Tax Controversy - January 2020

January 09, 2020

Tax Controversy - January 2020

Synopsis
5 Minute Read

Tax Controversy Newsletter January 2020

Tax Controversy

January 2020

In this latest issue, we will update you on this quarter’s ongoing CRA audit activity, share an article on CRA’s audit of trusts and tell a story about recent CRA scams We will also review some U.S. Internal Revenue Service (IRS) audit initiatives across the border that will impact U.S. citizens or green card holders.

Trends in Audit Activity

The CRA continues to keep us busy across the country. At the Canadian Tax Foundation’s Ontario Tax Conference in October, the CRA noted in 2018 it made audit assessments totalling $1.185 billion from audits of small- and medium-sized enterprises. We understand the CRA assessed an average of $137,000 per small business audit and $336,000 per medium-sized business audit.1

Below is a list of current CRA audit activity seen across MNP. This quarter, most of the audit activity appears to be standard desk audits.

Audit Type Description
Transfer Pricing Audits A transfer pricing penalty will apply if “reasonable efforts” are not made to determine arm’s-length transfer prices / allocations and the CRA’s adjustment to transfer pricing for a taxpayer in a tax year exceeds the lesser of 10 percent of the taxpayer’s gross revenue for the year and $5,000,000. There are important documentary requirements and deadlines which must be met to evidence these “reasonable efforts.”
Related party/Cross-border Transactions Review of cross-border transactions and related party balances. The CRA has indicated it is also sharing information with foreign governments. For example, in September the CRA sent 900,000 financial records to the IRS in respect of the 2018 taxation year. Under the information-sharing agreement, the IRS is supposed to send the CRA similar information about U.S. bank accounts held by Canadians.
Shareholder Loans Review of large shareholder loan balances, particularly where there is comparatively low income reported by the shareholder on their personal tax return.
Net Worth Audits Numerous audits across Canada.
Payroll Audits Various reviews (examination, amongst other things, of Canada Pension Plan and Employment Insurance remittances, worker classification, taxable benefits, etc.).
Related Property Rental Income Reviews occurring to determine whether income is classified as income from property or business.
Vehicle Expenses Audit of vehicle expenses for both individuals and corporations. For corporations, CRA requests:
  • A detailed list of all transactions included in vehicle expenses
  • Copies of invoices for the 10-largest amounts plus all general ledger items from the third month of each year under review
  • List of all vehicles for which amounts are claimed and details of owner as well as vehicle logs
Part III Assessments – Capital Dividends Review of capital dividend account (CDA) elections to determine if CDA calculations are accurate and if Part III tax can be applied on excessive capital dividend elections.
Empty Homes Tax (B.C.) Review of property status declarations in the City of Vancouver to determine if subject to the tax.
Election Forms Closer review of election forms such as S.85 and CDA elections.
GST / HST Audits
  • Refund integrity desk audits seen in Saskatchewan and Ontario
  • Ongoing HST / GST audits nationally
Post-Assessment Reviews (Personal Tax Returns)
  • Employment Expenses
    • Vehicle
    • Subsistence and mileage for employees (pipeline companies)
    • Requesting employers complete a job requirement questionnaire
  • Childcare, moving expenses, medical, donations, carrying charges, spousal support
  • RRSP over-contributions
  • Foreign tax credit claims

If you have any questions or concerns with requests for information or proposed reassessments by the CRA, please contact your MNP Advisor.

The CRA’s Audit Crackdown on Family Trusts

Jeanne Cheng, MNP LLP

This article was previously published in Tax for the Owner-Manager, Volume 19, Number 4, October 2019

and has been reproduced with permission.

In recent years, federal budgets have significantly increased funding to the CRA. Much of this funding has been and will continue to be used to expand CRA audit activity. Specifically, the CRA has focused on certain industries and areas of taxation, including small businesses, real estate sales activity, international tax reporting and planning and trusts. Taxpayers often experience anxiety, fear and uncertainty during the audit process, which can extend well beyond a year.

