Cancelled Arrears Interest Reduces Tax liability for Transferor & Transferee

Scott v The Queen – Cancelled Arrears Interest Reduces the Tax liability of both Transferor & Transferee under the Income Tax Act (Section 160)

Introduction – Relief from Arrears Interest & Section 160 Third Party Assessments

Under Canada’s Tax Act, the Canada Revenue Agency (“CRA”) may grant relief from penalties or interest where circumstances beyond the taxpayer’s control prevented him or her from meeting their tax obligations. These circumstances may include, but are not limited to, extraordinary circumstances, actions of the CRA, inability to pay and financial hardship. In such cases, taxpayers must make a request to the CRA for taxpayer relief to cancel or waive penalties or interest. This is referred to as taxpayer relief or TPR application. The CRA’s power to grant relief from penalties or interest is discretionary and arises under sections 220, 164 and 220 of the Income Tax Act. In determining whether to grant relief (or not), the CRA will consider certain factors including the relevant circumstances, the taxpayer’s supporting evidence and the point in time at which the relief request is made in relation to the relevant statutory limitation period. For both penalties and interest, the CRA is only empowered to consider a request for relief of amounts that accrued during the 10 calendar years before the year in which the request is made.

In Scott v The Queen, the Tax Court of Canada held that a transferee’s liability, pursuant to subsection 160(1) of the Income Tax Act, is reduced where the Minister, subsequent to an assessment issued to a transferee, cancels or waives the interest or penalties on the transferor’s liability. That means that the Minister’s cancellation of arrears interest owed by a transferor of property will reduce the transferee’s tax liability pursuant to subsection 160(1) of Canada’s tax act.

Income Tax Act – Section 160

Section 160 in Canada’s tax act applies when the following four conditions are met:

• The transferor must have a tax liability at the time of the transfer;
• There must be a transfer of property;
• The parties are not dealing at arm’s length; and
• The parties are jointly liable to the extent that the amount paid by the transferee is less than the fair market value of the transferred property.

Subsection 160(1) makes the transferee jointly and severally responsible with the transferor for all or a lesser part of the transferor’s tax liability if the amount is determined under subparagraph 160(1)(e)(ii). In Scott v The Queen, the Tax Court confirmed that because the liability is joint and several under subsection 160(1), a transferee’s tax liability cannot exceed the transferor’s tax liability.

Scott v The Queen – Factual Evidence

In Scott v The Queen, between 2005 and 2006 Mr. John Randall Scott the Appellant received $224,500.00 in wire transfers from his brother Mr. Daniel William Clayton Scott. To avoid ambiguity, this article refers to Mr. John Randall Scott as “the Appellant” and to Mr. Daniel William Clayton Scott as “Daniel”.

On May 22, 2015, the Minister issued a Notice of Assessment in which the Appellant was assessed for $224,500.00, pursuant to subsection 160(1) of the Income Tax Act. The subsection 160(1) assessment against the Appellant was in respect of Daniel’s tax liability, at the time that the funds were transferred.

The Appellant’s Canadian tax litigation lawyer argued that the section 160 assessment against him should be reduced by the amount of interest subsequent waived by the Minister with respect to the tax liability of the transferor (Daniel) and was used to in determining the basis of the assessment against the Appellant.

Scott v The Queen – Issues

• Whether the Appellant was liable under subsection 160(1) of the Income Tax Act pursuant to the Minister’s assessment dated May 22, 2015?
  • Did Daniel lend the Appellant the funds that were transferred to him?
  • Should the Appellant’s tax liability be reduced by the amount of interest that was subsequently forgiven by the Minister?

Subsection 160 Analysis and Application

• Did Daniel lend the Appellant the funds that were transferred to him?

Upon analyzing the factual evidence, the Tax Court concluded that the four conditions that give rise to a subsection 160 application were satisfied.

• The transferor must have a tax liability at the time of the transfer.
  • The existence of debt was not disputed. However, the amount of Daniel’s tax debt was challenged by the Appellant because part of the interest that was in Daniel’s tax debt – which was used to determine the Appellant’s tax liability – was subsequently forgiven by the Minister.

