Key Tax Issues for Corporate Counsel: Identifying and Managing Tax Risk Identifying and Managing Tax Risk

Michael Friedman, PartnerMichael Friedman, Partner

Carl Irvine, Associate

Presented at:Offices of McMillan LLPOffices of McMillan LLP

Toronto, OntarioOctober 16, 2012

Agenda

CRA Audit Activity: Recent Trends

Key Tax Concerns for Corporate CounselKey Tax Concerns for Corporate Counsel1) Employee vs. Independent Contractor Characterizations

2) Taxable Benefits from Employment

3) Employee Stock Options

4) Tax Compliance – Audit Management and Disclosures

5) Director’s Liability5) Director’s Liability

6) Commodity Tax Changes

QuestionsQuestions

2

CRA Audit Activity: Recent Trends

• In 2008-2009, the CRA:

• conducted over 370,000 audit and review actions, and

• identified over $7.4 billion in non-compliance among commercial enterprises

• Taxable benefits continue to be a key focus of CRA audit • Taxable benefits continue to be a key focus of CRA audit activity

• The CRA is undertaking a series of focused audit projects to • The CRA is undertaking a series of focused audit projects to identify systemic under-reporting of income and other acts of non-compliance

3

Key Tax Concerns for Corporate Counsel

1) Employee vs. Independent Contractor Characterizations

• One of the most common areas of focus of CRA payroll audits• One of the most common areas of focus of CRA payroll audits

• Tests to distinguish an employee from an independent contractor are difficult to apply and are extremely fact-specific

4

Key Tax Concerns for Corporate Counsel

1) Employee vs. Independent Contractor Characterizations

• In Sagaz Industries, the Supreme Court:• In Sagaz Industries, the Supreme Court:

o articulated the central legal test as being “whether the person who has been engaged to perform the services is performing them as a person in business on his own account”, andthem as a person in business on his own account”, and

o identified certain determining “factors” that distinguish an employee from an independent contractor employee from an independent contractor

5

Key Tax Concerns for Corporate Counsel

1) Employee vs. Independent Contractor Characterizations

Relevant FactorsRelevant Factors

• Degree of control/autonomy

o Payer’s right to control worker’s daily activities

• Ownership of tools and equipment• Ownership of tools and equipment

• Right to sub-contract work and hire assistants

• Financial risk/reward• Financial risk/reward

o Responsibility for operating expenseso Liability for contractual non-performanceo Opportunity for profito Opportunity for profit

• Responsibility for investment and management

6

Key Tax Concerns for Corporate Counsel

1) Employee vs. Independent Contractor Characterizations

• Later jurisprudence has also identified the intention of the parties as • Later jurisprudence has also identified the intention of the parties as a relevant factor (Royal Winnipeg Ballet)

Implications of the Employee/Independent Contractor Determination

1. Source withholdings and remittances• Income tax, CPP, EI

2. Supplementary employer remittance obligations2. Supplementary employer remittance obligations• CPP, EI, EHT, WSIB premiums

3. Reporting obligations• T4/T4A returns, EHT, WSIB

4. GST/HST payment obligations

7

Key Tax Concerns for Corporate Counsel

2) Taxable Benefits from Employment

• Taxation of non-monetary employee remuneration is frequently • Taxation of non-monetary employee remuneration is frequently a primary focus of CRA audits

• The Income Tax Act (the “ITA”) contains a detailed set of rules that require most benefits received by virtue of employment to be require most benefits received by virtue of employment to be included in an employee’s income

• The fair market value of an employment benefit, as opposed to its • The fair market value of an employment benefit, as opposed to its cost to the employer, is generally required to be included in the income of the employee

• In certain cases, applicable GST/HST must be included in • In certain cases, applicable GST/HST must be included in computing the value of a taxable benefit from employment

