Mid-Year Amendments to Safe Harbor Pension Plans Following Windsor Decision

4 Jul

Internal Revenue Service Notice 2014-37 addresses mid-year amendments to “safe harbor” pension plans, clarifying the earlier Notice 2014-19. Notice 2014-19 provided guidance on the application of U.S. v. Windsor, 133 S.Ct. 2675 (2013), which struck down the Defense of Marriage Act.

“Safe harbor” plans allow business owners to maximize personal contributions to the company’s retirement account, receive the benefit of company matching contributions, and reduce some of the limitations associated with non-discrimination testing. The employer either must make a matching contribution for all participating employees, on the first 4% of each employee’s compensation, or contribute 3% of the employee’s compensation for each eligible employee, regardless of whether the employee participates in the plan. Under a traditional plan, if too few employees participate, a formula limits the amount that the business owner can personally contribute.

Following the Windsor decision in June 2013, the Service adopted Rev. Rul. 2013-17, holding that, for Federal tax purposes, the terms “spouse,” “husband and wife” etc., include an individual married to a person of the same sex, if the individuals are lawfully married under state law. The couple may be domiciled in a state that does not recognize such marriages. Not covered are individuals (of the same or opposite sex) who have entered into a registered domestic partnership or civil union that is not denominated as a marriage under the laws of that state.

The Service is authorized to prescribe the extent to which any judicial or administrative decision is to be applied without retroactive effect. Rev. Rul. 2013-17 is applied prospectively as of September 16, 2013. Taxpayers may rely on the ruling retroactively with respect to any employee benefit plan, for limited purposes with respect to certain health coverage and fringe benefits.

Several Code provisions provide special rules with respect to married participants in qualified retirement plans.

(i) Certain qualified retirement plans must provide a qualified joint and survivor annuity (QJSA) upon retirement to married participants (and generally must provide a qualified preretirement survivor annuity (QPSA) to the surviving spouse of a married participant who dies before retirement). The QJSA (or QPSA) may be waived by a married participant only with spousal consent. If such a plan permits loans to participants, the plan must obtain the consent of the spouse before making a loan to the participant.

(ii) Certain qualified defined contribution retirement plans are exempt from the QJSA and QPSA requirements, provided that a married participant’s benefit is payable in full to the participant’s surviving spouse, unless the spouse consents to the designation of a different beneficiary.

(iii) Under the required minimum distribution rules and the rollover rules, additional alternatives are provided for surviving spouses that are not available to non-spousal beneficiaries.

(iv) Generally a spouse is treated as owning shares owned by the other spouse, for purposes of determining whether corporations are members of a controlled group.

(v) Generally a spouse is treated as owning shares owned by the other spouse, for purposes of determining whether an employee is a key employee, including whether an employee is considered a 5% owner.

(vi) An employee stock ownership plan (ESOP) that acquires certain employer securities generally must prohibit the allocation of those securities for the benefit of certain individuals, including the spouse of the seller and of any individual who owns 25% or more of the securities.

(vii) No portion of the assets of an ESOP attributable to employer securities consisting of S corporation stock generally may accrue during a nonallocation year for the benefit of any disqualified person or certain family members (including spouse).

(viii) The anti-alienation rules do not apply to the recognition of an alternate payee’s right to receive a portion of the benefits payable to a participant under a plan pursuant to a qualified domestic relations order (QDRO). An alternate payee who is a spouse or former spouse of the participant is treated as the distributee under a QDRO.

Notice 2014-37 provides guidance on plan amendments to reflect the outcome of the Windsor decision, which are adopted after the beginning of a plan year, and which apply to a 401(k) or 401(m) safe harbor plan. These amendments were first addressed in Q&A-8 of Notice 2014-19.

Notice 2014-19 addressed the deadline to adopt a plan amendment pursuant to that Notice. The deadline is the later of (i) the end of the plan year in which the change is first effective, (ii) the due date of the employer’s tax return for the year that includes the date the change is first effective, or (iii) December 31, 2014. In the case of a governmental plan, any amendment need not be adopted before the close of the first regular legislative session of the body with the authority to amend the plan that ends after 2014.

A 401(k) safe harbor plan must be adopted before the beginning of the plan year and generally must be maintained throughout a full 12-month plan year. Treas. Reg. § 1.401(k)-3(e)(1).  Similar rules apply to § 401(m) safe harbor plans.  Following Notice 2014-19, the Service was asked whether a safe harbor plan may adopt a mid-year amendment.  The Service responds affirmatively in Notice 2014-37: a plan will not fail to satisfy the requirements to be a safe harbor plan merely because the plan sponsor adopts a mid-year amendment under Notice 2014-19.

 

The Wolf Growls ….. The Sheep Howl ….. New IRS Notice on Foreign Account Compliance (FATCA)

19 May

IRS Notice 2014-33 announces that calendar years 2014 and 2015 will be regarded as a transition period, for purposes of enforcement of the dreaded Foreign Account Tax Compliance Act (FATCA) by withholding agents and foreign financial institutions (FFIs).

The Hiring Incentives to Restore Employment Act of 2010 added section 1471 through 1474 to the Internal Revenue Code (Chapter 4 of Subtitle A). Chapter 4 generally requires agents to withhold at a 30 percent rate on certain payments to an FFI, unless the FFI has entered into an agreement to obtain status as a participating FFI and to report information with respect to accounts held by or for U.S. persons.

