1996 May Report of the Auditor General of Canada
Chapter 1—Other Audit Observations
Serious concerns about the administration of the Income Tax Act involving the movement out of Canada of at least $2 billion of assets held in family trusts
1.2 The "Other Audit Observations" chapter fulfils a special role in the Report. Other chapters normally describe the findings of the comprehensive audits we perform in particular departments; or they report on audits and studies of issues that relate to operations of the government as a whole. This chapter reports on specific matters that have come to our attention during our financial and compliance audits of the Accounts of Canada, Crown corporations and other entities, or during our value-for-money audits.
1.3 The chapter normally contains observations concerning departmental expenditures and revenues. The issues addressed generally involve failure to comply with authorities, and the expenditure of money without due regard to economy.
1.4 Although the individual audit observations report matters of significance, they should not be used as a basis for drawing conclusions about matters we did not examine.
1.5 Observations reported cover the following:
- the lack of clarity about results expected from a $7.5 million community adjustment initiative; and
- serious concerns about the administration of the Income Tax Act involving the movement out of Canada of at least $2 billion of assets held in family trusts.
1.7 Section 7(2) of the Auditor General Act requires the Auditor General to call to the attention of the House of Commons any significant cases where he has observed that:
- accounts have not been faithfully and properly maintained or public money has not been fully accounted for or paid, where so required by law, into the Consolidated Revenue Fund;
- essential records have not been maintained or the rules and procedures applied have been insufficient to safeguard and control public property; to secure an effective check on the assessment, collection and proper allocation of revenue; and to ensure that expenditures have been made only as authorized;
- money has been expended for purposes other than those for which it was appropriated by Parliament;
- money has been expended without due regard to economy or efficiency; or
- satisfactory procedures have not been established to measure and report the effectiveness of programs, where such procedures could appropriately and reasonably be implemented.
Responsible Auditor: John O'Brien
Concerns about a community adjustment initiative
The Atlantic Canada Opportunities Agency is the federal department responsible for adjustment initiatives designed to assist communities affected by the reduction of military infrastructure in Atlantic Canada, including the closure of Canadian Forces Base Cornwallis in Nova Scotia. The Agency established the Cornwallis Park Development Association, a non-profit society, to implement a community adjustment initiative. The Agency did not clearly establish the results expected from this initiative, nor did it determine, on a timely basis, the activities eligible for funding through a $7.5 million contribution agreement with the Association. Important conditions were not included in the contribution agreement, such as the requirement for the recipient to develop and use conflict-of-interest guidelines in the expenditure of funds provided by the Agency, and the definition of specific eligible costs. The Agency did not receive a business plan from the Association until fourteen months following its creation. During that period, the Agency provided the Association with $2.7 million, or 36 percent of its approved funding. The Association spent these funds primarily on facilities administration, operation and maintenance, and capital improvements.
1.10 On 9 June 1994, the Treasury Board approved Agency funding of $30 million for base closure community support in Atlantic Canada. For the Canadian Forces Base Cornwallis closure, the maximum funding allowed was set at $7.5 million. In its approval, the Treasury Board attached terms and conditions to provide a framework for developing contribution arrangements with eligible recipients. These terms and conditions authorized the Agency to fund local development agencies based on detailed agreements that specified how funds were to be advanced, expended and accounted for.
1.11 On 29 July 1994, the Agency established a local development agency, Cornwallis Park Development Association (the Association), to provide a focus for economic development opportunities for the affected communities and a vehicle to take legal title and ownership of base assets identified as having a potential viable reuse. The Association was incorporated as a non-profit society in the province of Nova Scotia. As provided for in the bylaws of the Association, the Minister responsible for the Atlantic Canada Opportunities Agency appointed the Chairman of the Cornwallis Park Development Association.
1.12 On 16 August 1994, the Agency entered into a contribution agreement with the Association to fund its activities for five years, up to a total of $7.5 million.
1.13 On 30 March 1995, National Defence entered into a lease with the Association that effectively transferred control and responsibility for the former base and all remaining assets to the Association as of 1 April 1995.