8

Key Tax Concerns for Corporate Counsel

2) Taxable Benefits from Employment

• The CRA Audit Manual identifies a number of “common taxable • The CRA Audit Manual identifies a number of “common taxable benefits” that are to be examined by CRA auditors, including:

o personal use of employer assetso parkingo parkingo interest-free or low interest loanso incentives or prizeso incentives or prizeso giftso stock purchase optionso allowances paid to employeeso allowances paid to employeeso scholarships where the primary beneficiary is the employee

9

Key Tax Concerns for Corporate Counsel

2) Taxable Benefits from Employment

Certain taxable benefits from employment attract special Certain taxable benefits from employment attract special considerations

Automobile benefits

• Standby charge for an automobile• Automobile operating expense benefit

Parking benefitsParking benefits

• Assigned vs. “scramble” parking

10

Key Tax Concerns for Corporate Counsel

2) Taxable Benefits from Employment

Interest-free or low interest loansInterest-free or low interest loans

• Amount of taxable benefit based on prescribed interest rates• Commercial interest rate exception

Meals

• Generally viewed as a taxable benefit• CRA administrative exception• CRA administrative exception

11

Key Tax Concerns for Corporate Counsel

2) Taxable Benefits from Employment

• There are limited statutory/administrative exceptions to the general • There are limited statutory/administrative exceptions to the general requirement to include the value of benefits from employment in income:

• Certain counseling services• Certain counseling services• Certain restricted, on-site child care services• Certain, non-cash gifts and awards

Required withholdings• Consider whether CPP/EI withholdings required

12

Key Tax Concerns for Corporate Counsel

3) Employee Stock Options

• Preferential Canadian tax treatment typically afforded to employee • Preferential Canadian tax treatment typically afforded to employee stock options

• Absent special rules contained in the ITA, stock option benefits would generally be treated in the same manner as most other taxable would generally be treated in the same manner as most other taxable benefits from employment

13

Key Tax Concerns for Corporate Counsel

3) Employee Stock Options

General PrincipleGeneral Principle

Where a corporation has:

1. agreed to sell or issue its shares (or shares of a corporation with which it does not deal at “arm’s length”),

2. to an employee of the corporation (or of a corporation with which it does not deal at “arm’s length”),does not deal at “arm’s length”),

the preferential employee stock option rules in the ITA may apply

14

Key Tax Concerns for Corporate Counsel

3) Employee Stock Options

• No taxable benefit is recognized when the option is granted• No taxable benefit is recognized when the option is granted

• If the employee acquires shares under the agreement, a taxable benefit is deemed to arise in the year of acquisition that is equal to:

(A) the value of the shares at the date of their acquisition, MINUS(A) the value of the shares at the date of their acquisition, MINUS

(B) the amount paid or to be paid by the employee to the corporation for the shares, MINUScorporation for the shares, MINUS

(C) the amount, if any, paid by the employee to acquire the option

15

Key Tax Concerns for Corporate Counsel

3) Employee Stock Options

• Where the corporation is a “Canadian-controlled private • Where the corporation is a “Canadian-controlled private corporation” (a “CCPC”), provided the employee satisfies certain“arm’s length” tests, recognition of the stock option benefit is deferred until the shares acquired on the exercise of the option are deferred until the shares acquired on the exercise of the option are disposed of or exchanged (the “CCPC Deferral”)

• Previous deferral rules in respect of shares of certain non-CCPCs (e.g., options in respect of certain listed shares) were repealed (e.g., options in respect of certain listed shares) were repealed following the 2010 Budget

• Special rules apply where the stock option is sold by the employee• Special rules apply where the stock option is sold by the employee

16

Key Tax Concerns for Corporate Counsel

3) Employee Stock Options

• Where a stock option benefit is received, the employee may be • Where a stock option benefit is received, the employee may be entitled to claim a deduction equal to 50% of the benefit

• Certain elections and filings by the corporation and the employee may be required in order for the employee to claim the 50% deductionmay be required in order for the employee to claim the 50% deduction

• The tests to be applied to determine eligibility to claim the 50% deduction depend on whether the CCPC Deferral has been claimeddeduction depend on whether the CCPC Deferral has been claimed