Chapter 4 also imposes on withholding agents certain withholding, documentation, and reporting requirements with respect to payments made to non-financial foreign entities (NFFEs).

In 2013, Treasury and the Service published final regulations under chapter 4, and issued Notice 2013-43 to preview a revised timeline for implementation of the FATCA requirements. In February 2014, Treasury and the Service released temporary regulations that clarify and modify the final regulations.

The temporary chapter 4 regulations require that withholding agents (including participating FFIs, qualified intermediaries, withholding foreign partnerships, and withholding foreign trusts) begin withholding with respect to payments on or after July 1, 2014, unless the withholding agent can reliably associate the payment with documentation to treat the payment as exempt from withholding under chapter 4 (as opposed to general tax withholding on certain payments to non-residents).

Treasury has released Model 1 and Model 2 intergovernmental agreements (IGAs) to facilitate the implementation of FATCA and to avoid legal impediments under local law that would otherwise limit an FFI’s ability to comply. IRS Announcement 2014-17 provides that the jurisdictions treated as having an IGA in effect would include jurisdictions that, before July 1, 2014, have reached agreements in substance with the United States on the terms of an IGA, and that have consented to be included on the Treasury/IRS lists of such jurisdictions, in addition to jurisdictions that have already signed IGAs. An FFI that is resident in, or organized under the laws of, a jurisdiction that is included on the lists, is permitted to register on the FATCA registration website and certify to a withholding agent its status as an FFI covered by an IGA. As of May 1, 2014, Treasury had signed 30 IGAs, and had agreements in substance with 29 jurisdictions.

2014 and 2015 will be regarded as a transition period for purposes of IRS enforcement and administration of the chapter 4 due diligence, reporting, and withholding provisions, and certain other provisions modified by the temporary coordination regulations. The Service will take into account the extent to which a participating or deemed-compliant FFI, direct reporting NFFE, sponsoring entity, sponsored FFI, sponsored direct reporting NFFE, or withholding agent, has made good faith efforts to comply with the requirements of the regulations.

For example, the Service will take into account whether a withholding agent has made reasonable efforts during the transition period to modify its account opening practices and procedures to document the chapter 4 status of payees, apply the standards of knowledge provided in chapter 4, and, in the absence of reliable documentation, apply the presumption rules. The Service will also consider the good faith efforts of a participating FFI, registered deemed-compliant FFI, or limited FFI to identify and facilitate the registration of each other member of its expanded affiliated group as required.
Entity obligations issued on or after July 1, 2014

Under the chapter 4 regulations, withholding agents (other than participating FFIs and registered deemed-compliant FFIs) are generally required to implement new account opening procedures beginning on July 1, 2014. A participating FFI is required to implement new account opening procedures on the later of July 1, 2014, or the effective date of its FFI agreement. A registered deemed-compliant FFI is required to implement new account opening procedures on the later of July 1, 2014, or the date on which the FFI registers as a deemed-compliant FFI and receives a global intermediary identification number (GIIN).

Comments, growls and howls have disclosed practical problems in implementation. Treasury and the Service intend to amend the chapter 4 regulations, to allow a withholding agent or FFI to treat an obligation held by an entity that is issued, opened, or executed on or after July 1, 2014, and before January 1, 2015, as a preexisting obligation for purposes of implementing chapter 4. A withholding agent would otherwise be required to document the entity by the earlier of the date a withholdable payment is made, or within 90 days of the date the obligation is issued.

The proposed amendments will not be available for obligations held by individuals, because the procedures for documenting individual accounts are “less complex” than those for documenting entities, and Form W-8BEN (for withholding agents to document individuals) has been published in final form.
Intergovernmental agreements

The Model 1 and Model 2 IGAs contain a provision that allows a partner jurisdiction that has entered into an IGA to receive the benefit of certain more favorable terms that are set forth in a later signed IGA or Annex.

Annex I of future Model 1 and Model 2 IGAs will, for an entity account opened on or after July 1, 2014, and before January 1, 2015, allow an FFI to treat such an account as a preexisting entity account, but without permitting application to such accounts of the $250,000 exception for accounts that are not required to be reviewed, identified, or reported.

Prior to the publication of the proposed amendments to the chapter 4 regulations, a partner jurisdiction may rely on the Notice to permit a reporting Model 1 or 2 FFI to apply the due diligence procedures for documenting entity accounts.
Modification of the standards of knowledge rules

The temporary coordination regulations revised the reason-to-know standard under the general withholding tax regulations, to provide that a withholding agent will have reason to know that documentation establishing the foreign status of a direct account holder is unreliable or incorrect, if the withholding agent has a current telephone number for the account holder in the United States and no telephone number for the account holder outside the United States, or has a U.S. place of birth for the account holder. Treas. Reg. § 1.1441-7(b). The addition of rules concerning a U.S. telephone number and a U.S. place of birth was made to coordinate with chapter 4. The temporary coordination regulations provide a transitional rule to allow a withholding agent that has previously documented the foreign status of a direct account holder for general withholding tax purposes, prior to July 1, 2014, to continue to rely on such documentation without regard to the telephone number or place of birth. The withholding agent would, however, have reason to know that the documentation is unreliable or incorrect, if the withholding agent is notified of a change in circumstances.

