Category: Incorporation

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In recent years, the CRA has taken a more aggressive and proactive approach in auditing transactions in the real estate sector, especially house flipping. If you have investments in real estate you should pay attention to a recent decision issued by the Tax Court of Canada, Hansen v. The Queen on September 14th 2020. Many of these types of cases get settled before getting to court so when such a case actually gets to trial it is worth investigating further.

Overview

The CRA issued a reassessment on Mr. Hansen’s return around 2013-2014 for taxation years, 2007, 2008, 2009, 2011, and 2012. The CRA alleges that Mr. Hansen was involved in house flipping and that the numerous properties sold did not fall under the principal residence exemption which he claimed. In total, five houses and one vacant lot were sold by Mr. Hansen.

The decision of the court linked above provides many detailed facts which are worth reading to understand the context of the decision. To quickly summarize, most of the reasons for the sale of the houses were for the welfare of the Hansen’s two adopted daughters. Mr. Hansen has a sympathetic narrative which the court considered credible. We do not know all the evidence provided by Mr. Hansen, but testimony from his accountant, and affidavits and statements from neighbours were mentioned.

Main issues

There were several issues decided by the court but I’ll discuss the most important ones for future tax planning.

1. Was the CRA entitled to reassess the 2007, 2008, and 2009 tax years which were outside the normal assessment period?

The normal assessment period for an individual taxpayer is typically three years after the date of the notice of assessment or the last reassessment. If the CRA wants to reassess returns beyond this period, the CRA must establish on a balance of probability* that the taxpayer made a misrepresentation attributable to neglect, carelessness, or wilful default.

2. Whether the gains from the sale of the houses was business income or an adventure in the nature of trade.

If the income is reassessed as business income, the taxpayer loses the principal residence exemption AND the capital gain tax treatment. Instead of 50% of the gains being taxable, 100% of the gain will be taxed as business income. Furthermore, the taxpayer will owe GST on the transaction. Mr. Hansen must establish on a balance of probability that the income falls under the principal residence exemption.

3. Whether s163(2) penalties apply.

The CRA may impose s163(2) penalties on taxpayers who knowingly or under circumstances amounting to gross negligence make, participate in, asset to, or acquiesce in the making of a false statement or omission in a tax return. The penalty is the greater of $100 or 50% of the additional tax payable with the reassessment. This is a heavy penalty. For example, if you are reassessed to owe an additional $100,000, the s163(2) penalty would be $50,000 making the total amount payable $150,000. The CRA must establish on a balance of probability that the the taxpayer has acted with gross negligence.

Outcome and commentary

1.The CRA could not reassess 2007, 2008, 2009 tax years.

The court held that the CRA did not prove, on a balance of probabilities, that Mr. Hansen made a misrepresentation attributable to neglect, carelessness, or wilful default.

This goes to show that even a history of transactions which the CRA might characterize as a history of improper characterization of income does not on its own necessarily demonstrate that the taxpayer has made a misrepresentation.

Below is a selection of the cases the court cited to support this position:

– Savard v. The Queen: The taxpayer has the right to disagree with the CRA in their interpretation of the Income Tax Act without this necessarily being considered a misrepresentation.

– Regina Shoppers Mall Ltd. v. The Queen: There is no misrepresentation when a taxpayer thoughtfully, deliberately, and carefully assesses the situation

– Chaumont v. The Queen: Taxpayer’s interpretation was incorrect, but it was neither far-fetched nor unreasonable enough to conclude that it was a wilful default or mistake with the intent to escape from his tax obligations

In this case, Mr. Hansen gave a reasonable explanation for the disposition of the property in the years outside the normal assessment period. Presumably, there were few inconsistencies in his testimony and there was documented proof of his claims which is why the court believed it was a credible narrative. The CRA did not provide sufficient evidence that Mr. Hansen tried to deceive the CRA in his tax filing.

Ultimately, the court did not determine whether the taxpayer was correct in designating the properties sold in 2007, 2008, and 2009 as principal residences since the CRA was barred from reassessing those years. But based on the court’s reasoning, even if the taxpayer was incorrect and the gains should have been reported as business income, the CRA would not be able to reassess those years since the CRA did not provide sufficient evidence of misrepresentation.

My personal opinion on this issue is that it could have easily gone in the CRA’s favour and really depended on the court’s weighing of the evidence. This issue is probably why the case did not settle and went to trial.

2. The principal residence exemptions did not apply for the properties sold in 2011 and 2012.

The court held that the Mr. Hansen did not meet the burden of proving the properties were a capital asset, where the proceeds would be considered a capital gain and potentially sheltered with the principal residence exemption, or as an adventure in the nature of trade.