• There must be a transfer.
• The Tax Court rejected the Appellant’s position that the funds were borrowed by the Appellant from Daniel. The Tax Court explained that the Appellant’s statements during examination for discovery and during the trial were inconsistent. As well, statements given by the Appellant and Daniel with respect to the true purpose of their arrangement were inconsistent. The Tax Court held that both the Appellant and Daniel were “not reliable or credible witnesses”. The Appellant admitted that the money was transferred to him by Daniel, yet he provided insufficient proof with respect to the exitance of a loan.
• The parties are not dealing at arm’s length.
• This condition was undisputed among the parties.
• The parties are jointly liable to the extent that the amount paid by the transferee is less than the fair market value of the transferred property.
• The Tax Court rejected the Appellant’s argument that the fair market value of the loan was equal to the fair market value of the transferred property.
• Should the Appellant’s tax liability be reduced by the amount of interest that was subsequently forgiven by the Minister?

In February 2016, the CRA granted taxpayer relief to Daniel and cancelled his arrears interest that accrued between March 17, 2009 and July 26, 2013 in respect of his 1995 through 2002 as well as 2004 and 2005 taxation years. The total interest cancelled was $58,213.07. The parties agreed that, before the interest forgiveness, Daniel’s tax liability was $233,835 (this included interest of $149,350.27 of which $50,302.95 was subsequently forgiven). After the interest was cancelled, Daniel’s liability was $183,532.

The Tax Court determined that since the interest forgiveness reduced the Daniel’s debt for the purpose of section 160 of Canada’s tax act (reduction of $50,302.95), the Appellant’s tax liability therefore should also be reduced by $50,302.95. As a result, the Appellant’s tax liability was reduced from $224,500.00 (which was the fair market value of the property transferred i.e. wire transfers) to $183,532.

The CRA’s Canadian tax lawyer argued that the interest forgiveness is not retroactive in application. According to CRA, the tax liability of Daniel was $233,835. Therefore, no adjustment should be made in this regard. The Tax Court rejected arguments by CRA because that would result in the Appellant’s tax liability exceeding the transferor’s (Daniel’s) tax liability. The Tax Court explained that because the liability is joint and several under subsection 160(1), the Appellant liability cannot exceed Daniel’s (the transferor’s) tax liability. As previously mentioned, subsection 160(1) makes the transferee jointly and severally responsible with the transferor for “all or a lesser part” of the transferor’s tax liability. Subsection 160(1) does not create a tax liability that exceeds the transferor’s tax liability.

Section 160 & the Interest Relief

Section 160 of the Income Tax Act prevents taxpayers from avoiding their tax obligations by transferring certain property to another non-arm’s length person. While subsection 160(1) grants the Minister discretionary powers to collect a taxpayer’s tax liability from another person, the quantum however is limited to the property transferor’s tax liability at the time of the transfer and subsequent relief granted by the Minister and used in establishing a transferee’s tax liability under section 160 of the Income Tax Act.

Scott v The Queen is significant because it confirms that the Minister’s cancellation of arrears interest decreases the tax liability for both transferor and transferee under a subsection 160 assessment. On the one hand, interest owing by a tax debtor can be included in a section 160 assessment, and interest will run on the amount assessed to the transferee. On the other hand, subsection 160 allows a taxpayer transferee the opportunity to challenge the quantum that is in excess of the transferor’s tax liability and that is used to determine his or her section 160 liability.

Tax Tips – Cancellation of Arrears Interest & Section 160 Assessments

Understanding the collection provisions under the Income Tax Act can help taxpayers meet their tax obligations and minimize interest and penalties accrued which could account for thousands of dollars. If you have questions regarding taxpayer tax relief, the cancellation or waiver of interest and penalties or for inquiries regarding section 160 third party assessments, please contact our office to speak with one of our experienced certified specialists in taxation Canadian tax lawyers.