Treasury and the Service intend to amend the temporary coordination regulations to provide that a direct account holder will be considered documented prior to July 1, 2014, without regard to whether the withholding agent obtains renewal documentation for the account holder afterwards. Therefore, a withholding agent that has documented a direct account holder prior to July 1, 2014, is not required to apply the new reason to know standards relating to a U.S. telephone number or U.S. place of birth until the withholding agent is notified of a change in circumstances or reviews documentation that contains a U.S. place of birth.
Revision of definition of reasonable statement

A withholding agent may rely on the foreign status of an individual account holder for general withholding tax purposes, irrespective of certain U.S. indicia, if, in certain cases, the account holder provides a reasonable explanation supporting the account holder’s claim of foreign status. A reasonable explanation supporting a claim of foreign status for general withholding tax purposes can be a written statement prepared by an individual, or a checklist provided by a withholding agent stating that the individual meets the regulatory requirements.

The FATCA regulations also describes a reasonable explanation supporting a claim of foreign status. It is substantially similar to the description in the general withholding tax regulations, except that it limits the contents of a reasonable statement to the explanations permitted on the checklist, and does not permit an individual to provide a written explanation other than an explanation that the individual meets the requirements described in the regulations. Treasury and the Service intend to amend the final chapter 4 regulations, to adopt the broader description of a reasonable explanation of foreign status provided in the temporary coordination regulations.
Limited FFIs and limited branches

For any member of an “expanded affiliated group” to obtain status as a participating FFI or registered deemed-compliant FFI, each FFI member must have a chapter 4 status of a participating FFI, deemed-compliant FFI, exempt beneficial owner, or limited FFI. The final regulations also provide that an FFI or branch of a participating FFI must be registered with the Service and agree to certain conditions in order to be treated as a limited FFI or limited branch. Conditions include that the FFI or branch must not open accounts that it is required to treat as U.S. accounts, or accounts held by nonparticipating FFIs, including accounts transferred from any member of its expanded affiliate group.

The Service’s FATCA registration website serves as the primary way for FFIs to register as a participating FFI, registered deemed-compliant FFI, or limited FFI. FFIs that are members of an expanded affiliated group may designate a lead financial institution (Lead FI) to identify member FFIs that will register as participating FFIs, registered deemed-compliant FFIs, or limited FFIs and to perform certain functions with respect to member FFIs.

Howls and moans were heard from jurisdictions that are slow to engage in IGA negotiations and that have legal restrictions impeding their ability to comply with FATCA, including the conditions for limited FFI or limited branch status. The restrictions imposed by the regulations hinders the ability of an FFI to agree to the conditions of limited status due, for example, to requirements under local law to provide individual residents with access to banking services, or to the business needs of the FFI to secure funding from another FFI in the same jurisdiction with similar impediments to complying with the requirements of FATCA.

Treasury and the Service intend to amend the final chapter 4 regulations to permit a limited FFI or limited branch to open U.S. accounts for persons resident in the jurisdiction where the branch or FFI is located, and accounts for nonparticipating FFIs that are resident in that jurisdiction, provided that the FFI or branch does not solicit U.S. accounts from persons not resident in, or accounts held by nonparticipating FFIs that are not established in, that jurisdiction. The FFI (or branch) must not be used by another FFI in its expanded affiliated group to circumvent the regulations.

Certain jurisdictions are explicitly prohibiting an FFI resident in, or organized under the laws of, the jurisdiction, from registering with the Service and agreeing to any status, including as limited FFI. Treasury and the Service intend to amend the final chapter 4 regulations to provide that such a prohibition will not prevent the members of its expanded affiliated group from obtaining status as participating FFIs or registered deemed-compliant FFIs, if the ill-fated FFI is identified as a limited FFI on the FATCA registration website by a member of the expanded affiliated group that is a U.S. financial institution or an FFI seeking status as a participating FFI. If the Lead FI is prohibited from identifying the limited FFI by its legal name (why and by whom??), it will be sufficient if the Lead FI uses the term “Limited FFI” in place of its name and indicates the FFI’s jurisdiction of residence or organization.

 

Residence of Mr. Conrad Black

30 Apr

Poor Conrad Black, Baron Black of Crossharbour ! As though the assault and psychological horror inflicted on him by the authorities were not enough (disregarding legal and ethical considerations). He has now had the shame of having his affairs paraded before the Tax Court of Canada, for no apparent valid reason. The Court found his arguments to have no support in precedent or common sense, and it is unclear how the poor man was induced to file in court at all. G Conrad Black v The Queen 2008-2896 (IT) (TCC), January 14 2014.

In the tax year 2002, the taxpayer was resident of both Canada and the United Kingdom, under the domestic law of each country. Since his centre of vital interests was in the United Kingdom, the Canada-U.K. income tax treaty deemed him to be U.K. resident for purposes of the treaty.

Since the taxpayer did not establish a U.K. domicile, he was taxed in the United Kingdom under the fabled remittance system, which allows individuals ordinarily U.K. resident, but lacking a U.K. domicile, to pay U.K. tax only on income remitted to the United Kingdom, not income remitted or maintained offshore. The tax treaty specifies that any treaty relief from Canadian tax is granted only in respect of income that is subject to U.K. tax under the remittance regime, i.e., treaty benefits do not apply to income maintained offshore.