1.14 On 27 April 1995, the Treasury Board approved the sale of the former base to the Association, at a nominal value of $1. The rationale for the sale of the assets for $1 was that the market value of the fixed assets was less than the cost to sell. In addition, National Defence was to pay a lump sum grant of $6 million to the Association in recognition of the cost to demolish base assets having no further use. National Defence remained responsible for the clean-up of any existing adverse environmental conditions. The sale was finalized on 31 January 1996. We have been informed by National Defence that the military police are investigating concerns about the removal of assets from the base prior to the transfer of ownership.
1.15 We conducted an audit of the Agency's involvement in the community adjustment initiative with the objective of assessing the adequacy of its controls over this initiative. We did not audit the activities of the Cornwallis Park Development Association.
1.17 In addition, the agreement did not include the following conditions that we would have expected to see:
- It did not clearly establish indicators of economic development results expected from the Association's activities.
- It did not require the Association to prepare a plan or any other document, such as an annual budget, that established the Association's strategic direction and planned activities.
- It did not establish a definition of specific costs eligible for Agency funding. This made it very difficult for the Agency to determine which of the Association's expenditures should be funded.
1.19 Agency officials have indicated to us that the arrangement with the Association was designed to give it latitude in determining and meeting the local economic development needs. Payments to the Association were based on incurred expenditures and three-month forecasts. The Association received $2.7 million or 36 percent of its approved Agency funding by 15 August 1995. Of this amount, $1.6 million was advanced to the Association so that it could operate a sea cadet summer camp that was subsequently fully funded by National Defence. The Association incurred additional, eligible costs not related to the sea cadet camp, which the Agency applied against the $1.6 million advance. As of 30 November 1995, the Association reported that it had incurred a total of $3.2 million in eligible costs, $0.5 million more than it had received from the Agency. We are concerned that the Agency did not receive an overall strategy for the proposed use of its funding until it received a business plan on 1 December 1995 - fourteen months after creation of the Association.
1.20 In late August 1995, after receiving a request for an additional $2.4 million in funding, the Agency conducted a review of the Association's operation. As a result of the review, on 11 September 1995 the Agency notified the Association that it had discontinued further funding until the following key conditions were met:
- the completion of an acceptable business plan;
- establishment of an acceptable division of duties between staff and the Board of Directors of the Association;
- development of acceptable written operating procedures, approved by the Board of Directors and covering, at a minimum, the hiring, tendering and purchasing practices of staff; and
- a longer-term financial forecast for the disposition of revenue from operations and the $6 million grant from National Defence.
1.22 The Agency has informed us that, at a meeting held on 26 March 1996, the Board of Directors of the Association approved guidelines for avoiding conflict of interest in the expenditure of funds provided by the Agency.
1.23 In January 1996, the Agency resumed funding for this initiative, after implementing additional controls on the processing of claims and provision of advances. Since then, $150,000 in additional funding has been disbursed by the Agency.
1.25 The Agency failed to include important conditions in the contribution agreement with the Association and did not fully comply with Treasury Board guidance in its arrangements with the Association.
Agency's comments: It is a major challenge for a local development group to transform a large military base, with annual expenditures of over $30 million and 565 employees, into new, sustainable jobs for its citizens. The Cornwallis Park Development Association (CPDA) took on that challenge. This was not an audit of the CPDA, and therefore it does not address a number of the allegations that have been made over past months. As the Auditor General points out, the military police are investigating concerns about the removal of assets from the base prior to the transfer of ownership.
The CPDA has made considerable progress; yet as the Auditor General points out, further improvements are needed. Already CPDA has secured a $2.0 million annual contract to operate a sea cadet training facility, has restructured the Park's utilities operation to limit operating costs, has leased a number of buildings to new tenants and is pursuing several large new development opportunities. CPDA has prepared a long-term business plan and the Nova Scotia office of ACOA is working with CPDA to strengthen its results-targeting capabilities. Strict conflict-of-interest guidelines have been adopted by the CPDA Board. Further refinements of the guidelines for costs eligible for ACOA funding are being negotiated by the Nova Scotia office and will be incorporated in a revised contribution agreement with CPDA.