Those feelings are not unwarranted. The 2018 Fall Reports of the Auditor General of Canada

found the CRA did not consistently apply tax rules when it audited or reviewed taxpayers' files. The auditor general also found wide inconsistencies in the deadlines taxpayers were given to respond to CRA requests, the length of time it took the CRA to complete an audit and the documentation requirements imposed on taxpayers.

A particular area of focus for the CRA has been trusts; in fact, the CRA has a dedicated audit department for trusts. The government's increasing focus on trusts is also evidenced by the announcement of new trust reporting rules (draft legislation was released on July 27, 2018). The rules will require trust taxpayers (with some exceptions) to make additional disclosures relating to the settlor, trustees, beneficiaries and others, applicable for taxation years ending after 2021.

Often referred to as a family trust, a discretionary inter vivos trust can be set up to hold family assets, including shares of private corporations. Family trusts can help planners accomplish various objectives, including estate planning, asset protection and tax minimization. When the shares of a business are sold for a gain and the vendor is a discretionary trust with multiple beneficiaries, a significant reduction or even elimination of taxes related to the sale can be achieved, especially if the shares held by the trust are qualified small business corporation (QSBC) shares as defined in subsection 110.6(1). The CRA has been concerned about abuses in this area and recent audits have targeted family trusts that have reported sales of QSBC shares.

The CRA's audit process for a trust involves accumulating documentation and information about many details related to:

  • The trust's setup and administration, including its bank statements;
  • Evidence regarding the subscription of shares by the trust;
  • The payment of trust expenses; and
  • Trustees' resolutions concerning the payment of income and capital gains to beneficiaries.

Although many tax practitioners and trust experts have a good understanding of the intricacies related to the setup and administration of a trust, in practice, such details are not always addressed by trustees, especially those relating to tasks that can be burdensome or costly — for example, setting up a bank account for the trust and preparing annual resolutions.

Many of the trusts the CRA has selected for audit have reported a capital gain from the sale of shares of a QSBC. The tax rules that govern the capital gains exemption are complex and the beneficiaries and trustees of the trust may not always fully understand them.

For a trust to claim a capital gain, shares of a corporation held by the trust must first qualify as QSBC shares. The CRA may request a full analysis be provided to confirm the shares meet the multiple conditions in subsection 110.6(1). The CRA may also ask for bank statements for the trust and the beneficiaries in order to confirm the proceeds of the share sale were received by the trust and subsequently distributed to the relevant beneficiaries.

The calculation of a trust's taxable income involves the inclusion of the taxable capital gain from the sale as income to the trust, and a corresponding deduction pursuant to subsection 104(6) of amounts that are paid or payable by the trust to its beneficiaries. Subsection 104(24) provides that an amount is not considered to be paid or payable unless it was paid in the year to the beneficiary or the beneficiary had a legal entitlement to receive the amount. If the CRA does not obtain satisfactory evidence one of those conditions was met, it can reassess the trust and deny the subsection 104(6) deduction, resulting in a significant tax liability (plus any applicable penalties and interest). Therefore, it is critical the trustees ensure proper documentation and other timely actions, such as the movement of cash between bank accounts of the relevant parties. Further pitfalls may arise if the beneficiaries include individuals under the age of 18.

In a recent client matter, a trust had sold QSBC shares during a previous taxation year. The funds from the sale were distributed directly to only one beneficiary of the trust, even though the trust's tax return in the year of sale allocated taxable capital gains to several beneficiaries, all of whom reported the income on their personal tax returns and claimed their lifetime capital gains exemption in connection with the gain. Ultimately, the tax return of the beneficiary who actually received all of the funds was reassessed by the CRA to include all of the taxable income from the sale.

Given the increasing scrutiny by the CRA, it is imperative all relevant parties — especially trustees — understand their roles and responsibilities and carry out all necessary legal and administrative steps, beginning when the trust is created. As noted earlier, the new reporting rules will apply to returns filed for tax years ending after December 30, 2021. As the effective date for the new reporting requirements approaches, it is apparent the CRA's crackdown on trusts will continue — and if insufficient attention is paid to planning, documentation and implementation, practitioners and trustees can be sure the CRA's auditors will uncover it.