The taxpayer was induced to argue that, on the above basis, he should be treated as not resident in Canada for domestic law purposes. Thus, the taxpayer argued that he should be free from Canadian tax on non-Canadian employment income (approximately $2.8 million), on various shareholder benefits (approximately $2 million) and on investment income from non-Canadian sources (approximately $350K).

The only authority that the taxpayer could cite for his position, was a provision in the treaty-enabling statute, to the effect that the treaty prevailed to the extent of any inconsistency with domestic law. The taxpayer tried to argue that there was an inconsistency between Canadian domestic law treating him as resident, and the treaty, which treated him as U.K. resident. The Court properly found that there was no conflict whatsoever. In order for the treaty-tie breaker rule to apply, the taxpayer has first to be resident in Canada (and the United Kingdom) under domestic law. There is no authority under the treaty for concluding that taxpayer becomes not resident of Canada for any domestic law purpose, other than those purposes covered by the treaty. The treaty deals with specified items of income only, and none of the items in issue was regulated by the treaty.

The taxpayer was once advised by Canada’s leading tax law firm. It is difficult to believe that this firm would have led him into court over these issues. He was represented in this case by a Queen’s Counsel from Davis LLP, which is a good firm but not as prominent in tax. Still, even this firm is deemed to understand elementary tax treaty principles. Perhaps taxpayer was misled by accountants or other advisors, and found himself in a position that he and counsel decided had to be asserted, for better or worse.

Internal Revenue Service Notice on Bitcoins and Other Virtual Currencies

27 Mar

Internal Revenue Service Notice 2014-21, March 25, 2014, describes how existing general tax principles apply to transactions using virtual currency. Virtual currency is described as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. It operates like “real” currency but does not have legal tender status in any jurisdiction.

The Service answers frequently-asked questions on bitcoin status and solicits comments.  The Notice is uncontroversial, trendy and answering idiotic theories.

For federal tax purposes, virtual currency is treated as property. General tax principles are applicable. A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received. The basis of the currency in the recipient’s hands is determined the same way.

If a virtual currency is listed on an exchange, and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied.

If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain. The taxpayer has a loss if the fair market value of the property received is less. A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer, and ordinary gain or loss if the virtual currency is not a capital asset, e.g., inventory and other property held mainly for sale to trade customers.

Virtual currency is not treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes.

When a taxpayer successfully mines virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income. If a taxpayer’s mining constitutes a business, and the mining activity is not undertaken as an employee, the net earnings are subject to the self-employment tax. The fair market value of virtual currency paid as wages is subject to federal withholdings. A payment made using virtual currency is subject to information reporting to the
same extent as any other payment made in property.

A person who in the course of a trade makes a payment of $600 or more in a taxable year to an independent contractor for the performance of services is required to report that payment on Form 1099-MISC. A third party that contracts with a substantial number of unrelated merchants to settle payments between the merchants and their customers is a third party settlement organization (TPSO), required to report payments made to a merchant on a Form 1099-K, Payment Card and Third Party Network Transactions, if certain thresholds are met.

No clear answer was provided to the question whether taxpayers would be subject to penalties for having treated a virtual currency transaction in a manner that is inconsistent with the Notice, prior to March 25, 2014.

 

Capitalized interest on defaulted policy loans includible in taxable amount

21 Mar

In Black v. Commissioner of Internal Revenue, Docket No. 6406-12. Feb. 12, 2014, the U.S. Tax Court has determined that capitalized interest accrued on taxpayer’s loans against his life insurance policy, is includible in determining the gross distribution and the taxable amount arising from the termination of the policy. The taxpayer borrowed against a life insurance policy but failed to repay the loans. The policy was terminated, and the loans were satisfied by policy proceeds and extinguished.

In June 1989, the husband of the taxpayer couple acquired an insurance policy on his life from Northwestern Mutual Life Insurance Co. (Northwestern). The policy was a whole life policy, having both cash value and loan features.

Taxpayer was permitted to borrow against the policy. “Policy debt” consisted of outstanding loans and accrued interest. Unpaid interest was added to loan principal. Taxpayer could surrender the policy and receive as a distribution the cash value of the policy, minus any outstanding policy debt. The policy terminated, if policy debt exceeded the cash value.

Over time, taxpayer borrowed $103,548 against the policy, which he did not repay. In 2009, the policy was terminated. The combined balance of the loans, including principal and interest, was $196,230, and taxpayer’s investment in the contract (aggregate premiums paid) was $86,663.

Northwestern issued to taxpayer a Form 1099-R, Distributions From Pensions, Annuities, etc. reflecting a gross distribution of $196,230 and a taxable amount of $109,567. The latter represented the difference between the combined balance of the loans, and taxpayer’s investment in the contract, i.e., $86,663.

Taxpayers did not report any part of the taxable income on Form 1099-R, nor did they acknowledge the policy on their return.

In 2011, taxpayers nervously amended their 2009 return, to reflect an increase in income of $16,885, attributable to the difference between the principal of the policy loans less premiums paid. The amended return was not accepted. The Service issued a notice of deficiency of $30,571 and assessed an accuracy-related penalty.

The parties agreed that the taxable amount of the gross distribution that arose on termination of the policy did not include taxpayer’s investment in the contract of $86,663, and that the taxable amount takes into account the outstanding loans totaling $103,548. The Service contended that the taxable amount also takes into account capitalized interest.

