Tax Reporting Headache – Reportable & Notifiable Transactions

Lawyers can usually assist with implementing tax-driven reorganizations cooked up by tax accountants without having to worry about the related tax reporting. A lawyer who prepares a section 85 rollover agreement, for example, will almost always leave it to the accountant to prepare the T2057 election form.

Draft legislation released on February 4, 2022 (the “Draft”) will change the old certitude. The draft expands existing s 237.3 of the Income Tax Act (Canada) (the “Act”)[1] relating to “reportable” transactions and introduces new s 237.4, which implements rules for “notifiable” transactions. In both cases, all specified persons who participate in the transactions, including, possibly, lawyers who implement them, may be responsible for filing detailed reports about the transactions within a very short period of time after the commencement of the series of transactions that includes them.

The rules in the Draft are already in effect—they are supposed to apply to any series of transactions that commences after 2021—but penalties will only apply for a series of transactions that commences after the Draft receives Royal Assent.[2]

1          Reportable Transactions

The reportable transactions rules in s 237.3 have been in the Act since 2010. The Draft, however, significantly expands their scope. The old rules applied when a taxpayer undertook an “avoidance transaction”, if any two “hallmarks” were present in connection with the transaction.

Under the new rules, a transaction is an “avoidance transaction” “if it may reasonably be considered that one of the main purposes of the transaction … is to obtain a tax benefit.”[3] A “tax benefit” includes “a reduction, avoidance or deferral of tax or other amount payable under this Act or an increase in a refund of tax or other amount under this Act”.[4] The scope of the latter definition is broad enough that almost any kind of tax purpose, if it is one of the main purposes of a transaction, will make the transaction an avoidance transaction. An estate freeze would very likely qualify as an avoidance transaction because one of the main purposes of a freeze is almost always to defer tax.

Under the new rules, a transaction will be reportable only if it is an avoidance transaction and one of a number of “hallmarks” is present. The hallmarks include the following:

1. An advisor, a promoter (both are defined terms), or any person dealing not at arm’s length with either of them, is entitled to a “fee” (another defined term) that is based on or contingent on the tax benefit to be obtained by the transaction or that may be refunded if the tax benefit is not obtained, or on the number of persons who participate in the transaction (below, “hallmark fees”). For this purpose, “advisor” includes any person who provides “any assistance or advice with respect to … organizing or implementing the transaction”[5] (ie almost certainly a lawyer) and “fee” includes consideration received for “preparing documents supporting the transaction”.[6]

2. An advisor or promoter obtains “confidential protection” in certain circumstances. “Confidential protection” includes “anything that prohibits the disclosure to any person or to the Minister of the details or structure of the transaction”.[7]

3. A person who entered into the transaction or an advisor or promoter had “contractual protection”, which includes insurance (other than standard professional liability insurance) or an indemnity against the failure of the transaction to obtain its tax benefit or against costs incurred in respect of a dispute over the transaction.

2          Notifiable Transactions

Section 237.4 of the Draft Proposals introduced ‘Notifiable Transactions’, a new category of transactions that the CRA has found to be abusive. The CRA has identified these as ‘transactions of interest’ for which reports must be filed.

The draft legislation defines a notifiable transaction as one that is the same as or substantially similar to a series of transactions that has been designated by the Minister. The Minister, to date, has designated six different series of transactions as notifiable transactions. The six notifiable transactions are as follows.

2.1         Manipulating CCPC status

Some taxpayers are engaging in transactions regarding private corporations they control, directly or indirectly. These transactions seek to avoid CCPC status of such corporations – in circumstances where such corporations are or continue to be controlled (directly or indirectly) by Canadian residents – in order to achieve a tax deferral advantage in respect of other investment income. The transactions generally involve avoiding “Canadian corporation” or “Canadian-controlled” status, either of which could make it such that the corporation would not be a CCPC.

The designated transactions include avoiding “Canadian corporation” status (by continuing a CCPC under the laws of a foreign jurisdiction) and avoiding “Canadian-controlled” status (by issuing a majority of special, voting shares (a.k.a. “skinny” voting shares) to a non-resident person or public corporation).

2.2         Straddle creation transactions using a partnership

Some taxpayers are engaging in financial arrangements that seek to reduce tax by generating artificial losses with the use of complex financial instruments or derivatives. The designated series of transactions with respect to straddles is complicated, but essentially involves forward agreements which generate substantially equal and offsetting gains and losses.

2.3         Avoiding the 21-year deemed disposition rule for trusts

To avoid a situation where a transfer of trust property to the capital beneficiaries results in an inappropriate tax deferral advantage, the Minister has designated several notifiable transactions. All of the designated transactions contemplate the circumvention of the 21-year deemed disposition trust rules.

2.4         Manipulation of bankrupt status to reduce debt forgiveness

The debt forgiveness and debt parking rules in ss 80 to 80.04 apply when a commercial debt obligation is settled or extinguished for less than its principal amount. Some taxpayers are entering into arrangements in which they are temporarily assigned into bankruptcy before settling a commercial obligation in order to reduce its potential forgiven amount to nil. As a result, there is no reduction in the taxpayer’s tax attributes and no income inclusion even though the bankruptcy is subsequently annulled. This is now addressed as a designated transaction.