17

Key Tax Concerns for Corporate Counsel

3) Employee Stock Options

• Where the CCPC Deferral does not apply, provided the required • Where the CCPC Deferral does not apply, provided the required elections are made and filed, an employee may be entitled to claim the 50% deduction where:

1. the acquired share is a “prescribed share” at the time of its 1. the acquired share is a “prescribed share” at the time of its sale/issue,

2. the amount paid to acquire the share under the agreement is not less than the amount by which (A) the fair market value of the share at than the amount by which (A) the fair market value of the share at the time the agreement was made, exceeds (B) the amount, if any, paid by the employee to acquire the option, and

3. at the time immediately after the agreement was made, the employee was dealing at “arm’s length” with certain specified persons

18

Key Tax Concerns for Corporate Counsel

3) Employee Stock Options

• Where the CCPC Deferral does apply, an employee may be • Where the CCPC Deferral does apply, an employee may be entitled to claim the 50% deduction where:

1. the employee did not dispose of, or exchange, the share acquired on the exercise of the option within two years after acquired on the exercise of the option within two years after the date of its acquisition, and

2. no deduction has been claimed on the basis of the rules that apply to non-CCPC Deferral options.apply to non-CCPC Deferral options.

19

Key Tax Concerns for Corporate Counsel

3) Employee Stock Options

Tax PitfallsTax Pitfalls

1. Options granted to independent contractors

2. Option exchanges

3. Option exercise prices – valuation issues

4. Source withholdings in respect of stock option benefits

• Recent shifts in CRA policy have created particularly onerous withholding requirements under certain circumstances

20

Key Tax Concerns for Corporate Counsel

4) Audit Management and Disclosures

• Revenue authority audit activities often result in:• Revenue authority audit activities often result in:

o tax exposure,

o increased costs, and o

o operational inefficiencies

• These costs are frequently directly attributable to the failure to:

o properly manage revenue authority inquiries and audits,

o co-ordinate compliance measures, and

o address/correct past reporting inaccuracies/non-compliance

21

Key Tax Concerns for Corporate Counsel

4) Audit Management and DisclosuresManagement of Inquiries and Audits

The keys to effectively managing revenue authority inquiries/audits are:

1. Proper advance preparation and organization of supporting documentation (including memoranda/notes recording the bases for, documentation (including memoranda/notes recording the bases for, and methodologies underlying, past filing positions)

22

Key Tax Concerns for Corporate Counsel

4) Audit Management and DisclosuresManagement of Inquiries and Audits (cont.)

2. Alertness to key areas of revenue authority sensitivity, particularly:

o valuationo supporting contractual documentationo supporting contractual documentationo organizational resolutionso banking/financial documentationo transfer pricing contemporaneous documentationo transfer pricing contemporaneous documentation

23

Key Tax Concerns for Corporate Counsel

4) Audit Management and DisclosuresManagement of Inquiries and Audits (cont.)

3. Direct and timely response to revenue authority inquiries and information requests

o Properly ascertain scope and time period of inquiryo Properly ascertain scope and time period of inquiry

o Assemble necessary supporting documentation

o Designate appropriate contact person (including external o Designate appropriate contact person (including external counsel, accounting advisors)

o Draft direct, focused, written responses to inquirieso Draft direct, focused, written responses to inquiries

24

Key Tax Concerns for Corporate Counsel

4) Audit Management and DisclosuresCoordination of Corporate Compliance Measures

• Timely management and filing of required elections, notifications, designations, returns, and remittances

• This will often require/involve:• This will often require/involve:

o Identifying required filings and the relevant filing deadlines (including whether you can make late filings and the implications thereof)

o Triggering the commencement of tax limitation periods

o Requesting refunds and/or other relief within the permitted timeframe

o Properly managing proposed legislation (e.g., restrictive covenant elections, o Properly managing proposed legislation (e.g., restrictive covenant elections, thin capitalization amendments)

25

Key Tax Concerns for Corporate Counsel

4) Audit Management and DisclosuresCoordination of Corporate Compliance Measures (cont.)