Internal Revenue Code section 61 specifically includes in gross income, income from life insurance contracts and from discharge of indebtedness.

The Court regarded taxpayer’s policy loans as true loans. Taxpayers would not have had to recognize these loan proceeds as taxable income upon receipt. When an insurance policy is terminated and the proceeds are used to satisfy a policy loan, the transaction is treated as if the taxpayers received the proceeds and applied them against the outstanding loan.

Under Code section 72, an amount received in connection with a life insurance contract, which is not received as an annuity, generally constitutes gross income to the extent that the amount exceeds the investment in the insurance contract. The investment in the contract is defined generally as the premiums or other consideration paid, less amounts received under the contract, to the extent excludable from gross income.

The Court held that the capitalized interest was properly treated as part of the principal of the indebtedness. Capitalized interest is includible in determining the amount of a taxpayer’s gross distribution when an insurance policy is terminated. The policy loans, including capitalized interest, were charged against the available proceeds at that time. This satisfaction of the loans had the effect of a pro tanto payment of the policy proceeds to taxpayers, and constituted income to them. A contrary result would permit policy proceeds, including previously untaxed investment returns, to escape tax altogether and found no basis in the law.

Taxpayers argued that the termination of the life insurance policy gave rise to a discharge of indebtedness. The Court could not so characterize the source of taxpayers’ income. The loans to taxpayer were not discharged; rather, they were extinguished after Northwestern applied the cash value of the insurance policy toward the debt owed. Even if the income were discharge of indebtedness income, taxpayers did not allege that any exception under Code section 108 applied to exclude the amount from gross income.

Code section 6662(a) imposes an accuracy-related penalty equal to 20% of the amount of any underpayment of tax that is attributable to a substantial understatement of income tax. An understatement of income tax is “substantial”, if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return. There is an exception to the accuracy-related penalty with respect to any portion of an underpayment, if the taxpayer establishes that there was reasonable cause for such portion, and the taxpayer acted in good faith with respect to such portion. Taxpayers self-prepared their 2009 Federal income tax return, and nothing in the record suggests that they consulted with a professional adviser in connection therewith. Taxpayer is an attorney, yet failed to cite any case holding that interest on loans made against an insurance policy is not includible in the gross distribution when the policy is terminated for nonpayment. The only authorities taxpayers cited were Code sections and Treasury regulations that were inapposite. The Court held therefore that taxpayers failed the reasonable cause exception, nor could they invoke the “substantial authority” provision to reduce the amount of the understatement for penalty computation purposes.

Canada – Budget 2014 – International Tax Measures

12 Mar

Captive Insurance

Certain passive or Canadian-source income earned by a controlled foreign affiliate of a Canadian resident taxpayer is considered foreign accrual property income (FAPI) and is taxable in the hands of the Canadian taxpayer on an accrual basis.

Canadian risks are risks in respect of Canadian resident persons, property situated in Canada, or businesses carried on in Canada. Income from the insurance of Canadian risks is FAPI, where 10 per cent or more of the gross premium income (net of reinsurance ceded) of a foreign affiliate is premium income from Canadian risks.

Enlightened taxpayers engage in “insurance swaps”, feebly and shabbily designed to circumvent this rule, by purporting to transfer Canadian risks, originally insured in Canada, to a wholly-owned foreign affiliate of the taxpayer. The Canadian risks are then exchanged with a third party for foreign risks that were originally insured outside of Canada, while ensuring that the affiliate’s overall risk profile and economic returns are essentially unchanged.

Budget 2014 proposes to amend the existing anti-avoidance rule in the FAPI regime relating to the insurance of Canadian risks. The revised rule will apply where:

- taking into consideration any arrangements entered into by the foreign affiliate (or a person not dealing at arm’s length with the affiliate), the affiliate’s risk of loss or opportunity for gain in respect of foreign risks can reasonably be considered to be determined by reference to the returns from other risks (the tracked risks) that are insured by other parties; and

- at least 10 per cent of the tracked risks are Canadian risks.

Where the new rule applies, the affiliate’s income from the insurance of the foreign risks and any income from a connected arrangement will be included in computing its FAPI. This measure will apply to taxation years that begin on or after February 11, 2014.
Offshore Regulated Banks

Income from an investment business carried on by a foreign affiliate is included in the affiliate’s FAPI. An investment business is generally a business the principal purpose of which is to derive income from property. There is a regulated foreign financial institution exception, for a business carried on by a foreign affiliate as a foreign bank, a trust company, a credit union, an insurance corporation or a trader or dealer in securities or commodities. These activities must be regulated in the country in which the business is principally carried on, or another relevant foreign jurisdiction.

Certain clever Canadian taxpayers that are not financial institutions purport to qualify for the regulated foreign financial institution exception by establishing foreign affiliates and electing to subject those affiliates to foreign regulation. The main purpose of these affiliates is often to engage in proprietary activities, i.e., to invest or trade in securities on their own account (or those of group members, presumably), and not to facilitate financial transactions for customers.

Budget 2014 adds new conditions, making the regulated foreign financial institution available only where the following conditions are satisfied:

- The relevant taxpayer (i.e., the Canadian taxpayer of which the foreign corporation is a foreign affiliate) is (i) a Schedule I bank, a trust company, a credit union, an insurance corporation or a resident trader or dealer in securities or commodities, and supervised by the Superintendent of Financial Institutions or a similar provincial regulator, (ii) a wholly-owned subsidiary of such an institution, or (iii) a corporation that wholly owns such an institution (and is also subject to regulation).

