This month’s article concludes the discussion on nasty tax traps that commenced last month.  

 

Loans to Non-Resident Corporate Shareholders

Most readers will be familiar with the shareholder loan rules in subsection 15(2) – that the loan must be repaid no later than the end of the year after the taxation year of the corporation in which the loan was made.  As a general rule, inter-corporate loans do not trigger subsection 15(2); however, one exception is a loan to a non-resident corporate shareholder[1].  In this case, subsection 15(2) may apply, with the result that there will be non-resident withholding tax at applicable rates[2].  This is 25% unless the withholding rate is reduced by a tax treaty; e.g., under the Canada-US Treaty, the withholding rate on a loan to Parentco would be reduced to 5%.  (Also potentially applicable are subsection 17(1) and 80.4(2) and related provisions, that may impose “deemed interest benefits” on the lender and non-resident borrower[3].) 

 

Estate Freeze Beneficiary Crosses the Border

Doing an estate freeze in favour of children or grandchildren is one of the most commonplace Canadian estate planning transactions.  If an investment holding-type corporation is among the corporations subject to the freeze, a beneficiary of the trust who crosses the border to reside in the States can potentially be subject to the punitive US PFIC (Passive Foreign Investment Company) rules.  The PFIC rules will not be applicable until there is either a distribution from the company or a sale of its shares.  But at that point the tax consequences can be quite harsh: US tax will occur at the highest marginal rate plus an imputed interest factor to compensate for distributions that “should have been made” in previous years.  Generally, PFIC status will apply where 75% or more of a corporation’s gross income is passive income, or at least 50% of the value of its assets produce such income.[4]

There are various “look through rules” where entities are interposed between the US resident and a PFIC.  One of these relates to shares held by a trust.  My understanding is that if there have been no distributions from a discretionary trust, there is no IRS policy on a beneficiary’s ownership of the PFIC.  So in that case, it appears that the position can be taken that the PFIC rules do not result in US tax exposure.  Of course, if the shares are held directly by the US resident rather than through a trust, this position will not apply and the PFIC rules will be “live”.[5]  For many investment holding companies, distributions or sales of its shares may not be in the cards, at least for many years.  If this is the case, then the good news is that unless and until such time as there is a distribution or sale, the PFIC rules do not apply – the bad news is that when these events occur, the tax could be punitive.

There is now an added complication.  On March 18th, 2010, the US HIRE Act came into effect.  Formerly, US tax reporting[6] was required in respect of a PFIC only if there was a distribution or share sale.  However, for taxation years beginning on or after March 18th, 2010, mandatory annual reporting appears to be required.  If the information is not supplied, the IRS can impose a penalty of US $10,000 per infraction.  Worse still, the assessment limitation period on the 1040 return itself will not run until the information is submitted by the taxpayer.

The “PFIC taint” - as US practitioners like to call it - is so odiferous that it is typically recommended that the US resident or citizen file a “QEF” election.  If so, this means that the individual must report his or her share of accumulating income in the PFIC, even if it is not distributed.
 

Association Rules

An estate freeze can inadvertently result in association between corporations that might otherwise be entitled to claim a separate small business deduction from one another.[7] 

Assume, for example, that husband and wife each wholly own respective corporations that are each claiming a small business deduction.  Husband decides to do a freeze in favour of his children.  He changes his common shares into freeze shares with new growth shares held by a discretionary family trust.  For such a trust, each beneficiary is deemed to own all of the shares in the trust[8], with ownership of shares owned by a child under 18 normally attributed to the parents[9].  Accordingly, wife will be deemed to own the common shares of the husband’s company, thus associating the two corporations. 

If one of the child beneficiaries grows up and forms his or her own corporation, a similar result will occur.  The child is deemed to own all of the common shares of father’s corporation and thus father’s corporation will be associated with the child’s corporation.[10]

 

Assessment Limitation Period – Longer Than You Think

As a general rule, the assessment limitation period in respect of the utilization of tax accounts from prior years starts in the year in which the taxpayer seeks to benefit from them.  Examples include carry forwards of non-capital losses[11] and investment tax credits[12], capital dividend accounts[13], and refundable tax on hand[14].  With the extension of the non-capital loss/investment tax credit carry forward to twenty years, it is open for the CRA to challenge claims made long ago.  In the case of elements of the CDA, the period may be infinite.   

