The canada revenue Agency’s recent moratorium on advance tax rulings on income trusts tops the list of contentious issues that are heating up the already testy relationship between tax practitioners on one hand and the federal Finance Department and the CRA on the other.

These issues have been unresolved for too long, tax practitioners say, and the prolonged uncertainty makes it difficult for them to provide advice on tax liability to their clients with any assurance.

Also on the list of unresolved matters are new rules for offshore trusts and foreign investment entities that were announced in 1999 but have yet to make to the parliamentary order paper, as well as new rules for interest deductibility that were first announced in the fall of 2003.

It should be noted that amendments to tax legislation often include effective dates — either retroactive or in the future. It’s also CRA policy to treat amendment announcements as law, and assess tax returns on that basis. However, tax practitioners can argue that there is no basis in law for assessing a client based on proposals that are not passed.

Of course, that would lead to re-doing tax returns if and when amendments are passed — translating into extra headaches for tax practitioners and extra costs for reasonably disgruntled clients.

The CRA’s moratorium on advanced tax rulings for income trusts, unveiled in mid-September, followed the release of a consultation paper and the announcement that consultations on the economic and fiscal implications of income trusts would begin in early September.

Tax practitioners and business clients largely ignored the consultation announcement and barged ahead with converting their corporate structures into income trusts, Brian Ernwein, director of the tax legislation division of the federal Department of Finance told delegates to the 57th Canadian Tax Foundation conference in Vancouver in late September.

That’s why Finance took the drastic step of having the CRA place a moratorium on advance tax rulings.

But both these moves don’t necessarily mean the tax treatment will change, Ernwein says: “We’re not sure which way the issue will topple.”

That kind of statement incites an angry reaction from practitioners. “The situation has gone from ‘green’ to ‘yellow.’ It could go back to ‘green’ or ‘red’,” says Darcy Moch, a partner with Calgary law firm Bennett Jones LLP.

The uncertainty has had a highly adverse impact, says Moch, resulting in potential losses of millions of dollars of shareholder unit value. Like many tax practitioners, Moch is also skeptical about further consultations. Practitioners and clients have already reacted strongly against previous warning signals that Ottawa has sent out about income trusts.

Ottawa announced a limit on investment in business trusts by pension funds in the 2004 budget, for example, but the outcry was so intense that Finance backed off.
(Nonetheless, the measure may be resurrected after the latest consultation period).

“It’s hard to imagine that anything original could come out of further consultations,” says Moch.

Paul LeBreux, chairman of the Society of Trust and Estate Practitioners (Canada) and president of the Toronto-based Global Tax Law Professional Corp. counts himself among the many practitioners who believe that in issuing a moratorium, the CRA has gone too far.

“In principle,” he says, “there should be certainty in the tax system, and providing advance tax rulings is part of that certainty.” Finance can hold consultations, and continue to provide advance rulings, he says.

However, he also believes shareholders should shoulder some of the responsibility for the adverse impact of Ottawa’s announcements. “There has been lots of speculation in this sector,” he says. “There has also been lots of commentary indicating this is an over-heated bubble.”

LeBreux takes issue with the prevailing view in support of income trusts that excess company cash should be passed on to the unitholders rather than left within the company to be “wasted by CEOs.”

“What does an entity do when it needs the cash?” he asks. As an example of his point, he notes the Sept. 26 bankruptcy declaration made by the U.S. parent of Toronto-based income trust, Heating Oil Partners Income Fund, a home-heating oil supplier. With the price of heating oil soaring, LeBreux says, the trust didn’t have enough cash in the pot to pay out to unitholders.

Other contentious — and overdue — issues are:

@page_break@> Interest deductibility.

Tax practitioners had expected to see a revised version of Finance’s proposals on interest deductibility rules before the fall, but the department isn’t prepared to do any unveiling in the near future.

Meanwhile, practitioners are having a hard time envisioning how Finance will fix its proposals so they don’t result in adverse effects. Investors and advisors alike are struggling with how to develop investing strategies on a tax-effective basis.

In the fall of 2003, Finance proposed new rules that tax experts argue will discourage investors, start-ups and businesses from borrowing to finance investments, and, therefore, adversely affect the economy. The proposals were supposed to be effective as of the beginning of 2005.

For 20 years, the CRA has disallowed certain interest deductions from income on the grounds that the taxpayer-investor had no “reasonable expectation of profit.” Then, in 2002, the Supreme Court of Canada threw out the CRA’s use of this policy to measure whether a business or investment endeavour was bona fide and therefore eligible for interest deductions on debt borrowed to finance it.

However, the Finance Department wants to bring in legislation that will effectively overcome the SCC’s decisions by introducing a new cumulative “net profit” test, which must be passed before a taxpayer-investor can claim any deductions.

But tax practitioners say this test will penalize investors who need to borrow money to build wealth because, for example, it would be rare for a Canadian share to pay a regular dividend even close to the lowest borrowing cost.

Moreover, the usual time for holding a stock is less than five years — not enough to accumulate sufficient profit to pass the proposed test.

Ernwein conceded at the CTF conference that Finance has not been very successful in persuading practitioners that his department is on the right track.

Trying to make light of the situation, Ernwein told CTF conference attendees: “[The new rules] will be ready soon — before my next speaking engagement.”

> Auditor working papers.

As a matter of routine, the CRA has recently demanded that private-sector tax auditors provide the “working papers” that include their analyses of their clients’ present and future tax liabilities.

The CRA says it does this because a company’s books and records may be insufficient to determine tax liability.

But the tax accountants — many of whom are certified financial planners — are fighting back, arguing that the working papers are private. Unfortunately, they cannot argue — like lawyers — that the papers are protected by client privilege.

Therefore, the Canadian Institute of Chartered Accountants has recommended that the CRA adopt a “policy of restraint” when requesting working papers.

The CRA says it has finalized consultations with accountant groups and expects a new policy to be released by the end of this year. But accountants are not hopeful that the CRA will back down.

It’s possible that the CRA’s new policy will state that its auditors will not routinely ask for working papers — unless the client’s books and records are so inadequate that they cannot provide a reasonable basis for a tax assessment.

But that’s a best-case scenario in an already tense environment —with a tougher than ever CRA.

> Third-party penalties.

The limited imposition of civil penalties on tax practitioners may be the only good news to come out of Finance at the tax conference.

When the new regime imposing hefty fines on any advisor who advises or participates in planning or preparing a false tax return for a client was first proposed in the 1999 federal budget, it was greeted with howls of derision from tax practitioners.

In its defence, the CRA now says the third-party penalty review committee has kept to the agency’s promise to apply the penalties in only the most egregious circumstances.

Only 13 files have been considered for imposition of these penalties, says Arlene White, director of the CRA’s Vancouver-based tax services office.

Of those 13, she says, five cases have been rejected and only two cases have been approved as of August 2005. Those two cases involved “a tax return prepared with information that the practitioner knew to be false,” she said. The other six cases still undergoing CRA audits. IE