- More than 50 per cent of the total taxable capital employed in Canada of the taxpayer and all related Canadian corporations is attributable to taxable capital employed in Canada of regulated Canadian financial institutions. Certain regulated Canadian financial institutions that have with equity of at least $2 billion, and certain affiliates, will be deemed to satisfy this second condition.

Satisfying these new conditions will not guarantee that income of a foreign affiliate from proprietary activities will be considered active business income. The affiliate also must carry on a regulated foreign financial services business, as required under the existing law, and the proprietary activities must comprise part of that business.

Stakeholders are invited to submit comments concerning the scope of this measure by early April 2014.
Back-to-Back Loans

The thin capitalization rules in the Income Tax Act limit the deductibility of interest expense of a corporation or a trust, where debt owed by the debtor to specified non-residents exceeds a 1.5-to-1 debt-to-equity ratio. In the case of a corporation, the rules apply to debts owing to a specified shareholder, i.e., a non-resident person who, together with persons with whom the specified shareholder is not dealing at arm’s length, owns shares representing at least 25 per cent of the votes or value of the corporation. The rules also apply to debts owing to any other non-resident who does not deal at arm’s length with a specified shareholder.

In the case of a trust, the rules apply to debts owing to a specified non-resident beneficiary, and to debts owing to any other non-resident who does not deal at arm’s length with a specified beneficiary.

Part XIII of the Income tax Act also generally applies a 25-per-cent withholding tax (unless reduced by tax treaty), on interest paid or credited by a Canadian resident to a non-arm’s length non-resident. Withholding tax also applies to payments and credits by a non-resident, if the interest is deductible in computing taxable income earned in Canada.

Taxpayers trying to be clever have sought to avoid these rules, through “back-to-back loan” arrangements, interposing a third party (e.g., a foreign bank) between two related taxpayers (such as a foreign parent corporation and its Canadian subsidiary). Budget 2014 adds a specific anti-avoidance rule in respect of withholding tax on interest payments, and amends the existing anti-avoidance provision in the thin capitalization rules. Under the proposed rule, a back-to-back loan arrangement will exist where, as a result of a series of transactions, the following conditions are met:

• a taxpayer has an outstanding interest-bearing obligation owing to a lender (the intermediary); and
• the intermediary or any person who does not deal at arm’s length with the intermediary
- is pledged a property by a non-resident person as security in respect of the obligation (a guarantee, in and of itself, will not be considered a pledge of property),
- is indebted to a non-resident person under a non-recourse debt, or
- receives a loan from a non-resident person on condition that a loan be made to the taxpayer.

Where a back-to-back loan arrangement exists, appropriate amounts in respect of the obligation and interest will be deemed owing to the non-resident person for purposes of the thin capitalization rules, generally in an amount equal to the lesser of:

- the outstanding obligation owing to the intermediary; and
- the fair market value of the pledged property or the outstanding amount of the debt for which recourse is limited or the loan made on condition.

The taxpayer will also be deemed to have an amount of interest payable to the non-resident person equal to the proportion of the interest on the obligation owing to the intermediary that the deemed amount owing is of that obligation.

Withholding tax will generally apply in respect of a back-to-back loan arrangement to the extent that it would otherwise be avoided by virtue of the arrangement.

The new rules will apply (i) in respect of the thin capitalization rules, to taxation years that begin after 2014, and (ii) in respect of withholding tax, to amounts paid or credited after 2014.
Consultation on tax planning by multinational enterprises

The Organisation for Economic Co-operation and Development has launched a bright new project aimed at addressing “base erosion and profit shifting” (BEPS) strategies used by multinational enterprises (MNEs). The OECD and the G-20 are working together on the issues identified in the BEPS Action Plan, released July 2013.

The enlightened Department of Finance invites input on the following, often-excessively general and conceptual questions:

• What are the impacts of international tax planning by MNEs on other participants in the Canadian economy? How to ensure fairness among different categories of taxpayers ? (e.g., MNEs, small businesses and individuals)
• Which of the international corporate income tax and sales tax issues identified in the BEPS Action Plan should be considered the highest priorities for examination and potential action by the Department? The Department pointedly notes that in some countries (e.g., South Africa and the European Union), foreign-based vendors must register and charge sales taxes if they make e-commerce sales to local residents.
• Are there other corporate income tax or sales tax issues related to improving international tax integrity that should be of concern to the Department?
• What considerations should guide the Department in determining the appropriate approach to take in responding to the issues identified – either in general or with respect to particular issues?
• Would concerns about maintaining Canada’s competitive tax system be alleviated by coordinated multilateral implementation of base protection measures?
Consultation on Treaty Shopping

Related to the above general international tax consultations, Budget 2013 set out the government’s concerns over “treaty shopping”, i.e. clever arrangements under which a person not entitled to the benefits of a particular tax treaty with Canada uses an entity resident in a state with which Canada has a tax treaty, to obtain Canadian tax benefits. Budget 2013 announced consultations regarding possible approaches to address treaty shopping. A consultation paper was released in August 2013, with request for comments.

Treaty shopping was also targeted in the above OECD Action plan of July 2013. The Action Plan calls for the development of “model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances”. The OECD is expected to issue its recommendations in September 2014.

