If you are self-employed or a professional or you own a business, you are probably already doing tax planning each year to minimize the tax you pay.
Let’s see what is the best thing to do in British Columbia, Canada.
Even though no changes were included in the February 11, 2014 Federal Budget or the February 18, 2014 B.C. Budget, the previous changes announced in the February 19, 2013 B.C. Budget and the March 21, 2013 Federal Budget change the way dividends and salaries are taxed in 2014.
If you have incorporated, you probably earn active business income in your corporation and pay the small business rate (the rate in B.C. is 13.5%). This is a very favourable rate and was designed to encourage small businesses.
The Budgets did not make any changes to this 13.5% corporate tax rate. But the Budgets did announce changes to increase the personal tax rates. So even though the corporate rate did not change, when you want to withdraw funds from your corporation, you will pay more tax.
Most business owners take cash out of their corporations either by way of salary/bonus, or by way of dividend. There are some exceptions (e.g. shareholder loans, capital dividends, returns of capital) but I will focus on just these two.
Comparing salary vs. dividend is somewhat complicated because a salary is a deduction from the corporation’s income and therefore there is no corporate tax; there is only personal tax.
On the other hand, dividends are paid out after corporate taxes are paid, so there are two levels of tax: first corporate tax is paid and then personal tax is a second level of tax.
In addition, the comparison changes depending on what tax bracket you are in. So a dividend may be taxed less than a salary for someone in a low tax bracket compared to someone in a high tax bracket.
So let’s just analyze what has happened as a result of the B.C. Budget and the Federal Budget for someone in the top tax bracket in B.C. for 2014 ($150,000 of income).
If $100,000 of gross profits are earned in a corporation, and you flow it all through to the shareholder, this is the total of both levels of tax under the current rates for 2013:
|Amount left after tax||
|Effective tax rate||
From this you can see that both rates are quite close and dividends are taxed slightly lower than salary.
Under the new rates for 2014:
|Amount left after tax||
|Effective tax rate||
From this you will see that that the rates for both salary and dividends will go up in 2014. You will also note that dividend rates go up more than salary rates, so in 2014, it will be slightly more expensive to take dividends than salary.
We previously wrote about the Tax Court of Canada decision released on October 2, 2012, Guindon v. R., 2012 TCC 287 (“Guindon”). The Guindon decision had dramatic implications for any Canadians who were assessed third party penalties pursuant to section 163.2 of the Income Tax Act (the “Tax Act”). The decision found that the penalties were, in substance, criminal penalties. This finding had far reaching implications for administration of section 163.2 with respect to:
- the applicable standard of proof;
- section 11 Charter of Rights and Freedoms protections for those accused; and
- restriction on the information gathering power of the Canada Revenue Agency in the admininstration of these penalties.
The Crown appealed the Tax Court decision to the Federal Court of Appeal and the judgement of the Tax Court of Canada was overturned in Canada v. Guindon, 2013 FCA 153.
Among other findings, the Federal Court of Appeal found the penalties are administrative as opposed to criminal penalties.
The full text of the Federal Court of Appeal decision can be found here: http://decisions.fca-caf.gc.ca/site/fca-caf/decisions/en/item/37806/index.do?r=AAAAAQAHZ3VpbmRvbgAAAAAAAAE.
On October 2, 2012 the Tax Court of Canada released its decision in Guindon v. R., 2012 TCC 287 (“Guindon”).
This decision has dramatic implications for any Canadians who have been assessed third party penalties pursuant to section 163.2 of the Income Tax Act (the “Tax Act”). If you have been assessed a penalty pursuant to section 163.2 or such an assessment has been proposed by a Canada Revenue Agency auditor, you can breathe a sigh of relief - at least temporarily.
The facts of Guindon involve a lawyer who practiced primarily family law and wills and estates law in Ontario. Ms. Guindon became involved in a charitable donation arrangement called The Global Trust Charitable Donation Program. Ms. Guindon provided a legal opinion and signed tax receipts on behalf of the charity. Ms. Guindon provided the opinion and signed the tax receipts without reviewing documentation she purported to have reviewed and without the requisite tax expertise. Ms. Guindon was assessed a penalty pursuant to 163.2 for false statements that were made on tax returns filed by the participants in the charitable donation arrangement.