CRA Scams – New and Improved

Fraudsters are becoming ever more sophisticated in creating opportunities and tactics to scam unsuspecting individuals out of funds. Taxpayers need to be vigilant when they receive any sort of communication from someone claiming to be from the CRA – whether that be in the form of an email, text or telephone call. Typically, these scammers will insist a person provide personal information to receive a payment, for example a credit card or bank account number or a passport number. They also pose as collections agents, misleading taxpayers into paying false debts.

Taxpayers should never respond to any threatening or coercive language designed to scare them into paying fictitious debts to the CRA (jail or deportation, for example). They should not enter any personal information into websites to which they are directed. These are simply designed to obtain taxpayers’ private information.

The CRA may contact taxpayers by phone, mail or by email. They do not use text messages, Facebook Messenger or WhatsApp. Taxpayers are warned to not click on any links in any email they receive. This is a technique known as phishing and is used to steal personal information when the link is clicked. Taxpayer’s are also advised to consider email security (for example, when transmitting sensitive data or setting passwords). Personal email accounts can be hacked to gather sensitive personal information which can be used by fraudsters.

Recently, a scammer used the name of a real CRA agent and called an MNP client. They cited MNP’s name and the client they were going to be audited. Luckily MNP was able to verify the call was a scam and halted any further activity. In another situation, the fraudster somehow knew the taxpayer used MNP for their tax reporting, name-dropped MNP and advised the client that they should pay $6,000. The scammer also noted to the client the MNP Advisor (named) was aware and approved the payment. Unfortunately, the client fell for the scam and paid the money.

It is important for taxpayers to be aware of the status of their tax filings and any amounts owing or refundable; by doing so, they can often immediately detect the validity of a communication. A best practice is for a taxpayer to take down the CRA agent’s contact details and agent code and call their MNP advisor with the information to follow up with the CRA. If the communication is received by email, this can be forwarded to MNP to follow up. Additionally, the taxpayer can (and should) ask for any telephone request be made in writing and sent by mail or fax.

CRA will never:

  • Ask for information about taxpayer’s passports, health cards or driver’s licenses.
  • Demand immediate payment via non-cash means, i.e. bitcoin, Interac e-transfer, prepaid credit cards, gift cards, etc.
  • Leave voicemails that are threatening or contain personal or financial information.
  • Send emails requiring links to be clicked or information be filled out.
  • Set up a meeting with taxpayers in a public place to take payment.

If you suspect a CRA scam:

  1. 1. Confirm the legitimacy of the CRA caller: ask for their name, agent code, phone number and office location. Call the CRA to confirm the information (1-800-959-8281 for individuals, and 1-800-959-5525 for businesses).
  2. 2. Ask for the CRA request for information in writing (fax or send to address on file or send to MNP Address).
  3. 3. Trust your instincts.

The CRA has detailed information on its website about fraud and scam prevention:

CRA: Slam the Scam and What to Expect When the CRA Contacts You.

U.S. Tax Corner: The IRS’s Pursuit of Offshore Income – Targeted Audit Campaigns and $10,000 Penalties

Katri Ulmonen, MNP

Determined. Focused. Unrelenting. These are common traits shared by visionaries, leaders and world class athletes. But the IRS? Unfortunately for taxpayers and advisors alike, the answer is yes. In its own words, “The IRS remains committed to our priority efforts to stop offshore tax evasion wherever it occurs.”

In 2017, the Government Accountability Office, which is akin to our Auditor General, released a report that criticized the IRS’s inconsistent application of legislated international tax penalties to taxpayers. The IRS’ response was to begin a series of international tax audit campaigns under the Large Business and International division.

