Proposed Notifiable Transactions Under Upcoming Mandatory Disclosure Rules in Canada: A Canadian Tax Lawyer’s Explanation

Introduction: The Ministry of Finance has Walked Back the Deadline for Imposing Disclosure Obligations on Notifiable Transactions

As part of the 2021 Federal Budget, the Minister of Finance proposed the creation of a new category of “notifiable transactions” under the Canadian Income Tax Act, in an effort to supervise Canadian taxpayers engaging in tax planning structures with uncertain tax treatments. Under the newly-proposed section 237.4 of the Income Tax Act, the Minister of National Revenue in concurrence with the Minister of Finance would be granted the power to designate a transaction or series of transactions as a “notifiable transaction”. Under the proposed amendment, a Canadian taxpayer who accrues or expects to accrue a tax benefit, an agent or promoter, or any person not dealing at arm’s length with an advisor or promoter working for a fee concerning the transaction would be obligated to report on that tax planning structure to the Canada Revenue Agency (“CRA”). These rules were proposed in conjunction with a number of other mandatory disclosure rules affecting Canadian taxpayers and corporations alike.

The Ministry of Finance has released six sample arrangements and transactions that could be designated under section 237.4 of the Income Tax Act when the rules receive Royal Assent and the amendments become law. Those rules were originally intended to apply for transactions occurring after the 2022 calendar year. However, on November 3, 2022, Canada’s Ministry of Finance announced it would be imposing a moratorium on administering upcoming rules concerning those notifiable transactions so that it could better respond to public feedback and consultations that had taken place since the draft amendments were first proposed on February 4, 2022. It is now unclear how long it will take for the proposed rules concerning notifiable transactions to actually take hold, and it is also unclear at this stage exactly what the scope of those rules will ultimately be. Even so, the simple fact that the Ministry of Finance has identified those six particular arrangements and transactions as possible notifiable transactions should remain cause for alarm for any Canadian taxpayer engaged in tax planning. If you are engaging in or have considered engaging in any tax planning strategies for your wealth, you are encouraged to speak to one of our expert Toronto tax lawyers to remain appraised of and plan for your potential future reporting obligations under Canadian tax law.

The Sample “Notifiable Transactions” Listed by the Ministry of Finance

The proposed section 237.4 of the Canadian Income tax Act does not introduce any new tax on Canadian taxpayers who engage in Canadian tax planning strategies. It does impose additional reporting requirements in the form of information returns that must be filed with CRA describing those transactions when that Canadian taxpayer participates in the transaction. Those reporting obligations would also apply to a particular transaction or series of transactions that is the same or substantially similar to a designated notifiable transaction. It is therefore crucial to understand the substance of each designated notifiable transaction, to understand and recognize what may in turn be treated as a substantially similar transaction.

 

The Ministry of Finance identified the following six arrangements and transactions as samples of what the Minister of Finance and Minister of National Revenue could seek to designate as “notifiable transactions”:

 

1. Manipulating CCPC status to avoid anti-deferral rules applicable to investment income;
2. Straddle loss creation transactions using a partnership;
3. Avoidance of the 21-year deemed disposition rule for trusts;
4. Manipulation of bankruptcy status to reduce a forgiven amount concerning a commercial obligation;
5. Reliance on the purpose tests under section 256.1 of the Income Tax Act to avoid a deemed acquisition of control; and
6. “Back-to-back” arrangements.

Manipulating CCPC Status

Under the Canadian Income Tax Act, various anti-deferral rules exist to prevent an individual taxpayer from obtaining a tax advantage by incorporating for the sole purpose of earning investment income. More specifically, investment income earned through a Canadian-controlled private corporation (“CCPC”) is subject to a refundable tax mechanism under the Income Tax Act to limit the tax advantages that a CCPC has over non-CCPC corporations to income on active business income.