Section 163.2 of the Tax Act contains two penalties known in tax community as the “planner penalty” and the “preparer penalty”. Ms. Guindon was assessed the preparer penalty. The preparer penalty allows the Canada Revenue Agency to assess a penalty to a third party (usually a professional) for false statements made by the professional’s client. The penalty can be assessed where the professional knew the statement made by the client was false or “would reasonably be expected to know but for circumstances amounting to culpable conduct”.
The Canada Revenue Agency assessed Ms. Guindon a preparer penalty in the amount of $564,747 on the basis that she knew, or would have known but for wilful disregard of the law, that the tax receipts issued and signed by her constituted false statements.
The Canada Revenue Agency has always proceeded on the basis that the 163.2 penalties are civil penalties. The Canada Revenue Agency reassessed Ms. Guindon on the basis that the 163.2 penalty is a civil penalty.
However, since the penalty was introduced in the 1999 Federal Budget there have been tax practitioners who have speculated and argued that the penalty is potentially so onerous that it is, in substance, a criminal penalty as opposed to a civil penalty.
The Guindon decision was the first time that the Tax Court of Canada had to consider whether penalties pursuant to section 163.2 are in substance civil or criminal penalties.
After considerable analysis, the Tax Court of Canada found that the 163.2 penalties create in substance a criminal offence because section 163.2:
“is so far-reaching and broad in scope that its intent is to promote public order and protect the public at larger rather than to deter specific behaviour and ensure compliance with the regulatory scheme of the Act. Furthermore, the substantial penalty imposed on the third party – a penalty which can potentially be even greater than the fine imposed under the criminal provisions of section 239 of the Act, without the third party even benefiting from the protection of the Charter – qualifies as a true penal consequence.”
This finding that the 163.2 penalties are, by their nature, criminal sanctions has far-reaching consequences.
• Taxpayers charged with an offence under section 163.2 are guaranteed the protections afforded by section 11 of the Charter of Rights and Freedoms which guarantees fundamental substantive and procedural legal rights. A taxpayer assessed a civil penalty under the Act is not afforded or guaranteed such protection.
• The Canada Revenue Agency would be precluded from using its broad and powerful civil audit powers to gather information to support the assessment of a 163.2 penalty. Once a 163.2 penalty is contemplated the Canada Revenue Agency will be constrained by the Charter of Rights and Freedoms and will have to obtain a warrant to gather information to be used to support the penalty assessment.
• The taxpayer accused of an offence under 163.2 will be presumed innocent until proven guilty and the Canada Revenue Agency must prove its case beyond a reasonable doubt. When assessing a civil penalty the burden of proof is “proof on a balance of probabilities”.
• A criminal offence must be prosecuted in provincial court under the criminal procedure provided for in the Criminal Code as opposed to a civil penalty that is assessed and disputed in the Tax Court of Canada.
In this case, the Tax Court of Canada found that the penalties provided for in section 163.2 are criminal in nature and allowed Ms. Guindon’s appeal on that basis. The Tax Court was careful to point out that if the penalty were a civil one, the court would have upheld the assessment of the penalty.
The Department of Justice, on behalf of the Canada Revenue Agency, has appealed the decision of the Tax Court of Canada to the Federal Court of Appeal.
Any Canadians who are being audited for a section 163.2 penalty or who have been assessed a section 163.2 penalty will be very interested in the pending Federal Court of Appeal decision.
The Canada Revenue Agency seems more and more willing to impose penalties for all sorts of perceived transgressions. We've talked about penalties in a previous blog post ( http://taxdisputehelp.ca/2011/10/fighting-the-imposition-of-gross-negligence-penalties ).
One that seems to be a trap for the unwary and can be very unfair is the penalty for failure to report ownership of foreign assets having an aggregate cost of over $100,000.
Under s.233.3 of the Income Tax Act, a person must file a special return if they own foreign assets having an aggregate cost of over $100,000. The foreign assets are referred to as “specified foreign property” and include cash, bank accounts, investments, shares, an interest in a trust, and loans to foreigners. It does not include strictly personal use assets such as a vacation home or vehicles.
In my experience, this rule is not well understood by most Canadians. Even though there is a yes/no question about foreign assets at the top of the T1 personal tax return, it is often missed by the taxpayer or not raised by the tax preparer.
