WEALTH ATTACK – A SUMMARY
The tax authorities may be after you!

• Tax authorities from around the globe and across Canada are focusing on individuals of higher incomes, searching for unreported incomes and aggressive tax avoidance schemes.
• They are using experienced personnel and a 21 page questionnaire to identify areas of interest.
• A separate investigation into misuse of inter-vivos trusts is seeking to identify when trusts are insufficiently documented and are misdirecting under-taxed benefits to tax avoiders.
• U.S. and Canadian tax assessors are requiring detailed reporting of foreign accounts and related incomes.
• What can you do? Improve your regular tax reporting, to make it simple and clear. Follow good advice. Don’t be too aggressive unless your grounds are solid, and you are prepared for a counter-attack. Respond in short, concise answers. And plan ahead, to shore up areas of risk and uncertainty.

On June 14, 2011, we presented a Round Table Discussion in our Montreal office on the subject of tax authorities closing in on persons of higher wealth.  Following are notes that arose from that discussion.

 WEALTH ATTACK
The tax authorities may be after you!

Why me?

The tax authorities provincially, nationally and internationally are coordinating their efforts to investigate taxpayers who have higher wealth and complex financial affairs.  This is an internationally mounted effort arising from years of studies of offshore tax havens and tax evasion by the Organization for Economic Cooperation and Development, OECD.

Wealthy taxpayers have for years placed deposits in trusts and companies in offshore locations, and relied upon secrecy and lack of reporting to avoid tax on such monies.  Now in a concerted effort by the developed countries, each has assigned senior personnel to look at individual taxpayers rather than just focus on tax returns provided.  The idea is that taxpayers of substance have the financial ability and the motivation to seek to organize their affairs to reduce income taxes.   While for many years it has been acceptable to minimize taxes, this must be done in accordance with stricter and stricter laws, and not accomplished by burying one’s affairs in secret havens and complexity.

Add to that Canada’s Auditor General, who identified serious omissions in audits of trusts in her report of November 2005.  This resulted in a test investigation in Ontario in 2009, which has been followed-up by a full-fledged investigation team scouring the nation for offensive trusts.

To accomplish these new investigations, Quebec, Canada and the U.S.A. have added thousands of new audit staff and are deploying more experienced staff to investigate tax avoidance schemes, which may not be up to their standards.  The idea is to look at the individual and all related parties rather than just look at tax returns submitted.  Initially, individuals with $50 million of net worth and higher are being targeted to see if they have complex ownership of assets, including the use of partnerships, corporations, trusts, joint ventures, private foundations, foreign accounts and complex planning techniques.  They are seeking to understand the relationship between these entities and how income may or may not be fully reported.  Once the process is established, we expect that tax assessors will turn their attention to those with $10 million and up.

But how do they find you?  They look at who are shareholders, officers and directors of large public and private companies.  They are looking for substantial family ownership of such companies, which is required reporting in corporate tax returns – shareholders holding more than 10% of the shares.  They obtain this information from the reporting of corporate ownership and control that each large company is required to report annually.  They also pick up this information from personal tax returns, and information from the financial media and internet research.

Once they have selected you for an initial examination, they send you a 21 page questionnaire, asking you to answer in detail specifics about your financial assets and ownership structure.  These are precise questions and you are certifying your answers to be correct.  If they want to dig into an area further, they will return with more questions.  This is the type of investigation that large corporations have been subjected to.  The audit can take up to three years, particularly if technical areas interest them and require greater expertise or valuation.

Inter-Vivos Trusts

Separate from the Related Party Initiative, another group of auditors is examining the use of inter-vivos personal trusts.  Federal tax assessors have long been concerned about offshore trust that could direct investment earnings outside the purview of Canadian tax authorities.  Even provincial authorities have been concerned but interested in trusts that earn income in lower tax rate provinces such as Alberta, to pay out tax-free capital to beneficiaries in highly taxed Quebec and Ontario.  Two recent tax cases called Garron and Antle used trusts to direct income to be earned in Barbados. In Garron, the court decided that although the trustee was in Barbados, the mind and central management of the trust was in a lawyer’s office in downtown Toronto. In Antle, the judge found that the trust did not exist because it did not meet the test of certainty of intention and subject matter.

So while a trust may be a very effective instrument to provide control over assets while directing benefits to family members who need and deserve them, one must assure that essentials of the trust are preserved.  There must be a property that establish the trust and that should be available for examination.  There must be a clear intention or purpose of what the objectives of the trust are.  These have to be broader than just seeking a means of tax avoidance, and the operations of the trust must be documented and clear.   This means keeping good accounting records, preparing financial statements and preparing minutes where the trustees authorize transactions on a timely basis.  If distributions must be paid or are payable before the end of the fiscal year, then this should be demonstrated in fact.  If the trustees are in Alberta then they should be independent persons who clearly exercise management and control over the assets and income of the trust.

Cross-Border Challenges

Troubles also arise for Canadians when they cross the borders in the United-States.  Here you have several authorities to deal with:  U.S. immigration is interested that you are not intending to stay in the country illegally. U.S. income tax authorities are wanting to tax you if you spend too many days in the U.S., both on the basis of more than 183 days per year and on the basis of substantial presence in the U.S., based on the sum of your days visiting the U.S. last year, plus ¹/₃ of the preceding year’s stay, plus ¹/₆ of the pre-preceding year’s days.  That sum adds up to 183 days.  They are also interested in taxing you unless you can prove that you have more substantial ties to Canada.