Responsible Auditor: Barry Elkin
Serious concerns about the administration of the Income Tax Act involving the movement out of Canada of at least $2 billion of assets held in family trusts
When taxpayers contemplate transactions for which the tax treatment is uncertain, they can request an advance ruling from Revenue Canada. Advance rulings guarantee the income tax effect of the contemplated transactions. We have observed two advance rulings relating to moving at least $2 billion of assets held in family trusts into the United States from Canada. In our view, the transactions ruled on may have circumvented the intent of the law regarding the taxation of capital gains. Therefore, we are concerned that Revenue Canada may have eroded the tax base by forfeiting a legitimate future claim to many millions of dollars in tax revenue. As well, we are concerned about the lack of documentation and analysis of key decisions made by the Department and the potential impact of those decisions. Furthermore, because the rulings were not made public until recently, other taxpayers may have been denied the benefit made available to those who received the rulings.
1.27 The processing of requests for advance rulings requires expert analysis of tax law and policy. In determining its position, Revenue Canada consults at times with the Department of Finance to seek its views on the tax policy intent behind various tax provisions. It also consults with the Department of Justice for its legal interpretation of the provisions. While Revenue Canada may seek the views of others, it is responsible for administering the law.
The taxation of capital gains1.28 The Canadian income tax system is complex, but there are certain basic principles on which the system is founded. One principle is that income tax is applied on the basis of residency. Another principle is that there is tax on capital gains, a particular form of income from property.
1.29 With certain exceptions, the intent of the Income Tax Act is that capital gains accrued after 1971 on property held by residents of Canada are subject to taxation. During the lifetime of a resident of Canada, when a property is disposed of and a gain is realized the gain is taxed. Generally, when a resident of Canada dies, gains on property holdings are deemed to be realized and are taxed accordingly. Gains on certain property holdings are also deemed to be realized and are taxed when a person leaves Canada to take up residence elsewhere. When the tax system is viewed in these simple terms, one can see that it should not be possible to escape tax on capital gains.
1.30 For a trust that is resident in Canada, when it moves property out of Canada the general rule is that capital gains accrued since 1971 on that property are deemed to be realized and are taxed accordingly. An exception is made for a class of property known as "taxable Canadian property". The rationale for the exception is that Canada still retains its right to tax capital gains on that property (subject to possible exemption under a tax treaty) when those capital gains are actually realized, even though the property is held by a non-resident. In other words, the interests of Canada are still protected; the tax base is not eroded.
1.31 However, only a certain type of property owned by a trust is included in "taxable Canadian property". Generally, the nature of that type of property is such that Canada will be able to enforce its claim to any tax revenue. The prime example is real estate situated in Canada. Private company shares are also classified as "taxable Canadian property". In contrast, shares in a public company are not generally classified as "taxable Canadian property". The law allows an individual and a corporation resident in Canada who leave Canada to elect to have public company shares become "taxable Canadian property" upon giving satisfactory security to the Minister of National Revenue. Trusts are specifically prohibited from making this election.
1.32 We have observed two significant favourable advance income tax rulings relating to moving at least $2 billion of assets held in family trusts into the United States from Canada.
1.33 A 1985 advance income tax ruling said that public company shares could leave Canada on a tax-free basis. In 1984, an accounting firm asked for an advance income tax ruling on behalf of a client. The essence of the ruling it requested would be a declaration by Revenue Canada that it would consider public company shares held by a trust to be "taxable Canadian property" and that a change in residence of the trust, therefore, would not cause a deemed realization of capital gains on the shares.
1.34 Revenue Canada ruled that the public company shares held by the trust could leave Canada on a tax-free basis because they would be considered "taxable Canadian property". The ruling, which was issued in January 1985, is shown in Exhibit 1.1 .
1.35 A 1985 income tax opinion on a similar case said that public company shares would be subject to tax on leaving Canada. One week after issuing the 1985 advance income tax ruling, Revenue Canada received a request for an opinion (an opinion is not binding on Revenue Canada, whereas a ruling is) from another accounting firm, in a case where the circumstances were comparable. In May 1985, an opinion was issued to the effect that public company shares could not be considered "taxable Canadian property" to a resident of Canada. The opinion and the ruling were both issued by the Non-Corporate Rulings Division. The opinion is shown in Exhibit 1.2 .