I have been involved in numerous situations where a client has come to me because they have been contacted by the CRA to provide details of foreign assets and have threatened penalties for failing to file the required T1135 tax return each year.
While the CRA needs to ensure that Canadians report the income they earn from foreign investments, the unfairness can arise because sometimes these assets have not generated any income. Even if there is no income to report, a person can still be assessed for failure to report the ownership of the assets.
If you are an individual taxpayer, the T1135 has to be filed annually on or before the date that your regular T1 personal tax return needs to be filed.
If you don’t file it on time, the penalty is equal to the greater of $100 and $25 per day (to a maximum of $2500 per year).
If for example both you and your spouse have a joint bank account or investment account, you could each be assessed the penalties. So a couple could be facing penalties of $5,000 per year.
In addition, it’s not uncommon for the CRA to go back 6 years or more. So for 6 years you and your spouse could be facing penalties of $30,000 or more.
This is in addition to taxes, interest and penalties that you can face if you have any unreported income earned in that account.
So it seems quite out of proportion and unfair to hit a couple with these kinds of penalties just because they didn’t know the law and they inadvertently failed to file the T1135 forms each year. Imagine you and your spouse have a foreign investment account with $200,000 in it and it has never earned any income (or has in fact lost money). You could be facing a $30,000 penalty.
It doesn’t seem fair.
In such circumstances, we may be able to help. We may be able to limit the number of years or to advance a due diligence defence on your behalf.
There are many types of income splitting strategies which are used in Canada. All of them are based on the fact that in Canada each person is taxed separately. As a result, you create anomalies where the total tax paid by a family is higher or lower depending on how much each family member earns.
Tax rates go up progressively as your income goes up. For example, in British Columbia in 2012, once your total taxable income is over $132,000 per year, you are in the top tax bracket of 43.7%. However, if your total income is less than $37,000 per year, you pay tax at the rate of only 20%. And depending on your personal exemptions, you may not pay any tax at all. So there are definitely significant tax savings if income is earned by a family member in a lower tax bracket.
For example, imagine a family of four: 2 parents and 2 children who are 18 years old or older. If one of the parents earned all the family income (say $200,000 per year), the family tax bill would be over $67,000. However, if each of the 4 family members earned $50,000 each ($200,000 in total), the family tax bill would only be around $35,000. That’s a significant difference and to many families in Canada, this seems unfair and creates a large incentive to try to split income amongst family members.
And if you add to this the ability of children who are full-time students to claim all of the available credits for education and tuition fees, the total tax paid by the family is even less.
The Canadian Government allows a certain amount of income splitting but to do it properly, it has to comply with all the tax rules and needs to be done very carefully with great attention to detail.
One of the best and most flexible income splitting strategies involves paying dividends through a discretionary family trust. It works best for families that carry on an active business, but can also work reasonably well for investment assets.
It is very popular for any type of business that can be carried on through a limited company. Many people who are self-employed or carry on a professional practice (e.g. doctors, dentists, lawyers, accountants, etc.) are able to carry on their business or practice through a limited company. That is the key.
By way of a general overview, the way it works is that a discretionary family trust is set up for the family and this family trust buys shares of the limited company. As the business earns profits, the limited company is required to pay corporate tax on its profit. However, in British Columbia, an active business pays tax at the low rate of 13.5% on its profits (up to $500,000 of profits per year). That’s a very low rate and then allows the remaining 86.5% of profits remaining (profits after tax) to be paid out by way of dividends to the family trust.
Typically the family trust “flows through” these dividends to family members who are the lowest tax bracket so that they pay the least amount of tax. As long as the family trust flows through the dividends and doesn’t keep them, the family trust pays no tax.
If there are family members who earn no other income (e.g. full-time students), the tax on these dividends can be very low or even zero. In fact, it may be possible to earn $30,000 per year in dividends from the family trust and pay no tax at all. As a result of these tax rates, this strategy can be a very effective way to pay for a child’s post-secondary education using tax free dollars.
This strategy was challenged by the Canada Revenue Agency on numerous occasions in the past. Finally, the Supreme Court of Canada ruled in 1998 in Neuman that this form of income splitting using dividends was acceptable.