• Ensuring consistency of filing positions and documentation among entities within the corporate group

26

Key Tax Concerns for Corporate Counsel

4) Audit Management and DisclosuresAddressing Past Reporting Inaccuracies/Non-Compliance

• Need for principled system to address past reporting inaccuracies/non-compliance

• Consideration should be given to:• Consideration should be given to:

o non-tax reporting obligations (e.g., financial statement disclosure)disclosure)

o applicable limitation periods, and

o the availability and relative advantages/costs of a voluntary o the availability and relative advantages/costs of a voluntary disclosure

27

Key Tax Concerns for Corporate Counsel

5) Directors’ Liability

• The directors of a corporation are potentially jointly and severally • The directors of a corporation are potentially jointly and severally liable where the corporation fails to:

o withhold and remit taxes from certain payments, including salary, dividends, interest and rental payments under the ITAsalary, dividends, interest and rental payments under the ITA

o deduct and remit contributions under the Canada Pension Planand the Employment Insurance Actand the Employment Insurance Act

o remit net GST/HST or repay an overpayment of refund or interest under the Excise Tax Act

• Directors can also be liable for taxes under other federal and provincial statutes.

28

Key Tax Concerns for Corporate Counsel

5) Directors’ Liability

• In addition to potential liability for unremitted tax, directors may • In addition to potential liability for unremitted tax, directors may also be liable for interest and penalties thereon

• The CRA must satisfy certain conditions prior to being able to recover amounts from directors recover amounts from directors

o In practice, non-remittance often arises in circumstances where the corporation is facing financing difficultythe corporation is facing financing difficulty

• The CRA must commence an action against a director within 2 years of his/her ceasing to be a director of the corporation

29

Key Tax Concerns for Corporate Counsel

5) Directors’ Liability

Due Diligence DefenseDue Diligence Defense

• A director is not liable for the failure of a corporation to remit taxes where he/she exercised the “degree of care, diligence and skill to prevent that failure that a reasonably prudent person would have prevent that failure that a reasonably prudent person would have exercised in comparable circumstances”

• Some confusion in the case law as to appropriate standard of care.

• Traditionally, due diligence was determined based on “subjective • Traditionally, due diligence was determined based on “subjective objective” standard (see Soper v. the Queen)

• However, in R v. Buckingham, the FCA concluded that Soper was • However, in R v. Buckingham, the FCA concluded that Soper was no longer good law and that due diligence should be determined based on a purely objective standard

30

Key Tax Concerns for Corporate Counsel

5) Directors’ Liability

Due Diligence Defense (cont.)Due Diligence Defense (cont.)

In order to (i) prevent non-compliance with corporate remittance obligations, and (ii) demonstrate due diligence in the event of such non-compliance, directors should be proactive in ensuring compliance with compliance, directors should be proactive in ensuring compliance with remittance obligations:

o Implement policies and procedures governing remittances

o Delegate responsibility for remittances appropriately

o Risk management

o Regularly review status of remittances/ask questions

31

Key Tax Concerns for Corporate Counsel

6) Commodity Tax Changes

Significant changes to GST/HST and QSTSignificant changes to GST/HST and QST

• Reversion to PST from HST in BC

• Adoption of HST in PEI

• (Almost) full harmonization of the QST with GST

32

Key Tax Concerns for Corporate Counsel

6) Commodity Tax Changes

Reversion to PST in BC/Adoption of HST in PEIReversion to PST in BC/Adoption of HST in PEI

• Effective April 1, 2013, BC will abandon the HST and will revert to a PST regime that is substantially similar to its former PST regime

o Generally, 7% sales tax on sales of tangible personal property and o Generally, 7% sales tax on sales of tangible personal property and certain services (notably, legal services)

o PST is not recoverable, but certain exemptions are (expected to be) oavailable (notably, purchases for resale and certain manufacturing equipment)

• Effective April 1, 2013, PEI will do away with its 10% PST and • Effective April 1, 2013, PEI will do away with its 10% PST and adopt the HST with a 9% provincial component (for a combined HST rate of 14%)