Most countries that have addressed the issue in their tax treaties have used a general rule that denies a tax treaty benefit if one of the main purposes for entering into a transaction is to obtain the benefit. Some countries (e.g., the United States and Japan) have more detailed and specific rules.

Canada has included a main purpose rule in several of its tax treaties, as have several other countries. Stakeholders expressed concerns that a general approach might produce less certain outcomes in some cases (compared to a more specific approach). The Department responds that the U.S. limitation on benefits provision does not capture all forms of treaty shopping, e.g., arrangements that use certain entities, such as publicly-traded corporations or trusts.

Several stakeholders expressed a preference for a solution to treaty shopping that would require the re-negotiation of Canada’s tax treaties: a domestic law response to treaty shopping would alter the balance of compromises reached in the negotiation. The Department tartly responds that domestic law provisions to prevent tax treaty abuse are not considered by the OECD or the United Nations to be in conflict with tax treaty obligations, and that other countries have enacted legislation.

Some stakeholders asserted that only a few of Canada’s tax treaties would need to be re-negotiated in order to significantly curtail treaty shopping. Ah, but then other conduit countries would emerge, responds the Department.

Not minding to short-circuit the future public comments requested, the Department announces that the main elements it wants to see in the treaty-shopping rule are the following.

• A main purpose provision: subject to the relieving provision, a benefit would not be provided under a tax treaty, if it is reasonable to conclude that one of the main purposes for undertaking a transaction (which can be part of a series of transactions or events) that results in the benefit, was for the person to obtain the benefit.
• Conduit presumption: it would be presumed that one of the main purposes for undertaking a transaction that results in a treaty benefit, was to obtain that benefit, if the relevant treaty income is primarily used to transfer an amount to another person who would not have been entitled to an equivalent or more favourable benefit, had the other person received the relevant treaty income directly.
• Safe harbour presumption: subject to the conduit presumption, it would be presumed that none of the main purposes for undertaking a transaction was to obtain a treaty benefit, if:
- the person (or a related person) carries on an active business (other than managing investments) in the treaty state and, where the relevant treaty income is derived from a related person in Canada, the active business is substantial compared to the activity carried on in Canada giving rise to the relevant treaty income;
- the person is not controlled by another person who would not have been entitled to an equivalent or more favourable benefit had she received the relevant treaty income directly; or
- the person is a corporation or a trust the shares or units of which are regularly traded on a recognized stock exchange.

• Relieving provision: if the main purpose provision applies in respect of a treaty benefit, the benefit is to be provided, in whole or in part, to the extent that it is reasonable having regard to all the circumstances.

Even if a transaction results in a tax treaty benefit, the Department generously opines that it does not necessarily follow that one of the main purposes for undertaking the transaction was to obtain the benefit. The proposed rule would not apply in respect of an ordinary commercial transaction solely because obtaining a tax treaty benefit was one of the considerations for making an investment.

The rule would apply to taxation years that commence after enactment of the rule. The Department finds rather unreassuringly that transitional relief “may” be appropriate.

The Department invites comment on five specific examples. The first example involves assignment of income. Aco, resident in State A, owns intellectual property used by subsidiary Canco, resident in Canada. State A does not have a tax treaty with Canada. Aco incorporates Bco in State B, a state with which Canada has a tax treaty that provides for a nil rate of withholding tax on royalties. Aco assigns to Bco the right to receive royalty payments from Canco. Bco agrees to remit 80 per cent of the royalties received to Aco within 30 days. Bco pays tax in State B on its net amount of royalty income. State B does not impose withholding tax on royalties.

Under the conduit presumption, in the absence of proof to the contrary, one of the main purposes for the assignment of the royalties would be for Bco to obtain the withholding tax reduction. By virtue of the relieving provision, Bco may be allowed the benefits of the treaty in respect of the portion of the royalty payments not used by Bco to pay Aco.

If, instead, only 45 per cent of the royalties received by Bco were used to pay Aco, the conduit presumption would not apply as to the main purpose of the transaction, and it would be a question of fact whether the main purpose provision applied.

The second example involves payment of dividends. Canco is owned by Bco, resident in State B. The sole investment of Bco consists of the shares of Canco. Bco was established by its two corporate shareholders, Aco and Cco, residents of State A and State C respectively. Canada has a tax treaty with State B. Canada also has tax treaties with States A and C, which provide a higher rate of withholding tax on dividends than the State B treaty rate. Bco is required to distribute the entire dividend received from Canco to Aco and Cco almost immediately. Under the domestic laws of State A and State C, dividends received from foreign corporations are subject to tax.

Under the conduit presumption, one of the main purposes for the establishment of Bco would be to obtain the withholding tax reduction under the treaty between Canada and State B. Subject to the relieving provision, the benefit would be denied. The benefits that would have applied if Bco had not been established may be provided under the relief provision, to the extent it is reasonable having regard to all the circumstances, i.e., the benefits under the tax treaty between Canada and States A and C, had the dividend been paid directly from Canco. The Department would also require in this instance that Aco and Cco be taxable on the dividends.

