In the 2021 federal budget, the government wrote: “The lack of timely, comprehensive and relevant information on aggressive tax planning strategies is one of the main challenges faced by tax authorities worldwide.”
To fill this gap, that budget announced plans for a consultation on more detailed reporting requirements for some types of transactions. The 60-day consultation was opened with the release of draft legislation and a backgrounder on February 4, 2022.
In this blog, we provide an overview of these proposals. We also summarize concerns that our members and others have identified with these rules, as well as some potential solutions.
As currently drafted, the proposals are organized in three components that would:
- expand the current rules for reportable transactions
- introduce a new requirement to report notifiable transactions
- add a new requirement for specified corporations to report uncertain tax treatments (UTT)
Where a filing requirement arises under the proposed reportable and notifiable transaction rules, reporting is generally required within 45 days after the person enters, or becomes contractually obliged to enter, into the transaction. A corporation reporting under the proposals for UTTs must file an information return before the income tax filing deadline for the year.
Penalties would apply for failing to comply with the new rules, but these penalties will not apply to disclosures required before the legislation receives Royal Assent. In addition, the CRA’s ability to assess the transaction would not become statute barred as long as the underlying transaction remains unreported. The usual assessment time period would only start when the disclosure has been made.
Balancing CRA needs against compliance burdens
The original budget announcement highlights the importance of striking the right balance when setting disclosure rules.
On one hand, if the rules are too stringent, the CRA may not receive the information it needs to properly administer the tax system when it needs it.
On the other hand, it is important to avoid putting more burden on taxpayers than necessary. The rules on reportable and notifiable transactions may require action within 45 days of entering into a transaction. Therefore, the government needs to clearly show that the CRA must receive that information quickly and separately to do their job. If the CRA could receive the added information it needs on a regular tax return, the requirement to file an additional information return separately and within 45 days would impose an extra—and inappropriate—compliance burden.
Further, the proposals carry significant penalties, and it would seem unfair to penalize a failure to file what may be routine tax information.
The Organisation for Economic Co-operation and Development has emphasized the need for balance as a key for setting tax reporting rules, along with clarity, effectiveness and flexibility.
Mandatory disclosure regimes should be clear and easy to understand, should balance additional compliance costs to taxpayers with the benefits obtained by the tax administration, should be effective in achieving their objectives, should accurately identify the schemes to be disclosed, should be flexible and dynamic enough to allow the tax administration to adjust the system to respond to new risks (or carve-out obsolete risks), and should ensure that information collected is used effectively.
These principles are also at the heart of submissions to the Department of Finance on reportable transactions and notifiable transactions made by the Joint Committee on Taxation of the Canadian Bar Association and CPA Canada (the “Joint Committee”), as well as a submission made by CPA Canada on uncertain tax treatments.
Below, we summarize some of the key issues raised in these submissions.
Reportable transactions: Current rules
The current reportable transaction rules in section 237.3 of the Income Tax Act (ITA), which were introduced in 2010, require a transaction to be reported if a two-part test is met.
First, the transaction must be an “avoidance transaction” as defined in the general anti-avoidance rule (GAAR). This definition covers any transaction that would result, directly or indirectly, in a tax benefit, unless the transaction may be reasonably considered to have been undertaken or arranged primarily for other valid purposes.
Second, the transaction must have two of the following three “hallmarks,” which were designed to identify certain types of potentially abusive tax avoidance transactions:
Fee hallmark – This hallmark applies if the fee related to an avoidance transaction is:
based on the amount of a tax benefit
- contingent on obtaining a tax benefit (or on failing to obtain a benefit), or
- based on the number of persons involved in the transaction
Confidential protection hallmark – This hallmark applies where an advisor obtains anything that would prohibit the disclosure of the avoidance transaction’s relevant details to any person or the CRA.
Contractual protection hallmark – This hallmark applies where the avoidance transaction:
- includes insurance or other protection that protects against a transaction’s (or series of transactions’) failure to achieve a tax benefit (excluding standard professional liability insurance), or
- provides for the payment or reimbursement of any expense, fee, tax, interest, penalty, etc. arising from a dispute over the transaction’s tax benefit
We understand that only a relatively small number of disclosures have been made since the current rules were first introduced, and this is one of the key reasons why the government is broadening the rules.
