thought was settled, and they think this has made new law in an area, such as I alluded to in my presentation, the CRA, at least in the audits we're dealing with, seems to have taken the position now that the very structure of a hybrid transaction is in question, even if they can't identify property or surplus funds of a corporation that had been distributed or appropriated. Just because you enter into an agreement to sell a portion of your business via a sale of shares, just because the value of those shares are tied to the assets, as I indicated, that doesn't mean that there's a distribution of corporate property. Much like in Geransky, the court was just unable to, I think they used the language, "to stretch the meaning of subsection 84(2)", to cover that type of situation.
Steve: Alright. Thanks, Dan. We have a question on the SRED topic. How do you avoid the court rejecting an expert witness? So, this I think is important to make sure that the experts being asked to opine on the technical issues only. The case law has said that the expert's function is to provide prescription lenses through which the court can view technical issues, and to avoid asking the witness to opine or provide an opinion on the ultimate issue, because that's for the court to decide. So in the context of SRED cases, you would typically want to ask the expert to provide an opinion on each of the technical aspects for the five criteria that are used to determine eligibility for SRED. So was there technological risk, or uncertainty, and was there technological advancement? Where the records kept consistent with what you would expect to see in the business of the taxpayer in issue, and again, not to ask for an opinion on the ultimate issue, which of course would be, whether these expenditures are eligible?
So with that, you'll see on the screen the scanning for the QR code, which we would ask that you please take a moment to do scan that code to take a short survey on today's webinar. That would really help us in terms of planning future sessions. As I mentioned at the outset, our next session will be scheduled in September, so please be looking for that invitation. Thank you all very much again for joining today. Have a safe and enjoyable summer with your family and friends. Have a great day. Bye-bye.