The factors in this determination were laid out in Happy Valley Farm Ltd. v. MNR: Nature of the property sold, Length of ownership, Frequency of similar transactions, Effort expended in bringing the property into a more marketable condition, Circumstances responsible for the sale of the property, Intention at the time of acquiring the property.

The court’s held that Mr. Hansen had an intention to profit from the sale of the property when he acquired the property. Furthermore, the court again reiterated that a primary intention to profit is not necessary. Even if you establish that you had a primary intention of using the property as a capital asset, if there is sufficient evidence to establish a secondary intent to profit, that might be enough to weigh the “intention factor” towards a determination of an income asset.

3. S163(2) penalties did not apply.

Since the CRA did not establish that Mr. Hansen made a misrepresentation for the 2007, 2008, and 2009 tax years, s163(2) penalties were not applicable for those years.

The court held that Mr. Hansen made a false statement in claiming the principal residence exemption for the 2011 and 2012 properties sold.

But the court held that the CRA did not meet the burden in establishing that Mr. Hansen made the false statement knowingly or in circumstances amounting to gross negligence.

Again, the court relied on the credible testimony and evidence provided by Mr. Hansen. Mr. Hansen’s testimony provided a non-farfetched explanation for his incorrect interpretation of the Income Tax Act. Mr. Hansen also used a CPA for his tax filings. The CPA’s testimony indicated that Mr. Hansen provided the necessary information for the CPA to advise Mr. Hansen that the principal residence exemption was applicable. The court held that it was reasonable for Mr. Hansen to rely on the CPA’s advice.

Takeaways

Regarding assessments outside the normal assessment period.

• Be aware of the normal assessment period. The normal assessment period outlined in s152(4) of the Income Tax Act is an important protection for the taxpayer. If the CRA reassesses a year outside the normal assessment period, this ground for dispute should always be at the forefront of your objection. I have seen far too many situations where a taxpayer has disputed the substance of the CRA’s reassessment without considering their rights outside the normal assessment period.

• A history of incorrect/false tax filings does not, on its own, or even with additional supporting evidence, indicate misrepresentation. I think this case is a great example of this. Mr. Hansen bought and sold five houses and even a vacant lot. Mr. Hansen was essentially the general contractor for several of the houses he built and sold. General contractors are considered experienced real estate professionals and often are looked at with more scrutiny since they are more knowledgeable in the industry. These factors in favour of the CRA’s position can still be overridden which brings me to…..

• A taxpayer’s well documented and thoughtful consideration of his interpretation is key. The central question is whether the taxpayer carefully considered his position AND attempted to deceive the CRA. The CRA must prove misrepresentation but you should keep in mind that the court still looks at the reasons you provide for reaching your position. Therefore, having a clear outline of your narrative and providing supporting evidence to support your position is vitally important especially at the objection stage where you can prevent the dispute from escalating further to an expensive appeal.

Regarding the characterization of a capital asset vs adventure in the nature of trade.

• Intention of the taxpayer at the time of acquisition is the single biggest determining factor. If there is an intention, whether primary or not, to profit from the sale of a house at the time of acquisition, the transaction will likely be considered an adventure in the nature of trade. Since there is often very little physical evidence of your intention at the time of acquisition, the most important evidence is a credible testimony and providing circumstantial evidence to support your real intention, which presumably is not to profit from the sale of the house.

Regarding s163(2) penalties.

• It is reasonable to rely on a tax professional’s advice. It should be noted that the tax professional should have the full picture of your situation to give the proper advice. It follows that it is less reasonable to rely on the tax advice provided by your “uncle who is a really good business man”.

Seek Professional Help.

If you receive a call from the CRA asking for additional information about previous real estate dispositions, chances are that the CRA has either obtained information from a third party or that your previous tax filings has triggered a red flag which has resulted in an audit.

Before answering any questions, seek professional help.

The CRA will likely call and tell you that they will be sending you a questionnaire, you should not fill out this questionnaire before consulting a professional. We have seen far too many clients dig themselves a hole that took years of negotiations with the CRA to resolve.

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*In the legal context, a balance of probability means “more likely than not” or numerically speaking, more than 50% chance that something is true. This is in contrast to “beyond a reasonable doubt” which is often applicable in criminal cases.

I work with many new immigrants and small business owners and I find that many people have similar questions and misunderstandings of the Canadian tax system. This post will be part of a series which addresses some of these common questions.

This specific article may be useful if you are currently operating a business as a partnership or sole proprietorship. Issues or situations that would apply for a larger business may not be addressed here but feel free to contact us with any questions.

