Transfer of assets to avoid tax debt, probably won't fool the CRA

If you owe back taxes to the Canada Revenue Agency and hope to avoid paying up by simply transferring your assets to your spouse, partner or relative, be forewarned — the tax man can seek the funds directly from your relative.

Joint liability rule

Under the “joint liability rule,” the CRA has the ability to hold another individual liable for the tax debts of someone with whom they have a non-arm's length relationship if they've been involved in a transaction that was undertaken to avoid tax.

“Non-arm's length” refers to individuals who are related, typically blood relatives, spouses or common-law partners, as well as a corporation and its shareholders, and anyone else whom the CRA believes is factually not at arm's length with each other.

For the CRA to successfully win a joint-liability assessment, four criteria must be met: there must have been a transfer of property, the transferor and the transferee must not have been dealing at arm's length, there must not have been adequate consideration paid by the transferee to the transferor and, finally, the transferor must have had an outstanding tax liability at the time of the transfer.

The most common example of such a transaction is where a spouse, say, the husband, transfers his half-interest in the matrimonial home to his wife for no consideration, leaving the husband with no assets for the CRA to seize for his tax arrears. The wife can then be assessed by the CRA for the value transferred (net of any mortgage), and her assets, including her bank accounts and investment portfolio, can be seized to satisfy this debt, up to the amount transferred.

The case

The joint-liability rule was recently invoked by the CRA in an attempt to collect on a tax debt involving a Brampton, Ont. electrician, his wife and their company. The couple were employees, directors and equal shareholders of the husband's incorporated electrical business. The corporation provided electrical services primarily to residential customers, but also served some commercial and industrial customers. The corporation's success was wholly attributable to the couple's work and effort — the husband did the electrical work, while his wife was responsible for the corporation's administrative work, including taking phone calls and messages, dealing with the mail, sorting supplies, banking and bookkeeping.

The CRA assessed the couple as jointly and severally liable, along with their corporation, for taxes owing by the corporation. The CRA argued that the corporation transferred property to them, by way of the payment of dividends, when the corporation had a tax debt totalling $86,848, including interest and penalties, relating to its 1995, 1997 to 2000 and 2013 tax years.

From 1995 to 1997, the couple received salaries from their corporation, but in 1998, the corporation began paying the couple dividends as well, and, other than in 2004, each spouse received dividends from the corporation annually until 2013. From 1997 to 2012, the couple also earned employment income and/ or business income (as independent contractors) from the corporation. The couple testified that the mix of payments they received from the corporation was determined by their accountant, but suggested all payments were intended to be compensation for the services they provided to the corporation.

The accountant was in charge of the compensation strategy and had told the couple that since dividends were subject to lower tax than employment income, it was advantageous to pay dividends to the couple which they could use for their own purposes. The accountant said that each year he and the couple would discuss the nature of the amounts to be paid by the corporation.

The dispute

The CRA took the position that the payment of dividends by the corporation was a transfer of property, but the couple disagreed, arguing that the dividends they received were part of the compensation paid for services they provided to the corporation in those years. Thus, they argued, they gave consideration (their services) for the dividends, and that consideration had a fair market value “at least equal to the dividends they were paid.”

In other words, the couple asserts that the corporation paid for their services through a combination of salary and/or dividends and that, while the mix of those components of remuneration received varied from year to year, in all cases the total amounts paid to them by the corporation was consideration for the services they provided. Any change in the mix of payments was a function of tax advice they had received from their accountant and was made “for tax planning purposes.”

The ruling

The judge cited prior jurisprudence of the Supreme Court of Canada which ruled that a dividend is related to shareholdings, and not to any other consideration the shareholder might have provided. As the court wrote, “a dividend is a payment which is related by way of entitlement to one's capital or share interest in the corporation and not to any other consideration. Thus, the quantum of one's contribution to a company, and any dividends received from that corporation, are mutually independent of one another.”

In another case, the Supreme Court added, “To relate dividend receipts to the amount of effort expended by the recipient on behalf of the payor corporation is to misconstrue the nature of a dividend … (A) dividend is received by virtue of ownership of the capital stock of a corporation. It is a fundamental principle of corporate law that a dividend is a return on capital which attaches to a share, and is in no way dependent on the conduct of a particular shareholder.”

The Tax Court judge therefore concluded that the dividends could not be said to be consideration for services performed, and thus the couple was personally liable for the tax debts of the corporation, having received dividends totalling more than the $86,848 tax debt.

As the judge wrote, “Having decided to transform what the (couple) now wish to characterize as consideration for services rendered into a dividend for any reason, including tax advantages, the (couple) must accept the consequences of that decision. Put another way, the (couple's) liability is determined in this case based on what they did, not what they might have done.”

Financial Post Jamie.Golombek@cibc.com Jamie Golombek, CPA, CA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Private

Wealth Management in Toronto.