Proposed changes to reportable transactions
The proposed rules would extend the definition of avoidance transaction to any transaction (or series) if it may be reasonably considered that obtaining a tax benefit is one of the main purposes. We think the new definition is too broad for two reasons:
First, the proposals would presumably catch any form of tax planning, even routine transactions that are well within the ITA’s object and spirit. For example, the proposals would consider incorporating a sole proprietorship, including a subsection 85(1) election, as an avoidance transaction.
Second, a series of commercial steps would be construed as an avoidance transaction even if just one step in the series were tax motivated. Again, routine tax planning could get caught. It seems likely, therefore, that taxpayers would need to consider all tax planning arrangements—aggressive and routine—against the hallmarks to determine if the rules apply.
The proposals also reduce the number of hallmarks that trigger reporting to just one.
Because so many transactions could potentially be in play due to the revised avoidance transaction definition, the Joint Committee raised the concern that the reporting net will be based on mainly the hallmarks. In particular, the Joint Committee identified issues with all three hallmarks that could cause bona fide commercial transactions or routine tax planning or practices to create a reporting requirement. Now that only one hallmark could create a disclosure requirement, these concerns are even more significant.
The existing hallmark definitions are mostly unchanged, apart from a new exclusion from the contractual protection hallmark for “a form of insurance, protection or undertaking that is offered to a broad class of persons and in a normal commercial or investment context in which parties deal with each other at arm's length and act prudently, knowledgeably and willingly.”
Some additional concerns raised by the Joint Committee
Timing – The proposals are set to apply retroactively, beginning on January 1, 2022, so the 45-day reporting deadline for some transactions will have passed before the proposals are passed into law.
Lack of materiality – The proposals do not include an element of materiality regarding the amount of the tax benefit or the amount of the fee under the fee hallmark.
Definition of advisor – The definition of “advisor” is broad and includes each person who provides any assistance or advice for creating, developing, planning, organizing or implementing the transaction or series of transactions. Further, the government is proposing to repeal ITA subsection 237.3(4), which relieves reporting for all where one person reports, so each advisor may have a reporting requirement if a hallmark is triggered. The submission discusses several concerns with this definition.
The 2021 federal budget introduced the concept of “notifiable transactions.” The proposal uses several concepts that are similar to the rules for reportable transaction, with proposed section 237.4 generally restating the operative rules and definitions. For example, the definitions of “advisor” are similar under both rules, as are the deadlines for filing a disclosure.
A notifiable transaction is defined to be a transaction that is the same as, or substantially similar to, a designated transaction or a transaction in a series of transactions that is the same as, or substantially similar to, a designated series of transactions.
A transaction or series is “substantially similar” to a designated transaction or series if both:
- the transaction or series leads to the same or similar “tax consequences”
- it is either factually similar or based on the same or similar tax strategy
The legislation calls for the “substantially similar” requirement to be interpreted broadly in favour of disclosure.
Designated transactions will be set by the Minister of National Revenue, with the Minister of Finance’s agreement. A backgrounder released with the draft legislation sets out six sample notifiable transactions. One sample, on manipulating the status of a Canadian controlled private corporations, was also a focus of specific changes in Budget 2022 (see CPA Canada’s 2022 Federal Budget Tax Highlights). The backgrounder calls these “sample transactions”, although it is not clear what the final designated transactions will be once the rules are in place.
The Joint Committee’s submission identifies several similar issues for reportable transactions on timing, lack of materiality, and the broad definition of advisor.
Other recommendations made by the Joint Committee on notifiable transactions
Process for designating transactions – The committee calls for a well-defined process for adding designated transactions to a list (beyond posting updates to the CRA’s website) and for removing ones that are no longer relevant. When a new transaction is added, sufficient lead time should be allowed for compliance.
Transactions with recurring benefits – Some transactions may provide benefits over more than one taxation year. Rules should be added to minimize multiple filing requirements.
Practical guidance needed – The reference to transactions that are “substantially similar” may cause confusion. Where possible, guidance should be provided similar to the CRA’s GAAR commentary in Information Circular 88-2.