33

Key Tax Concerns for Corporate Counsel

6) Commodity Tax Changes

Harmonization of QSTHarmonization of QST• QST has always been substantially harmonized with the GST/HST

regime, with certain significant exceptions (e.g., zero-rating of financial services, restricted recovery of tax for “large businesses”)financial services, restricted recovery of tax for “large businesses”)

• New regime will (almost) fully harmonize QST with GST/HST regime

• Quebec will remove GST from the QST tax base • Quebec will remove GST from the QST tax base o QST will no longer be imposed on GST, but QST rate will be

increased so that the effective QST rate (9.975%) remains the same

• Quebec will retain separate QST legislative and administrative • Quebec will retain separate QST legislative and administrative regime

34

Key Tax Concerns for Corporate Counsel

6) Commodity Tax Changes

Harmonization of QST (cont.)Harmonization of QST (cont.)• Big impact for financial institutions (“FIs”)

• Financial services will be “exempt”, rather than “zero-rated”, supplieso FIs generally will not be able to claim input tax refunds (“ITRs”) to recover o FIs generally will not be able to claim input tax refunds (“ITRs”) to recover

QST on inputs

• Quebec will be deemed to be an HST province for the “selected listed financial institution” GST/HST rules financial institution” GST/HST rules o Will generally result in higher HST burden for non-Quebec resident FIs (in

particular, investment funds with Quebec-resident investors)

• Quebec is partially eliminating the compensation tax on FIs• Quebec is partially eliminating the compensation tax on FIs

35

Key Tax Concerns for Corporate Counsel

6) Commodity Tax Changes

Harmonization of QST (cont.)Harmonization of QST (cont.)

• Quebec will phase out restricted ITRs for “large businesses”

o Current rules deny ITRs for certain expenses for “large businesses”

o “Restricted ITR” rules will be phased out over 8 years (mirroring restricted input tax credit rules in Ontario)

• Federal government and Quebec government have agreed to pay • Federal government and Quebec government have agreed to pay QST and GST/HST, respectively, as of April 1, 2013

o Businesses will want to ensure that they charge the appropriate tax to o Businesses will want to ensure that they charge the appropriate tax to previously exempt government entities

36

Key Tax Concerns for Corporate Counsel

6) Commodity Tax Changes

Implementation ConsiderationsImplementation Considerations

Businesses will want to ensure that appropriate systems are in place prior to January 1, 2013 (QST) and April 1, 2013 (BC PST, PEI HST)• Businesses may be required to register for BC PST purposes • Businesses may be required to register for BC PST purposes

o BC has an expansive PST registration requirement – can be required to register for, and collect, BC PST even if not physically present in BC

• Businesses will also want to ensure that their systems will charge the • Businesses will also want to ensure that their systems will charge the correct GST/HST, QST and PST rates on sales of taxable goods and serviceso Ensure they start charging GST/HST and QST on supplies to governments as o Ensure they start charging GST/HST and QST on supplies to governments as

of April 1, 2012

o Must pay attention to when tax is deemed to be payable

37

Key Tax Concerns for Corporate Counsel

6) Commodity Tax Changes

Tax Planning ConsiderationsTax Planning Considerations• Because of the difference between the PST and HST systems, there

may be some limited tax planning opportunities relating to the implementation of PST in BCimplementation of PST in BC

• If a transaction is taxable for HST, and is not exempt from BC PST, it may be desirable to execute that transaction before April 1, 2013 in order to be able to recover HST in order to be able to recover HST o PST is generally not recoverable

• Similar limited opportunities for FIs in Quebec before December 31, 201231, 2012

• Must be conscious of rules to prevent tax avoidance transactions with non-arm’s length parties

38

with non-arm’s length parties

39

Reference Sources

Employee vs. Independent ContractorRC4110 – Employee or Self-Employed?http://www.cra-arc.gc.ca/E/pub/tg/rc4110/rc4110-11e.pdfhttp://www.cra-arc.gc.ca/E/pub/tg/rc4110/rc4110-11e.pdf