The Minister of Finance has proposed designating three types of arrangements involving the tax avoidance of CCPC status by Canadian taxpayers:

1. “Foreign Continuance” Arrangements: The tax residence of a Canadian corporation is generally determined by where “central management and control” of the corporation is exercised. A taxpayer may incorporate in a Canadian jurisdiction for the purpose of holding investments, migrate the corporation to a foreign jurisdiction and under its laws, while still managing the corporation from Canada. Thus, the corporation is not “Canadian” for purposes of the Income Tax Act and to meet the definition of a CCPC, but remains a tax resident of Canada. The corporation thus avoids the issue of triggering a deemed disposition on the corporation’s assets or becoming subject to the foreign accrual property income (“FAPI”) regime on passive income.
2. “Skinny Voting Share” Arrangements: Control in law over a corporation will generally exist for purposes of the Income Tax Act where a person or group of persons hold a majority of the voting rights among shares in that particular corporation. A Canadian corporation holding investment assets may issue a majority of “skinny voting shares”, or special voting shares that are redeemable for a nominal amount and that generally do not carry rights to dividends or assets on a winding-up of the corporation, to a non-resident shareholder or to a public Canadian corporation. As a result, the corporation will not be treated as an entity controlled by Canadian residents and will not meet the requirement of being “Canadian-controlled” to qualify as a CCPC.
3. Avoiding Control Through Use of Options: Control of a corporation may exist in the hands of a shareholder where that shareholder possesses enough stock options which, if exercised, would grant that shareholder a majority of shareholder voting rights in the corporation. A Canadian corporation can thus issue stock options with the right to obtain a majority of voting shares to a non-resident shareholder or to a public Canadian corporation. As a result, the corporation will similarly not be treated as “Canadian-controlled” and will fail to meet the definition of a CCPC under the Income Tax Act.

Straddle Loss Creation Transactions

A “straddle transaction” is a type of tax planning arrangement in which a taxpayer utilizes offsetting financial instruments to create controlled losses for tax purposes. Generally, the taxpayer will enter into offsetting arrangements, and settle the “losing” leg in its first tax year, and its “winning” leg in the following tax year. The loss realized in the taxpayer’s first tax year will be realized before the income to offset the loss in its second tax year. The taxpayer, in essence, earns access to the loss early to apply against other income, even though from an accounting perspective the taxpayer is in exactly the same financial position in those first and second tax years. In theory, a taxpayer could indefinitely engage in straddle transactions to continue deferring related gains, and with additional planning a taxpayer could realize the loss while shuffling the associated gain to another taxpayer. Anti-avoidance rules under section 18 of the Income Tax Act were introduced as part of Budget 2017 to prevent abuse of straddle transactions to generate losses. The Minister of Finance has proposed designating as notifiable transactions those arrangements and transactions that employ partnerships and foreign exchange forward purchase and sale agreements in an attempt to avoid the application of straddle transaction anti-avoidance rules to the winning and losing legs of a straddle transaction.

21-Year Deemed Disposition Rule

Under subsection 104(4) of the Canadian Income Tax Act, certain assets including most capital property, resource property, land inventory and depreciable property held as part of most trust arrangement are deemed to be disposed of and re-acquired every 21 years. In doing so, the accrued gains and losses on those assets must be recognized every 21 years, which prevents a taxpayer from passing accrued capital gains along indefinitely for a significant tax planning advantage.

In turn, subsection 107(2) of the Income Tax Act provides that the trust property of a trust may be transferred to a capital beneficiary on a tax-deferred basis. An exception to this rule is provided under subsection 104(5.8) where the trust property is transferred to another trust. The Minister of Finance has proposed designating certain transactions as notifiable transactions, where the purpose of those transactions is to avoid the application of the 21-year rule to trust property:

1. Indirect Transfer of Trust Property to Another Trust: A Canadian resident trust that owns shares in a Canadian corporation may arrange for that corporation to become a beneficiary of another Canadian resident trust that holds capital property or land inventory. Before the 21-year deemed disposition occurs, the Canadian resident trust holding that property may elect under subsection 107(2) to transfer that property to the corporation on a tax-free basis. In effect, the 21-year deemed disposition rule will begin counting anew for the trust that acquired the property, and will not apply to the previous trust, extending the period of tax deferral on the trust property.
2. Indirect Transfer of Trust Property to a Non-Resident: Similar to the above, the non-resident beneficiaries of a Canadian resident trust may interpose a corporation to hold the property of that trust. The corporation may receive as beneficiary of the trust the trust property on a tax-deferred basis under subsection 107(2). As a result, the 21-year deemed disposition rule will not apply to the trust.
3. Transfer of Trust Value Using a Dividend: Through an arrangement of trusts and holding corporations, the profits of an operating company may be extracted as a deemed dividend and shifted from an existing trust to a new Canadian resident trust. In such arrangements, the 21-year deemed disposition rule will be negated for the existing trust and will reset the time for the new Canadian resident trust, extending the period of deferral.