Also infinite are the assessment limitation periods in respect of non-resident withholding tax, director’s liability for unpaid source deductions[15], section 116 withholding for a purchase of taxable Canadian property from a non-resident[16], penalties for failure to withhold tax[17], failure to withhold on fees paid to non-residents for services rendered in Canada[18], failure to remit amounts required to be deducted or withheld[19], as well as liability for section 160 assessments[20] – i.e., joint and several liability of a non-arm’s length transferee (including dividends paid to a shareholder of a closely-held corporation)[21].  Another disturbing trend is the opening up of the normal three-year reassessment period on the basis of neglect or carelessness.[22]

If a partnership return is not filed, there is no assessment limitation period for the partnership’s income, loss or other matters in respect of the partnership[23].  (This applies even if the partnership is not required to file a return – e.g., per the requirements announced in the fall.)

 

Corporate-owned Insurance – Split-premium Structures

It’s one of the oldest insurance estate planning chestnuts around: Holdco is the beneficiary of the insurance policy, and Subco (often an operating company) pays the premiums (see Fig. 1).  Asset protection could be a rationale for the structure.  Perhaps a little more to the point, the idea is that, with the premiums paid by Subco, the CDA account would be based on the death benefit, i.e., without a reduction for the adjusted cost basis of the policy resultant from a portion of premium payments.  After threats of applying GAAR over the years[24], the CRA finally put its proverbial foot down at the 2009 Canadian Tax Foundation conference[25], announcing that, in this situation, the premiums paid by Subco would constitute a subsection 15(1) benefit starting in calendar 2011 for life insurance policies issued prior to the time of the statement[26], adding for good measure that GAAR could apply, presumably if the holding of the insurance was structured to unduly increase the CDA.

Unfortunately, the CRA has been less than sympathetic to structures intended to cope with the new policy.  (One simple strategy could be to transfer the ownership to Holdco; however, there could be a policy gain on such a transfer[27].)  At the 2007 APFF conference, the CRA was queried as to the result of the situation depicted in Fig. 2 - where Mr. A. holds two sister corporations: Corp 1 is the policy holder and pays the premiums; Corp 2 is the beneficiary.  The CRA indicated that Mr. A. could be subject to subsection 15(1)[28].

At the 2010 CALU meeting, the CRA was asked to comment on three separate situations[29].  The first, depicted in Fig. A, is the reverse of the structure discussed above.  In this case, Holdco pays the premiums and names Subco as a beneficiary.  The CRA responded that subsection 15(1) is not applicable but subsection 246(1) could apply to Subco.

Situation B, depicted in Fig. B, is like situation A (i.e., where Subco is the beneficiary) except that Subco is designated as an irrevocable beneficiary and reimburses Parentco for the insurance premiums.  The CRA indicated that the reimbursement might be included in Parentco’s income under section 9 or paragraph 12(1)(x)[30].  Somewhat perversely, the CRA indicated that the reimbursement would not boost the ACB of the policy (and therefore reduce the CDA).  Similar results would occur in Situation C, depicted in Fig. C, where an individual holds sister corporations, with Sisterco 1 paying the premiums and Sisterco 2 being the irrevocable beneficiary which reimburses Sisterco 1.[31]

These comments (particularly with respect of the application of subsection 246(1)) could have wide-ranging significance in respect of corporate-owned insurance structures, particularly in respect of buy-sell agreements.  

 

Other Tax Traps

 In this article and the last, I have attempted to summarize the most troublesome tax traps.  There are many, many others.  The following is a list of some of these:

In last month’s article, I promised to give some consoling advice, for those who are caught in a trap.  With the help of professional tax advice (typically, the person retained by the advisor’s insurer) it is often possible to find a solution to the problem.  For example, it may be possible to obtain a court order rectifying the transaction, perhaps on the grounds that it was intended that the transaction be effected without tax.  When you first encounter the tax trap – that’s when the situation looks blackest.  Hopefully, it will get brighter.   

David Louis, tax partner, Minden Gross LLP, a member of MERITAS law firms worldwide. David's practice focuses on tax and estate planning for entrepreneurs and their corporations (dlouis@mindengross.com). Special thanks to Joan Jung and Michael Goldberg, who made many valuable suggestions for discussion in this article.