Then there are the estate tax people who seek to tax you in the U.S. on assets that are located there, such as real estate, U.S. stocks and bonds, and business and physical assets that might be registered there.  Finally, there are concerns that the Canadian provincial medicare authorities have over whether you have been outside the country too long.  And of course, there are customs duties and sales taxes that you might be presumed to have avoided.

Foreign Accounts

U.S. tax authorities are closing in on citizens that reside outside the country or that have investment and banking accounts outside the U.S.  They are concerned about non-reporting of investment income that might have been earned on such accounts.  They require you file each year a detailed report of all foreign accounts, and the  highest balances that existed in the previous year.

Canada is interested in oversees accounts as well.  You were asked in your annual tax returns to report all property that cost you $100,000 or more, located outside the country.  You first answer yes or no to a straightforward question and if the answer is yes, you must complete a T1135 which asks for property held in different countries or regions, that had a cost in excess of $100,000, $300,000 and up to greater than $1 million.  If you fail to respond or give a false statement, the tax authorities can take drastic action.

Both U.S. and Canada are providing opportunities to make voluntary disclosure to clear up omissions or misstatements of previous years.  This can be done without penalty if you have reported the income in the past or come forward to report it currently, together with interest for all previous years’ unpaid taxes. But these windows of tax amnesty will soon close.

Of course, there are many laws which seek to trip up planning that is improperly implemented.  For example, investment income and capital gains can be earned in the names of minors or spouses in appropriate ways, but this is often done casually and improperly.  If one can expect a higher degree of scrutiny, you will need to follow tax planning principals much more closely.  In a number of other areas, tax authorities are closing in.  Tax shelter investments have to be registered now before being sold.  Entering into an aggressive tax plan or scheme has to be reported in advance to tax authorities, and can get the promoters, accountants and lawyers into problems if not properly designed.  U.S. and Canada are focused on ensuring that self-employment income and expenses are properly reported, including GST/QST reporting.  They are also very interested in examining receipts supporting charitable donations and medical expenses, whereas they formerly accepted these as filed.

The tax authorities have strenuous questionnaires to be completed to help them hone in on questionable areas.  They can also seize tax planning correspondence or indeed seize your computer for detailed examination.  This begs the question of what can you do about it.

What can you do?

You still have the right to organize your affairs in a manner to seek to minimize income taxes.  But this must not be seen as the primary reason for so doing.  For example, establishing a trust to hold funds and direct income for the benefit of family members is a valid and reasonable thing to do.  You are seeking to assist them while protecting the funds from claims of creditors.  While you are alive, you may be the person best suited to protect your family’s assets.  But income from such a trust cannot be used to pay for your personal expenses.  If you are using the tax benefits of the trust to shelter income for your own personal use, then that will not be allowed.

Trusts should have a clearly demonstrated purpose or intention.  Trustees should be independently established and should manage the affairs of the trust clearly for the benefit of the beneficiaries.  Accounting records should be maintained.  Separate banking or investment accounts should be maintained.  Financial statements should be drawn-up each year.  (We are aware of the proposal in place in Ottawa to require the filing of financial statements for all trusts.)  Trust funds should not be commingled in any way with your personal assets, nor should they make any personal payments to you or for your benefit, unless fully backed-up by receipts demonstrating how you provided for the children.  A permanent record/minute book should be maintained of key decisions taken by the trust including distributions.  Any payment not made should be supported by a promissory note showing amounts due to the beneficiaries.

In respect of other tax matters, when dealing with questionnaires and the like, you should give short, concise and honest answers. You should involve a number of advisors in addressing such detailed audits.  Of course you will want your tax planner and accountants, but you may also want legal advisors if matters look like they might go to court.  You should consider who should be your spokesman in presenting information on your behalf.  You may wish to use your right to retain legal counsel or assert client-solicitor privilege over certain discussions and correspondence.  You should communicate amongst the parties and other family members to make sure everyone is on the same page.  You should provide straightforward answers and respond clearly to reasonable questions raised, but draw the line when those should become unreasonable.

Probably the most important protection is to plan ahead.  You should have a review of your financial activity to identify any areas of greater risk, those areas where it is of high priority to pull together information and support the activity you have taken.   You will want to think about the documentation that may be required by the tax authorities one day to support your position and develop a process for gathering and delivering it quickly.  You should look at your procedures for retaining tax related documents for at least a minimum statutory time period, and possibly a longer period if this information may be critical in the future.

Finally you need to come up with clear, concise reporting when you do your regular compliance filings.  That means that personal, corporate, and trust tax returns and supporting financial statements should be prepared professionally by a good team of advisors who know your affairs fully.

For keep in mind that if tax assessors choose to make your life difficult, they can take up considerable amounts of your time and attention, and can cost you thousands of dollars in compliance.  You may not like dealing with the tax authorities and may feel that you have paid more than your fair share, but it is just part of business.  If you provide the required information fully and completely, they will eventually go away, and if they are seen to harass you, you have rights to seek more professional treatment.