Manipulation of Bankruptcy Status

A taxpayer who is unable to and fails to meet their commercial debt obligations may fall into bankruptcy. The taxpayer’s various creditors may agree to compromise on their debts and to realize some value from the taxpayer as part of a plan of arrangement or receivership. The forgiven amount of those settled commercial debt obligations must be used to reduce certain loss carryovers of the taxpayer and may ultimately form part of the taxpayer’s income.

However, when a taxpayer is assigned into bankruptcy, it may be possible for that taxpayer to settle a commercial obligation for an amount that is less than the principal amount of that obligation, and then to file a proposal under the Bankruptcy and Insolvency Act to have the bankruptcy annulled. The Minister of Finance has proposed to designate any such transaction that settles or is deemed to settle a commercial obligation through manipulation of bankruptcy status as a notifiable transaction.

Section 256.1 and the Purpose Test

Section 256.1 deems control of a Canadian corporation to have been acquired for purposes of loss restriction rules under the Income Tax Act where significant equity in the corporation is obtained by a person or group of persons that do not exercise control, but reasonably acquired that equity and not control to avoid those restrictive rules. More specifically, subsubsection 256.1(2) will deem control of a Canadian corporation to have been acquired where:

1. The person or group of persons acquires shares having more than 75% of the fair market value of all shares of the corporation;
2. The person or group of persons did not and does not have control of the corporation for purposes of the Income Tax Act; and
3. it is reasonable to conclude that one of the main reasons that the person or group does not control the corporation is to avoid the application of the provisions of the Income Tax Act.

Section 256.1 principally exists to prevent trading of losses and tax attributes between corporations in unintended or potentially abusive ways. Crucially, the intent of the acquisition dictates the applicability of section 256.1. The Minister of Finance has proposed deeming arrangements or transactions as notifiable transactions those that meet the conditions of triggering section 256.1, but where the taxpayer takes the position that the acquisition of the corporation’s equity did not meet the purpose test.

“Back-to-Back” Arrangements

Subsections 18(4)-(8) of the Income Tax Act prevent erosion of Canada’s tax base by foreign entities by denying the incentive to excessively seek interest deductions through debt capitalization. More specifically, subsection 18(4) does so by denying a deduction for interest paid or payable on debts owed to relevant non-residents, and which generally includes non-arm’s length non-residents with the Canadian taxpayer. Subsection 18(4), and other related rules under the Income Tax Act, are referred to as the “thin capitalization” rules.

Subsection 212(3.1)-(3.3) of the Income Tax Act in turn prevent taxpayers from obtaining a more favourable Canadian tax result by interposing a non-resident intermediary to avoid the application of thin capitalization rules and Part XIII withholding tax on interest. In the absence of these “back-to-back” loan rules, it would be possible for a Canadian taxpayer and a non-arm’s-length non-resident to involve an arm’s length party in a loan arrangement to avoid the application of the thin capitation rules and withholding taxes.

The Minister of Finance has proposed designating two arrangements as notifiable transactions under section 237.4:

1. Intermediary Non-Resident Arrangements: A taxpayer may receive a loan from an arm’s-length non-resident, after an agreement to make that loan to the taxpayer was formed between the arm’s-length non-resident and a non-resident not at arm’s-length with the taxpayer. The taxpayer may take the position that the resulting debt is not subject to the thin capitalization rules. The Minister of Finance has proposed declaring such an arrangement as a notifiable transaction.
2. Circumventing Part XIII Withholding Tax: A non-resident individual may choose to make a loan to another non-resident individual related to a Canadian taxpayer to avoid the debt being subject to Part XIII tax. In such cases, the Minister of Finance has proposed declaring that arrangement to be a notifiable transaction.

Pro Tax Tip: Even if They Have Not Received Royal Assent, You Should Absolutely Not Ignore These Rules. Square Away Your Tax Planning Now, Before it Becomes an Issue.

As the Ministry of Finance’s about-face on November 3, 2022 has proven, these proposed reporting obligations remain dynamic and subject to change. As a government bill, there is a very high likelihood that section 237.4 will become law. Unless you remain appraised of changes to the proposed rules, you risk exposing yourself needlessly to penalties for failure to comply with the law. While section 237.4 reporting obligations do not impose tax obligations and would only apply to future transactions, it imposes a serious penalty for late filing or failure to file a required information return.

Specifically, for section 237.4 notifiable transactions, individuals who file late are subject to a maximum penalty of the greater of $25,000 and 25% of the tax benefit obtained from the transaction, while corporations with asset ownership over $50 million may be subject to a penalty of the greater of $100,000 or 25% of the tax benefit.