1.36 We attempted to review the analysis supporting the opinion. We were informed that the file contains only the request for the opinion and the opinion itself. There is nothing in the file to support the reasoning behind the opinion. Revenue Canada advised us that it now considers the opinion to be technically incorrect. At the completion of our audit, the accounting firm had not been advised of this.
1.37 A 1991 advance income tax ruling again said that public company shares could cross the border on a tax-free basis. In 1991, Revenue Canada issued an advance income tax ruling to a legal firm on behalf of another trust related to the parties who had received the 1985 advance income tax ruling. While some of the details are different, the main issues are identical to those in the 1985 advance income tax ruling.
1.38 The 1991 ruling dealt with the income tax consequences for a trust that would cease to be resident in Canada and would become resident in the United States (this trust is referred to as "Protective Trust" in the ruling). Shortly after it became resident in the United States it would receive public company shares from a trust resident in Canada (this trust is referred to as "Family Trust" in the ruling). In this instance, however, the trust leaving Canada had been in existence for less than 10 years. Because of a provision in the tax treaty between Canada and the United States, this meant Canada would have no right to tax the accrued capital gain on the shares that moved to the United States when that gain is realized by the Protective Trust.
1.39 In giving a favourable ruling, Revenue Canada accepted the taxpayer's representation that the public company shares held by the Canadian Family Trust constituted "taxable Canadian property". This representation was based on an earlier transaction in which the trust had received the public company shares in exchange for private company shares.
1.40 Before issuing the ruling, Revenue Canada was fully aware of the risk (outlined in paragraph 1.38) presented by the then-proposed transaction. The advance ruling was issued subject to the condition that the taxpayer provide an undertaking and a waiver ( see Exhibit 1.3 ).
1.41 The trust moving to the United States (Protective Trust) provided an undertaking that if it sold the shares within 10 years from the date it became a resident of the United States, it would not invoke the provision in the Canada-U.S. tax treaty that could enable it to escape Canadian income tax completely on the capital gain accrued to the date it left Canada.
1.42 The Family Trust provided a waiver effective for 10 years that would allow Revenue Canada to reassess it. Revenue Canada's files and the waiver show that if the Department exercised the waiver it would have to reverse its previous position and issue a reassessment on the basis that the public company shares were not "taxable Canadian property" and that the accrued capital gain should therefore have been subject to tax in Canada when the shares left in 1991.
1.43 The 1991 advance income tax ruling is shown in Exhibit 1.3 and Exhibit 1.4 is a chronology of the key events leading up to the issuance of the ruling; and Exhibit 1.5 shows the transactions entered into by the taxpayer.
The transactions may have circumvented the intent of the law1.44 As we have noted, the general rule for a trust resident in Canada is that when it moves property out of Canada there will be a deemed realization of capital gains accrued since 1971 on that property. An exception is made for a class of property known as "taxable Canadian property". Generally, public company shares are not considered "taxable Canadian property".
1.45 Some years before the 1991 ruling, the Family Trust had received the public company shares in exchange for private company shares. At the time of the exchange, both trusts were resident in Canada. The section in the Income Tax Act (paragraph 85(1)(i)) that characterizes public company shares as "taxable Canadian property" when they are exchanged for private company shares clearly applies to non-residents. Revenue Canada had to decide whether this provision applied to residents as well. In the end, supported by advice from the Department of Finance, Revenue Canada's view was that residents could hold "taxable Canadian property".
1.46 This advice was based on one paragraph in the Income Tax Act , paragraph 97(2)(c). That paragraph, dealing with Canadian partnerships, parallels other rollover provisions in the Act but its purpose appears unclear. Read literally, and in context with section 102 of the Act, however, the paragraph suggests that a Canadian resident can have "taxable Canadian property". At the same time, there are several other provisions in the Act that strongly suggest that the overall scheme of the Act contemplates the ownership of "taxable Canadian property" only by non-residents: for example, subsections 107(5) and 115(1) and section 128.1. As well, the paragraph in the Act that characterizes public company shares as "taxable Canadian property" when they are exchanged for private company shares (paragraph 85(1)(i)) was intended to prevent a non-resident from avoiding Canadian tax.