Today, the Canada Revenue Agency still reviews these kinds of income splitting strategies, but their audit focus is on ensuring that the arrangements have been properly implemented and documented so that they comply with all of the detailed rules contained in the Income Tax Act. So income splitting with a family trust is an excellent strategy, but make sure it is set up properly and you have dotted all your i’s and crossed all your t’s.
If you are not familiar with accounting, adjusting entries are commonly made by accountants and bookkeepers to fix entries that were previously made with were incorrect or which adjusted the wrong accounts.
For example, a payment by a business of a Visa bill might have included an airline and hotel expense of a shareholder or employee and treated by the bookkeeper as a business expense.
However, later the accountant may find that this was actually a personal expense and so the expense should be personally paid back to the company by the shareholder. To simplify this, accountant may simply make adjusting journal entries to reverse the deduction of this amount as an expense and instead charge it to the shareholder or employee.
As well, at the year-end of a business, it is often necessary for the accountant to make all sorts of adjusting entries. Amounts owing by the shareholder to the company are “set off” against amounts that the company owes to the shareholder.
So the accountant has to make sure that the amount owing by the company to the shareholder is large enough to cover this “set off”. In many cases that amount owing by the company to the shareholder is based on distributions by the company to the shareholder at the year-end.
The timing is such that these entries are dated as of the year end but are actually done many weeks or months after the year end when the accountant has all the information to work on the year-end financial statements of the business.
This is very common.
One of the decisions that is very difficult to make before the year-end financial statements are prepared, is how to distribute “profits” from that year to the shareholders. You usually need to know how much profit has been made before you can decide how to distribute it.
However, in closely-held private companies (such as family owned businesses), the distribution of the “profits” of the business involve an analysis of whether it is better to pay salary or to pay dividends.
Technically, a salary is a deduction (it’s an expense of the business) and so if you want to what to pay a salary to a shareholder, it should be part of the year end adjusting entries so that it is included as a deduction in that financial year. If you deduct it later when the financial statements are done, it won’t be deductible until the next financial year.
So again, although not perfect, it is very common to do an adjusting year end entry to show a salary or bonus as a deduction to reduce the taxable income (and tax payable) of the business.
So what does a shareholder do if they want to withdraw money from the company during the year? Since they aren’t sure if it will be classified as salary or bonus or as a dividend, for convenience it might be recorded as a salary or dividend or charge to the shareholder loan during the year when the money is paid out, and then an adjusting entry is done at the year-end once a final decision is made as to how to treat it.
All of these kinds of decisions and adjusting entries are absolutely essential to properly prepare financial statements for the business and to minimize taxes. Most accountants are very good at this and do a very good job.
However, the law is very clear that:
“…accounting entries do not create reality. They simply reflect reality. There must be an underlying reality that exists independently of the accounting entries…”
It is very important that the underlying reality be legally documented in some manner, typically a director’s resolution or minutes of a directors meeting, to create the obligation of the company to pay a salary or bonus payable or to declare a dividend.
As well, if an amount owing by the shareholder to the company is to be set off against the shareholder loan account, there should be legally binding documentation that shows that the particular amounts are being charged to that shareholders loan account or are being paid by crediting that shareholders loan account, or are being set off against the other.
The Courts have said that too often, some accounting and tax professionals have a tendency to assume that the facts are shaped by accounting entries whereas in reality, the figures should reflect the facts, not the contrary.
Adjusting journal entries are essential for the efficient operation of businesses. However, they must be supported by the appropriate legal documentation. Otherwise, there is a considerable risk that such journal entries will not be accepted by third parties such as the Canada Revenue Agency and may result in double taxation through the assessment of shareholder benefits, and possibly the imposition of 50% gross negligence penalties.
Many small and medium sized businesses are incorporated. And most of those incorporated businesses are owned by one person, one family or a small group of owners. We call these closely-held private companies.
When the Canada Revenue Agency audits a closely-held private company, they pay particular attention to transactions involving the shareholders or the families of the shareholders. They are looking for transactions where the company has paid personal expenses on behalf of the shareholders (or their families) or where money in the company or property owned by the company ends up in the hands of a shareholder (or a family member).
There is nothing necessarily wrong with having your company pay personal expenses and it is normal for a company to make payments or transfers to its shareholders.