Series of transactions – Applying the rules to a series is complicated because it might not be known from the series’ outset whether a reporting obligation will arise. It is also possible that transactions in a series may be designated as notifiable after the series commences. The Joint Committee suggested that a better trigger point for reporting would be at the time when the tax benefit is realized.
Uncertain tax treatments
The third component of the proposed changes would affect corporations that have recorded uncertain tax treatments (UTT) in their financial statements. These proposals would apply to a “reporting corporation,” which is defined as a corporation that:
has prepared “relevant financial statements” (basically audited financial statements for the corporation or its consolidated group)
- has assets with a total carrying value of $50 million or more at the end of the year
- is required to file a return of income for the year under ITA section 150
Note: Private corporations would be subject to the rules if they meet these tests and if their financial statements are prepared in accordance with IFRS.
A UTT is a tax treatment that is used, or planned to be used, in a corporation’s income tax filings when it is uncertain that it will be accepted as complying with tax law, and that uncertainty is reflected in the corporation’s (or its group’s) audited financial statements for the year.
An affected corporation would be required to file prescribed information on each of its UTTs for tax years starting after 2021. (As noted, however, no penalties would apply to tax years that begin before the legislation is enacted.)
In CPA Canada’s submission to the government on these rules, we re-emphasized the key concerns that we raised before the Federal Court of Appeal in the BP Canada tax case as an intervenor regarding the CRA’s right to ask taxpayers for their tax accrual working papers (2017 FCA 61; see our earlier tax blog). Giving the CRA access to subjective information on tax risks without any safeguards may discourage corporations from preparing such analyses because they might have to disclose them.
The need for complete disclosure of tax risks by corporations to their external auditors in the context of their financial reporting obligations is crucial so that auditors can fulfil their responsibilities in the interest of the Canadian public.
As we submitted in BP Canada, a better way would be for the Department of Finance to require taxpayers to disclose material transactions, but not any subjective risk assessments. Failing that, we recommended that the proposed legislation should clearly indicate that:
- UTT reporting requirements can be met by providing factual information only
- reporting corporations would not be required to provide subjective tax information beyond identifying the individual UTTs
As part of our work in this area, we formed a group of members to provide us with feedback. Some technical concerns they identified include:
Uncertainty of scope – Since questions were raised about the rules’ scope, we suggested several ways to clarify the definition of “reportable uncertain tax treatment.” For example, we recommended making it clear in the rules that they only require the reporting of Canadian income tax issues when the related uncertainty is reflected in the relevant financial statements.
Lack of de minimis threshold – In our submission, we pointed out that similar rules introduced in the United Kingdom and Australia include a de minimis test so that immaterial UTTs in the financial statements do not have to be disclosed. Adding such a rule to the Canadian regime would help reduce the compliance burden and minimize financial reporting concerns.
No reporting for known issues – Some UTTs will already be known to the CRA, such as those already subject to an objection or appeal. The proposals should be revised to align with the CRA’s general “tell us once” philosophy. Having to report the same information more than once in different ways is inefficient and adds costs.
We also raised concerns about issues such as functional currency reporting, inconsistencies for short taxation years, UTTs that offset in consolidated statements, and the need for multiple reporting where UTTs exist for more than one fiscal year.
We further recommended that, like the penalties, none of these new rules should be applied to years that begin before the legislation receives Royal Assent.
Finally, when all three components of the rules are considered, it becomes apparent that the same issue could trigger a reporting obligation under more than one component of the rules. In line with the “tell us once” principle, a rule should be added to determine which reporting takes precedence as the single disclosure.
Watch for further developments
Although we understand the government’s need for more information to enhance tax administration, it is equally important to find the right balance and clarity level to avoid extra costs and inefficiencies for taxpayers and the CRA. We hope that the Department of Finance will carefully consider the feedback provided by the Joint Committee and CPA Canada. We look forward to providing more input to the government as these proposals make their way into law. Watch our Canadian tax news page for further developments on this and other tax topics.
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The views and opinions expressed in this article are those of the author and do not necessarily reflect that of CPA Canada.