Taxable Benefits from EmploymentRC4130 – Employers’ Guide - Taxable Benefits and Allowanceshttp://www.craarc.gc.ca/E/pub/tg/t4130/t4130-11e.pdfhttp://www.craarc.gc.ca/E/pub/tg/t4130/t4130-11e.pdf

IT-63R5 – Benefits, Including Standby Charge for an Automobile, from the Personal Use of a Motor Vehicle Supplied by an Employer, After 1992http://www.cra-arc.gc.ca/E/pub/tp/it63r5/it63r5-e.html

IT-421R2 – Benefits to Individuals, Corporations and Shareholders from Loans or DebtIT-421R2 – Benefits to Individuals, Corporations and Shareholders from Loans or Debthttp://www.cra-arc.gc.ca/E/pub/tp/it421r2/it421r2-e.pdf

IT-432R2 – Benefits Conferred on Shareholdershttp://www.cra-arc.gc.ca/E/pub/tp/it432r2/it432r2-e.pdf

IT-470R (Consolidated) – Employees’ Fringe BenefitsIT-470R (Consolidated) – Employees’ Fringe Benefitshttp://www.cra-arc.gc.ca/E/pub/tp/it470r-consolid/it470r-consolid-e.pdf

CRA – Benefits and Allowances http://www.cra-arc.gc.ca/tx/bsnss/tpcs/pyrll/bnfts/menu-eng.html

40

Reference Sources

Employee Stock OptionsIT-113R4 – Benefits to Employees – Stock Options http://www.cra-arc.gc.ca/E/pub/tp/it113r4/it113r4-e.htmlhttp://www.cra-arc.gc.ca/E/pub/tp/it113r4/it113r4-e.html

CRA – Security Optionshttp://www.cra-arc.gc.ca/tx/bsnss/tpcs/pyrll/bnfts/fnncl/scrty/menu-eng.html

Director’s LiabilityIC-89-2R2 – Director’s Liability – Section 227.1 of the Income Tax Act and Section 323 of the IC-89-2R2 – Director’s Liability – Section 227.1 of the Income Tax Act and Section 323 of the Excise Tax Acthttp://www.cra-arc.gc.ca/E/pub/tp/ic89-2r2/ic89-2r2-e.pdf

BC PST, PEI HST and QSTBC PST, PEI HST and QSTBC - Common Questions About Returning to PSThttp://www.hstinbc.ca/moving-forward/faqs/

CRA - Changes to Harmonized Sales Tax (HST)CRA - Changes to Harmonized Sales Tax (HST)http://www.cra-arc.gc.ca/gncy/hrmnztn/

PEI – HST Frequently Asked Questions for Businesshttp://www.gov.pe.ca/photos/original/fema_hstfaqbusi.pdf

41

Reference Sources

BC PST, PEI HST and QST (cont.)Finances Québec – Changes to Québec’s Tax System Pursuant to the Undertakings to Harmonize it with the Federal Tax System Applicable in 2013Harmonize it with the Federal Tax System Applicable in 2013http://www.finances.gouv.qc.ca/documents/bulletins/en/BULEN_2012-4-a-b.pdf

42

Cautionary Note

The foregoing commentary is summary in nature and does not address all of the issues and considerations that may be relevant under any particular set of circumstances.particular set of circumstances.

The statements and material presented herein do not represent legal or tax advice.tax advice.

No transactions should be executed on the basis of the foregoing statements and commentary.

Formal legal, tax, and accounting advice should be obtained prior to making any investment or executing any transaction.

43

Key Tax Issues for Corporate Counsel: Identifying and Counsel: Identifying and

Managing Tax Risk

Michael Friedman, Partnermichael.friedman@mcmillan.ca

d 416.865.7914 | f 416.865.7048

Carl Irvine, Associatecarl.irvine@mcmillan.ca

d 416.865.7266 | f 416.865.7048d 416.865.7266 | f 416.865.7048

McMillan LLP181 Bay Street, Suite 4400181 Bay Street, Suite 4400

Toronto, ON M5J 2T3