The issue is whether or not those transactions are properly recorded in the accounting records of the company and properly accounted for on the company’s tax return and the individual shareholder’s personal tax return.
Money or property of a company can really only come out of the company into the hands of a shareholder in one of the following ways:
1. Salary and benefits;
3. Loans or advances to the shareholder (shareholder loans).
The first two above are usually well documented and require tax slips to be issued each year.
Shareholder loans can be trickier and, in many cases, are poorly documented. Mistakes and omissions are common.
One of the problems is that many shareholders treat their company as if it is their personal bank account. So if there is money in the company, they will use that money to pay both business expenses and personal expenses.
Business expenses are a deduction for a company. Personal expenses are not deductible.
Sometimes it isn’t clear to the bookkeeper if it’s a business expense or a personal expense so it is entered incorrectly. Sometimes it is a combination of business expense and personal expenses (e.g. travel). So it can be confusing. In a typical Notice to Reader engagement, the company’s accountant may not be able to detect the error.
In addition, personal expenses paid by the company need to be treated as a payment to a shareholder. So not only are they not deductible, but they must also be treated as either
1. salary and benefits (e.g. a company car),
2. dividends or
3. a charge to the shareholder loan account (a debit to the shareholder loan account).
Cash transfers to a shareholder are easier for accountants to spot. Payments of personal expenses and non-cash transfers are much more difficult to detect.
For example, a problem can arise when an asset owned by the company is transferred or sold to a shareholder (or a family member). Such transactions are typically called “non-arm’s length” transactions and must be recorded at the current fair market value. If they are properly recorded, they are treated as if the asset is sold to the shareholder at its fair market value. However, some company’s choose to record these transactions at a price that is under the prevailing fair market value or they aren’t recorded at all.
For example, suppose a property development company builds 50 homes to sell for $400,000 each. Suppose that the total expenses work out to be $250,000 for each home. Now the shareholder decides to transfer one of the homes to his daughter. The company records the transfer as a sale at cost ($250,000). The Canada Revenue Agency’s position is that the company should be reporting this as a sale at $350,000 (with a $100,000 profit) plus HST and the daughter should be paying the company $350,000 plus HST.
If this is not reported, the Canada Revenue Agency will assess the company for the additional unreported profit of $100,000, the unremitted HST and will also assess the shareholder for the $350,000 as a shareholder benefit (less anything the daughter has actually paid to the company).
Or suppose a company constructs a building on the shareholder’s personally owned property. Although this building is used for the business of the company, unless it is properly documented, that building attaches to the land and therefore has added to the value of the land which is personally owned by the shareholder. The Canada Revenue Agency will treat this as conferral of a personal benefit under subsection 15(1) of the Income Tax Act and will tax the shareholder on the value of that benefit.
We deal with these kinds of tax assessments all the time. Although in a few cases they are deliberate, the vast majority of them are done unintentionally.
The best strategy is to record these transactions properly and put the supporting legal documentation in place. However, if that is not done and is detected in the course of an audit, we will need to appeal the assessment and use the case law to attempt to minimize or eliminate the taxes owing, especially if the error was unintentional.
Trusts have become very popular over the last 20 years. Many families have established trusts to take advantage of income splitting or multiplying the $750,000 lifetime capital gains deduction so that each member of the family can take advantage of it. Living trusts, alter ego trusts and joint spousal or common-law partner trusts are also very popular, often used to avoid probate fees or a challenge of a will by disappointed beneficiaries.
The problem is that as trust usage has become more popular, some of the unique rules that apply to trusts have been overlooked. If a trust is not set up properly, it may not be a valid trust. If that happens, and the trust is challenged by the Canada Revenue Agency (CRA), all of the tax benefits for the life of the trust may be lost resulting in a large tax bill (plus interest).
It is absolutely essential that your trust be set up properly. Otherwise, it is not worth the paper it is written on.
One of the biggest problems with trusts is that they are often not “settled” properly. I have seen many situations where the client has a signed Trust Agreement or Trust Deed which appears to be fine. But the proper procedures to establish or “settle” the trust were not followed. In those circumstances, there is usually nothing that can be done to fix the trust. So everything the trust purported to do since it was established is void.