2.5         Avoidance of acquisition of control of a corporation in certain circumstances

Section 256.1 contains rules meant to constrain the trading of corporate tax attributes among arm’s length persons. The designated series of transactions include the purpose tests inherent in paragraph 256.1(2)(d), paragraph 256.1(4)(a) and paragraph 256.1(6). The Minister designated certain transactions that avoid the tax attribute trading restrictions in section 256.1 by relying on one of the purpose tests in that section to conclude that the restrictions do not apply to the particular transactions or events.

2.6         Back-to-back lending to avoid either thin capitalization rules or non-resident withholding tax

The designated transactions include any situation where the thin cap rules apply and situations where Part XIII tax is avoided by interposing a corporation to which interest is paid. Thin cap rules currently exist to address these kinds of transactions, but the designation of the transactions ensures that the burden is no longer on the CRA to identify them.

3          Reporting and (harsh) penalties for not reporting

The rules for both reportable transactions and notifiable transactions require that information returns be filed in respect of the transactions. Anyone “for whom a tax benefit results” must file a return. In the case of reportable transactions, every advisor or promoter who earns hallmark fees must file a return. For notifiable transactions, every adviser or promoter must file a return regardless of the type of fees earned.

Old s 237.3(4) provided that any return filed satisfied the filing requirement for all persons otherwise required to file a return. The Draft proposes to repeal s 237.3(4), which means that all persons required to file returns for a reportable transaction or notifiable transaction must file the return.

The information to be provided is significant if the nine-page form currently used for reportable transactions (RC312) is anything to go by. The report must include a description of the expected tax treatment of the transaction, its tax benefit, the transactions in the series that includes the transaction and the parties involved.

The return is due 45 days after the earlier of the day the taxpayer becomes contractually bound to enter into the transaction and the day on which the taxpayer enters into the transaction.

The penalties for failing to file a return for a reportable or notifiable transaction in a timely manner are significant. For an advisor, the penalty is the total of (1) all fees charged in respect of the reportable transaction, (2) $10,000 and (3) $1,000 per day that the report is late to a maximum of $100,000.

In addition, the normal reassessment period for a transaction for which a return must be filed does not start until the return is filed.

4          Your life is now more complicated

A lawyer who assists with implementing a tax-driven reorganization by preparing the legal documents to implement it is an “adviser” for the purposes of the rules governing reportable and notifiable transactions. If the reorganization includes a notifiable transaction, then the lawyer must file a return about it with the CRA. If the reorganization includes a reportable transaction, then the lawyer must file a return if the lawyer charged a hallmark fee.

What constitutes a hallmark fee is not entirely clear. Does value billing fall within the ambit of the rules? What about a flat rate for a particular kind of agreement that is used multiple times in the reorganization (eg a rollover agreement)? Is that a fee that is “based on” the tax benefit that will be derived from the reorganization?

Lawyers can avail themselves of a due diligence defence for failing to file a return as required by the rules, but it is important to keep in mind “due diligence” depends on

whether the person believed on reasonable grounds in a non-existent state of facts which, if it had existed, would have made his or her act or omission innocent, or whether he or she took all reasonable precautions to avoid the event leading to the imposition of the penalty[8]

Ignorance of the law—even ignorance of the Act—is not an excuse: “[D]ue diligence consists in taking steps to fulfil a duty imposed by law and not in the ascertainment of the existence of a statutory prohibition or its interpretation.”[9] As a result, for example, a lawyer is without excuse who is unaware that a transaction he or she helped to implement was on the CRA’s list of notifiable transactions.

The rules impose other headaches on lawyers. For example, how does the lawyer comply with a reporting obligation and protect solicitor-client privilege? A discussion of the latter issue is beyond the scope of this article, however.

5          What is to be done?

As tax advisers, we are struggling to come up with guidance that can ensure a lawyer who is not a tax specialist will always stay on the right side of the reportable and notifiable transaction rules. Given what constitutes due diligence, the lawyer tasked with implementing transactions set out in an accountant’s steps letter cannot simply ask the accountant whether the rules apply to the transactions and then rely on the answer as a defence if the accountant’s response is incorrect.

Nevertheless, asking that question is an important first step. The lawyer can probably rest easy if the accountant provides a detailed memo on why the rules do not apply. If the accountant responds with “The reportable what now?”, however, the lawyer will know that further investigation is warranted.

[1] All statutory references are to the Act unless otherwise noted.

[2] As of the time of writing, the Draft has not been introduced as a Bill.

[3] S 237.3(1) “avoidance transaction”.

[4] S 237.3(1) “tax benefit”, which references the definition of that term in s 245(1).

[5] S 237.3(1) “advisor”.

[6] S 237.3(1) “fee”.

[7] S 237.3(1) “confidential protection”.

[8] Corp. de l’École Polytechnique v Canada, 2004 FCA 127, para 28, cited in B Ball, M Dolson, P Lynch, G Watson and C Brayley “Reportable and Notifiable Transactions”, Canadian Tax Foundation online seminar.

[9] R v Pontes, 1995 CanLII 61 (SCC), [1995] 3 S.C.R. 44, cited in B Ball et al., note 8 above.