Example 3 involves change of residence. Aco, resident in State A, owns shares of a Canadian-resident corporation and is contemplating their sale. The sale would trigger a capital gain taxable in Canada. Canada does not have a tax treaty with State A. Shortly before the sale, Aco is continued into, and becomes a resident of, State B, a state that does not impose tax on capital gains. The tax treaty between Canada and State B provides an exemption for capital gains on shares of a Canadian corporation disposed of by residents of State B. Aco sells the shares and retains the proceeds of disposition.

Since the proceeds of disposition remain with Aco, the conduit presumption would not apply. However, the main purpose provision would still apply.

If Aco were already a resident of State B at the time of the initial acquisition of the shares, it would need to be determined whether one of the main purposes for the establishment of Aco as a resident of State B was to obtain the capital gains exemption. All the relevant circumstances would need to be considered, including, for example, the lapse of time between the establishment of Aco in State B and the realization of the capital gains, and any other intervening events.

Example 4 involves “bona fide” investments. B-trust is a widely held trust that is a resident of State B, a state with which Canada has a tax treaty. B-trust holds 10 per cent of its portfolio in shares of Canadian corporations. Under the tax treaty between Canada and State B, the withholding tax rate on dividends is reduced to 15 per cent. A majority of investors in B-trust are residents of states with which Canada does not have a tax treaty. B-trust annually distributes all of its income to its investors.

Because dividends received by B-trust from Canadian corporations are primarily used to distribute income to persons not entitled to tax treaty benefits, under the conduit presumption one of the main purposes for the structure is to obtain the benefit under the tax treaty between Canada and State B. It would have to be clearly established that none of the main purposes for undertaking these investments, either alone or as part of a series of transactions, was to obtain the benefit of the tax treaty. This could be the case here, since investors’ decisions to invest in B-trust are not driven by any particular investments made by B-trust, and B-trust’s investment strategy is not driven by the tax position of its investors.

Example 5 addresses the safe harbours for foreign active business operations. Aco is resident in State A, with which Canada does not have a tax treaty. Aco owns all the shares of Finco, resident in State B, which has a tax treaty with Canada. Finco acts as a financing corporation for Aco’s wholly owned subsidiaries, including Canco and Bco (also resident State B). Bco carries on an active business in State B, which is substantial in comparison to the activities carried on by Canco. Aco’s other subsidiaries are residents of other states with which Canada has tax treaties with benefits on payments of interest equivalent to those in the Canada-State B tax treaty. Finco receives payments of interest from Aco subsidiaries and reinvests its profits.

Since the interest payments received by Finco from Canco are primarily used to pay persons who would have been entitled to an equivalent benefit had they received the interest payment directly from Canco, the conduit presumption would not apply. The safe harbour presumption describes categories of persons who, unless they are used in conduit arrangements, are generally considered not to be engaged in treaty shopping in the course of their normal operations.

FATCA Flexes and Frightens: Highly-Superficial Canada-U.S. Agreement on Foreign Account Compliance

7 Feb

The Canadian Finance and National Revenue ministers announced smugly on Wednesday that, after lengthy negotiations, Canada and the United States have signed an agreement under the Canada-U.S. tax treaty, deferring the application of the dreaded U.S. Foreign Account Tax Compliance Act. Enacted in 2010, FATCA requires non-U.S. financial institutions to report to the Internal Revenue Service the bank accounts held by non-resident U.S. taxpayers. Failure to comply subjects a financial institution or its account holders to an array of sanctions, including special withholding taxes on payments to them from the United States.

Without an inter-governmental agreement in place, this unprecedented invasion of privacy would have been imposed on Canadian financial institutions and their clients as of July 1, 2014.

Under the new agreement, financial institutions in Canada will not report any information directly to the Service. Rather, relevant information on accounts held by U.S. residents and U.S. citizens will be reported to the Canada Revenue Agency. Big difference !! Revenue Canada will then exchange the information with the Service, under the very limited and vague safeguards in the tax treaty. This rather cosmetic change is believed to bring the process within Canadian privacy laws.

This so-called protection of privacy is in fact a type of furtive and illegal adoption of a Canadian FATCA by administrative decree. The Service is only too happy, under the agreement, to provide Revenue Canada “with enhanced and increased” information on bank accounts of Canadian residents at U.S. banks.

Revenue Canada vainly tries to reassure the public that significant exemptions and relief have been obtained. Certain accounts are exempt from FATCA and will not be reportable: Registered Retirement Savings Plans, Registered Retirement Income Funds, Registered Disability Savings Plans, Tax-Free Savings Accounts, and others. This is insulting nonsense, since Revenue Canada already has all that information !

More bizarrely, smaller deposit-taking institutions, such as credit unions, with assets of less than $175 million, will be exempt. These are presumably the plumbers’ credit union-type organizations, that U.S. citizens abroad wouldn’t even be eligible to join, anyway.

The 30 percent FATCA withholding tax will not apply to clients of Canadian financial institutions, and can apply to a Canadian financial institution only if it is in significant and long-term non-compliance with its obligations under the agreement.

More tellingly, in September 2013, our fearless G-20 “leaders” committed already to automatic exchange of tax information as the new global standard, and endorsed an OECD proposal to develop a global model for the automatic exchange of tax information. They also signaled an intention to begin exchanging information automatically on tax matters among G-20 members by the end of 2015.

So at least we know now how efficiently our taxes are applied, to the inflated salaries of the drafters of these highly-superficially protective agreements, and to their related travel and deliciously-catered negotiation sessions.

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