1.47 We note that the 1985 income tax opinion (Exhibit 1.2) makes a convincing argument that the general scheme of the Act contemplates the ownership of "taxable Canadian property" only by non-residents. In our view, the transactions ruled on in 1991 may have circumvented that intent by characterizing public company shares held by a resident of Canada as "taxable Canadian property" and thereby avoiding tax when those shares crossed the border. Furthermore, we believe the transactions circumvent the overall intent of taxing the accrued capital gains on property, other than "taxable Canadian property", when that property leaves Canada.
The ruling may have forfeited a future claim to significant tax revenue1.48 Documents contained in Revenue Canada's files indicate that, over the two months during which the ruling request was considered, officials concluded repeatedly that the Department should not rule favourably.
1.49 However, during a series of meetings on 23 December 1991, senior officials of Revenue Canada authorized a favourable ruling. Revenue Canada advised us that its files do not contain any minutes of these meetings or additional details about them. The Department of Finance advised us that, for the meeting it attended on 23 December, its files also do not contain any minutes of, or additional details about, the meeting. We note that the senior Revenue Canada official responsible for rulings did not attend the meetings. Some analysis was prepared after the fact to justify the ruling.
1.50 The analysis supporting Revenue Canada's interpretation of the law was based on a letter dated 23 December 1991 from the Department of Finance. Finance told us that it was unable to locate any documentation to support the conclusions reached in the letter or on their potential fiscal impact. The letter concluded that the law intends that both resident and non-resident taxpayers can hold "taxable Canadian property". As we have noted, based on this advice Revenue Canada concluded that the public company shares were "taxable Canadian property".
1.51 Whether or not the particular shares ought to be considered "taxable Canadian property" was ambiguous, due to the complex nature of the Income Tax Act provisions where the term is used. Also, as we have noted, if Revenue Canada acted on the waiver it would have to try to sustain a reassessment on the basis that the shares were not "taxable Canadian property". The issue can be settled only by the courts, should a relevant case some day be litigated.
1.52 By accepting the taxpayer's representation that the shares were "taxable Canadian property", Revenue Canada may have guaranteed the complete elimination of Canadian income tax in the future on capital gains on property of enormous value. It is unlikely that, without the ruling, the proposed transactions would have proceeded and triggered an immediate tax. However, we are concerned that Revenue Canada may have eroded the tax base by forfeiting a legitimate future claim to hundreds of millions of dollars in tax revenue.
1.53 Furthermore, we would have expected Revenue Canada's files to contain minutes of the meeting held with the Department of Finance officials and some analysis of why Revenue Canada officials accepted the advice given. This is particularly important in this situation, given the amounts involved and the fact that the advice received from the Department of Finance caused Revenue Canada to change its position. We also would have expected Revenue Canada's files to contain at least some analysis of the potential impact on other sections of the Income Tax Act as a result of accepting the Department of Finance's advice. We believe that without a documented appropriate analysis, public accountability for these types of decisions is compromised.
The advance ruling was applied to a completed transaction1.54 The 1991 ruling was based on the view that, because the public company shares were acquired in exchange for private company shares, they were "taxable Canadian property". This was one of the key issues to be resolved before the ruling was issued. However, the exchanges were completed transactions. While the ruling technically was not given on whether the shares were "taxable Canadian property", that was the essence of the ruling. Minutes of meetings and deliberations of rulings officials, the undertaking, the decision of the rulings review committee and the memorandum to the Deputy Minister all confirm this.
1.55 Revenue Canada's Information Circular 70-6R2 states that "advance income tax rulings will be given only on proposed transactions". Completed transactions are normally dealt with by audit. Although audit officials had not reviewed the exchange transaction to determine if the public company shares were "taxable Canadian property", rulings officials concluded that they were.
The undertaking and the waiver have limited value1.56 Revenue Canada's files show it was concerned that the taxpayer might undertake further undisclosed transactions, particularly ones designed to avoid tax. To address this concern, the taxpayer provided an undertaking and a waiver as a condition of receiving the 1991 advance income tax ruling.
1.57 Revenue Canada advised us that the undertaking given, together with the waiver, reinforced the fact that the proposed transactions were not designed to avoid tax. The Department stated that this resolved any concerns about future transactions where the application of the general anti-avoidance rule could be considered, and provided it with a measure of protection should the facts change in the future.