When these audit campaigns were introduced back in January 2018, there was a mere baker’s dozen of audits. With the announcement of the IRC 965 campaign (see below) in November, we now have more than 50 active campaigns, many of which could impact unsuspecting and otherwise compliant clients. To make matters worse, the IRS has discretion to use an assortment of techniques in its audit endeavors, including issuing $10,000 penalty notices in advance of a detailed investigation (thus treating impacted taxpayers as “guilty until proven innocent”). Taxpayers who are legitimately caught on audit may be subject to both civil and criminal charges in addition to an increased tax liability. Some of these types of penalties may have a very high financial cap, far in excess of $10,000.

Below is a summary of current IRS audit campaigns that may impact individuals in Canada.

Should you be in receipt of any IRS notification, it is imperative to discuss this with your MNP Tax Advisor to determine the appropriate course of action.

Audit Campaign Name

Impacted Individuals

IRS Audit Objective

Focus: U.S. Persons

Expatriation

U.S. persons that expatriated after June 2018

Delinquent U.S. filings Underpayment of U.S. taxes

Forms 3520 / A: Non- Compliance

U.S. persons who have transactions and / or own a Foreign Trust

Delinquent, late or inadequate U.S. filings

Foreign Earned Income Exclusion

Taxpayers who claimed a foreign earned income exclusion on their 1040

Taxpayers that do not qualify for the foreign earned income exclusion

High Income Non-Filers

U.S. persons who have not filed U.S. tax returns

U.S. persons who have not reported their worldwide income to the IRS

Individual Foreign Tax Credit (FTCs) (Phase 1 & 2)

Taxpayers claiming FTCs

Incorrect FTCs computed and claimed or taxpayers that do not qualify for FTC

IRC 965

U.S. persons who are shareholders of Canadian Corporations

Underpayment of 2017 Transition Tax related to Deferred Foreign Income in the Canadian corporation

Offshore Voluntary Disclosure Program (OVDP) Declines- Withdrawals Campaigns

U.S. persons who initiated an OVDP application but did not complete the voluntary disclosure

Non-Compliant U.S. taxpayers

Post OVDP Compliance

U.S. persons who disclosed under the OVDP program

Subsequent compliance and reporting post OVDP disclosure

Audit Campaign Name

Impacted Individuals

IRS Audit Objective

Focus: Non-Resident Persons

Non-Resident Alien Schedule A and Other Deductions

Non-residents claiming deductions

Non-residents who do not qualify for deductions claimed

NRA Tax Credits

Non-residents claiming credits

Non-residents who do not qualify for credits claimed

Verification of Form 1042-S Credit Claimed on Form 1040NR

Non-residents claiming withholding tax credits on their 1040NR

Non-residents claiming unsubstantiated withholding tax credits

Helpful Tips for Clients When the CRA Calls

  • Consult a tax advisor
  • Be courteous
  • Be cautious
  • Stay organized
  • Understand your rights

How MNP Can Help

Our Tax Controversy Specialists will work with you to prevent, manage and resolve tax disputes with the tax authorities in a way that reduces your tax cost and minimizes disruption to your business. We then go one step further to help you develop strategies and policies that work to protect your business in the case of future audits disputes.

For more information, contact your local MNP Business Advisor or visit MNP.ca

Footnote 1

1 B. Hodge, G. Robert, S. Sicard and M. Tonkovich, “CRA Audit Updates / Best Practices” (presentation delivered at the 2019 Canadian Tax Foundation Ontario Tax Conference & Live Webcast, Toronto, 29 October 2019).

Insights

  • Progress
    ""

    July 22, 2021

    Cloud accounting and bookkeeping can transform your real estate and construction operations

    Priorities are changing after the long hours that came with navigating COVID-19. Here’s how you can free up time to focus on what really matters.

  • Progress
    Family in backyard

    July 21, 2021

    The four key solutions of MNP’s Family Office

    Family office is a term that many people have heard of, but few people understand. Learn more about family office and how it can support your goals.

  • Confidence
    Confident woman

    July 21, 2021

    How a LifeBook can prepare you for twists and turns

    The pandemic has caused many people to reflect about their personal affairs. A LifeBook can help you feel confident that your family will be looked after.