The period of reassessment for a notifiable transaction remains live under the proposed amendments as long as a taxpayer has failed to file an information return. However, you should absolutely not ignore these obligations when they arise for several reasons. First, subsection 237.4(15) of the proposed amendments to the Canadian Income Tax Act would provide some measure of protection in the face of a future tax audit by CRA. Under the proposed subsection, information returns filed under section 237.4 cannot be treated as an admission of guilt on the part of a taxpayer, should the matter be re-assessed by CRA. It is almost guaranteed that a Canadian taxpayer who files an information return for a notifiable transaction will attract the attention of the CRA and face a potential tax audit. A Canadian taxpayer who files their tax returns diligently begins the normal tax reassessment period under subsection 152(3.1) of the Income Tax Act. Once the normal tax reassessment period has passed, the CRA is prevented from reassessing a taxpayer’s tax assessments for that year except under limited means, including where the CRA can demonstrate there was “negligence, carelessness, or wilful neglect” by the taxpayer in filing taxes for that year. Where a taxpayer relies on a reasonable interpretation of Canadian tax law when reporting to the CRA, the taxpayer is more likely to be found to have acted reasonably in reporting. Ignoring your reporting obligations to the CRA can impose indefinite liability on you for transactions you have already undertaken.

Reporting the matter to the CRA, however, ensures that they must meet the burden of proof to reassess you for those transactions should they take too long to do so in the normal course of their operations. It is in your best interests to make sure you report your transactions correctly. Further, where it is doubtful whether a transaction may or may not be substantially similar to a designated notifiable transaction, it is absolutely crucial that you speak to an expert Canadian tax lawyer to determine how best to treat the transaction for reporting purposes. Remining diligent is your best weapon against unfair treatment by the CRA of your tax planning arrangements.

FAQs:

What changes has the Minister of Finance proposed to mandatory reporting obligations under the Income Tax Act?

As part of the 2021 Federal Budget, the Minister of Finance proposed three major changes to mandatory disclosure requirements under the Canadian Income Tax Act: 1) A lower threshold for triggering “reportable transaction” rules; 2) The creation of a new category of “notifiable transactions” as jointly categorized by the Minister of Finance and Minister of National Revenue; and, 3) Mandatory reporting requirements for large corporations engaged in transactions with an “uncertain tax treatment”. Each transaction caught by the proposed rules would have to be disclosed in an information return to the Canada Revenue Agency, with penalties and potential re-assessment applying to late filers or non-filers.

When do the new mandatory disclosure rules concerning notifiable transactions take effect?

The new mandatory disclosure rules proposed by the Minister of Finance have not yet been made law in Canada. An amended version of the proposed legislation was released in August 2022, following a public consultation process. Originally, the mandatory disclosure rules were to apply to transactions that occurred in the 2023 calendar year and beyond. As of November 4, 2022, the Minister of Finance has suspended the application of those rules until the Ministry of Finance has been able to fully reconcile the new amendments to the Income Tax Act with the results of its public consultation process.

What is a “notifiable transaction” for purposes of the Income Tax Act?

Under the newly-proposed section 237.4 of the Income Tax Act, the Minister of National Revenue in concurrence with the Minister of Finance would be granted the power to designate a transaction or series of transactions as a “notifiable transaction”. Under the proposed amendment, a Canadian taxpayer who accrues or expects to accrue a tax benefit, an agent or promoter, or any person not dealing at arm’s length with an advisor or promoter working for a fee concerning the transaction would be obligated to report on that tax planning structure to the Canada Revenue Agency (“CRA”). Those reporting obligations would also apply to a particular transaction or series of transactions that is the same or substantially similar to a designated notifiable transaction.

What arrangements or transactions has the Minister of Finance designated as a notifiable transaction?

The new mandatory disclosure rules proposed by the Minister of Finance have not yet been made law in Canada. The Ministry of Finance did release, however, a list of sample notifiable transactions that presumptively form the first six notifiable transactions that will be designated once the amendments receive Royal Assent. Those transactions include: 1) manipulating CCPC status to avoid anti-deferral rules applicable to investment income; (2) straddle loss creation transactions using a partnership; (3) avoidance of the 21-year deemed disposition rule for trusts; (4) manipulation of bankruptcy status to reduce a forgiven amount concerning a commercial obligation; (5) reliance on the purpose tests under section 256.1 of the Income Tax Act to avoid a deemed acquisition of control; and (6) “back-to-back” arrangements.