1.58 We agree that the undertaking and the waiver provided the Department with some comfort to support the favourable ruling. However, the scope of the waiver was limited and would permit Revenue Canada to reassess only on the basis that the public company shares were not "taxable Canadian property". But the ruling accepted the argument that the shares were indeed "taxable Canadian property" and could therefore move to the United States on a tax-free basis. To act subsequently on the waiver, Revenue Canada would have to try to sustain a reassessment on the basis that the shares were not "taxable Canadian property". If Revenue Canada was prepared to use that argument in the future if necessary, it must have considered the argument valid when it issued the ruling.
1.59 Furthermore, Revenue Canada knew that the undertaking provided little protection, since it was aware of relevant jurisprudence that had ruled such documents unenforceable. The memorandum prepared for the Deputy Minister also advises that an undertaking would not be enforceable if the taxpayer later reversed its position and claimed protection under the Canada-U.S. tax treaty. The documents show that the Department decided the taxpayer would not renege on the agreement because doing so would hurt its position in future dealings with the Government of Canada. We also note that for the undertaking to have any value, the trust would have to believe that Revenue Canada could convince a court that the public company shares were not "taxable Canadian property". The waiver and the undertaking were not supported with security.
Other taxpayers may have been denied the benefit made available to those who received the rulings1.60 The legal firm that requested the 1991 advance income tax ruling had a copy of the 1985 advance income tax ruling that had been given to an accounting firm. This provided it with an advantage over others who were not aware of the 1985 advance income tax ruling. The accounting firm that received the opposite income tax opinion in 1985 may not have been aware of the advance ruling that same year and may not now be aware of the 1991 ruling. We also note that the 1985 opinion is in the public domain.
1.61 In 1993 we recommended that Revenue Canada release, in severed form, issued advance income tax rulings. Revenue Canada has released some rulings, although it chose not to release the rulings discussed in this observation at the time they were issued. The 1991 ruling was issued in severed form, in March 1996.
1.62 In November 1995, during the course of our work on this observation, Revenue Canada announced that it plans to release all rulings in severed form. We support this position. Advance income tax rulings are an important part of the tax administration process. Making them available should result in a more consistent and uniform application of the law among taxpayers and should improve the transparency of the tax system. Transparency not only assists taxpayers and their advisors but also helps parliamentarians and the public understand how tax law is used and how it works. Transparency should also improve accountability.
Revenue Canada's comments: An advance income tax ruling is an assurance given by Revenue Canada that transactions that will be undertaken by taxpayers will have specified tax consequences. Taxpayers request advance rulings where there is uncertainty about the tax consequences of proposed transactions that frequently involve complex business arrangements with significant tax implications. Taxpayers require certainty in order to proceed with legitimate business transactions. In granting an advance ruling, Revenue Canada must make decisions with respect to the application of law that may be ambiguous.
The granting of a ruling does not preclude an audit of the transactions proposed in the ruling at a later time. If an audit verifies that the facts and proposed transactions that were represented in the ruling are complete, accurate and are carried out as proposed, Revenue Canada would abide by the ruling.
In interpreting the law that applies to the transactions to be undertaken, Revenue Canada determines the intent of the law by considering not only the words of the particular provision, but also the context in which the particular provision is found.
The crux of the rulings is the nature of the shares of the public company owned by the trusts. If they are taxable Canadian property to the Canadian resident trusts, they can be distributed by the trusts to the non-resident beneficiary without being subject to capital gains tax at that time. These public company shares were acquired by the trusts in exchange for shares of a private company owned by the trusts. A specific provision of the Income Tax Act characterizes public company shares as taxable Canadian property when they are exchanged for private company shares. Whether this provision applies to the transactions proposed in the ruling depends on whether a resident of Canada can own taxable Canadian property.
As noted by the Auditor General, this issue is complex and involved ambiguous provisions of the law. As is customary in resolving issues of this nature, Revenue Canada analyzed the relevant provisions of the Income Tax Act and their context and consulted the Department of Finance to ensure that its interpretation was consistent with the intent of the law. On the basis of its analysis and advice from the Department of Finance, Revenue Canada concluded that the public company shares were taxable Canadian property to the Canadian resident trust.
This interpretation has been published in the form of an advance income tax ruling and a general technical interpretation, which have been released to the public.