There comes a time for every business venture when the question comes up: Should I incorporate?

While incorporation offers many benefits, it is important to think about whether you will actually take advantage of those benefits. Below are just a few considerations.

1. Cost

Besides the annual T2 corporate tax filing fee, annual corporate return, and the legal fees to setup the corporation, there are also additional administrative and record keeping (ie. minute book) expenses which take up time and money. You should carefully consider these costs and whether they make sense at your stage of the business.

Another consideration is the cost of incorporating later on in your business. For example, if your business requires significant assets such as vehicles or real property, there may be additional expenses (ie. registration fees, land transfer tax, legal fees) in transferring legal ownership to the corporation. If there are significant valuable assets, a section 85 rollover might be applicable to defer taxes.

It can be hard to do a cost-benefit analysis on your own and a misstep could result in having to pay unanticipated taxes. Involving an experienced accountant or lawyer early in the process will save you headache and money in the future whether it is direct taxes saved or costly mistakes avoided.

2. Lower tax rates

While a corporation has a lower tax rate on its income, you should keep in mind that taking money out of the corporation is subject to taxation on your personal tax return. A fundamental idea of the Canadian tax system is that there shouldn’t be a tax advantage whether the income is earned in a corporation or by an individual.

Therefore, the Income Tax Act is written in a way where if you earned income in a corporation, then paid out a dividend to yourself, the amount you would end up with net of taxes would be approximately equal to the net amount if you earned the income directly. The real advantage of incorporating is in keeping profits in the corporation to defer the realization of taxes.

Alternatively, if the corporation paid you a salary, you would be taxed on that as well at your personal tax rate. To the corporation, the salary is an expense therefore it is not taxed. Again, the end result is that you end up with income taxed at your personal tax bracket.

This is why business owners who incorporate are even more incentivized to expense their spending using corporate accounts than those who operate a sole proprietorship. The corporate business owner can only take advantage of the tax benefits by keeping profits in the corporation; he needs to minimize the amount of dividends or salary he pays himself for personal expenses. You cannot expense personal spending through the corporate accounts (unless you want a nasty surprise in a CRA audit) but generally, any expense that can be linked to the business should be charged to the corporate account.

3. Personal income requirements

You may have personal circumstances that might require a certain amount of income on your personal tax filings. For example, if you plan to sponsor a family member to come to Canada whether for permanent residence or a Super Visa, the IRCC requires that the sponsor meet a certain income level. If you keep profits in your corporation, it will not show up as income on your personal tax return. Alternatively, if you pay out a salary from your corporation, you lose the benefit of the lower corporate tax rate. The IRCC may make exceptions to the income requirement but this is on a case by case basis and the documentation for the application becomes far more arduous. Please contact us if you are in this situation.

If you retain income in your corporation and have little if any personal income, you may also have difficulty getting a mortgage. In this situation a mortgage broker should be able to work with you on a solution but it does introduce another cost in structuring your business as a corporation.

4. Business losses

Many businesses operate at a loss for the first few years. Under a sole proprietorship, those business losses can be used to reduce other taxable income, such as employment income from another job. Business losses in a corporation are generally kept within the corporation. The losses can be carried forward (or backwards) to other years where the corporation has profits but you do not have access to these losses for your personal income tax.

Furthermore, if your business is operating at a loss, you cannot get the benefit of lower corporate tax rates!

5. Protection of personal assets from creditors

Canadian law recognizes that a corporation is a separate legal entity from an individual. This means that if your corporation goes bankrupt or an injured customer or tenant sues the corporation, they cannot go after your personal assets.* Depending on the type of business, this could be a significant factor in your consideration to incorporate.

6. Diversifying ownership

After your business is incorporated, you do not have to be the only owner. The shareholders are the owners of the business. You could have all the shares and retain 100% ownership or the shares can be given to family or sold to investors.

The ability to have multiple shareholders gives you additional flexibility in tax planning. The income from the corporation does not have to go to you directly, but other shareholders, such as family members who might have a lower tax bracket.

The ability to allocate ownership of the business to others also allows more estate planning options. The shares representing ownership of the corporation can be passed on to family members or sold. If the business was operated as a sole proprietorship, there would be no shares and individual assets would need to be accounted for and transferred, a process that could cost more in time and money.

Conclusion

These are only a few of the common practical considerations for incorporation. There are many other issues that might arise on a case-by-case basis which requires a consultation with an experienced accountant or lawyer.

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*There are exceptions to this if the corporation is a sham where the courts can “pierce the corporate veil”,