Under trust law, for a trust to be validly created, the 3 certainties must be proven. In simple terms, you must be able to prove that:
1. There was intention by the settlor to create the trust.
2. The beneficiaries of the trust are clear.
3. There must be clearly identified property which is transferred by the settlor to the trustee to establish the trust.
Items 1 and 3 above are the frequent problem. It is clear from the decisions of the Courts, that simply saying that all these things have occurred in the written trust document is not sufficient. It is also open to the Court to examine the actions of the parties.
For example, what if the trust document says that the settlor intended to establish the trust, but the settlor’s actions indicate otherwise. This occurred in the Antle decision of the Tax Court (affirmed by the Federal Court of Appeal). In that case, the Court found that Mr. Antle didn’t have the necessary intention to establish a trust. In fact the proper procedures weren’t followed and as a result, the Court decided that the trust was not valid.
There are many very technical steps that must be followed for a trust to be valid. Sometimes there is a temptation to cut corners and this puts the trust at risk.
For example, often a family trust needs a settlor who is not a trustee or a beneficiary. So the family will be forced to find a “friendly” settlor such as a relative or friend or professional advisor to establish the trust. Often this is done as a favour for the family, so the family will try to minimize the cost and hassles for the settlor. This can often backfire and jeopardize the validity of the trust.
Often the friendly settlor will sign the trust documents without really knowing what they are signing. Ask yourself what this person would say many years later if asked under oath if they knew what they were doing. Would the answers satisfy the Court that the settlor had enough understanding to conclude that the settlor had the necessary intent? Would you want to put the settlor through this kind of ordeal?
The settlor also has to transfer some identified item of property to the trust to validly establish the trust. There are many problems with this. For example, is it clear what was transferred (for example, it is common to use a gold or silver coin to establish a trust)? Was it clearly identified in the trust documentation? Was it transferred into the names of the trustees? Can you prove it? If it was a gold or silver coin, can it be located?
Can the settlor prove he or she owned the item of property? If it was purchased, did the settlor pay for it? Is there a receipt? Is there proof of payment by the settlor? Or has someone else paid for it or has someone else reimbursed the settlor for the purchase.
An additional problem is the dating of the documents. While many legal documents routinely have a date on them which is different than the date signed, it is much more of a problem with trusts. The trust document should reflect what actually happened and so it is important that the trust document be signed as the procedures to establish the trust occur.
This is reflected in the following comments from the comments of the Tax Court Judge (Miller) in the Antle decision:
“This conclusion emphasizes how important it is, in implementing strategies with no purpose other than avoidance of tax, that meticulous and scrupulous regard be had to timing and execution. Backdating of documents, fuzzy intentions, lack of transfer documents… all frankly miss the mark – by a long shot. They leave the impression of elaborate window dressing. In short, if you are going to play the avoidance game, it is not enough to have brilliant strategy, you must have brilliant execution.”
Is your trust valid? Did it have brilliant execution, or was it really just elaborate window dressing?
 Paul Antle and Rene Marquis-Antle Spousal Trust v. Her Majesty the Queen 2009 TCC 465, affirmed by the Federal Court of Appeal in 2010 FCA 280 (leave to appeal to the Supreme Court of Canada denied).
The Board of Directors of a company are responsible for making decisions for the company. The directors manage or supervise the management of the business and affairs of the company. The directors are elected by the voting shareholders of the company to fill this important role. With the role come certain responsibilities and potential liabilities.
This article focusses on certain tax liabilities of a company imposed under the Income Tax Act (the “ITA”) and the Excise Tax Act (the “ETA”) for which directors of the company can be held personally liable. This article is not an exhaustive discussion of all potential corporate liabilities for which directors can be held liable but is focussed on certain tax liabilities for which directors can be held liable.
Directors’ Liability for Certain Tax Obligations
Directors’ Liability for Payroll Deductions
Under the ITA a company is required to withhold/deduct and remit amounts to the Canada Revenue Agency for salary, wages, benefits and payments out of various plans (“Payroll Deductions”). If the company fails to withhold or deduct from remuneration (paid to a resident of Canada) an amount that is required to be withheld, the directors can be held personally liable for a penalty of 10 or 20 percent of the amount that ought to have been withheld and deducted plus any related interest.
If the company fails to remit an amount to the CRA that was withheld and deducted by the company as Payroll Deductions the directors can be held personally liable for the whole of the unremitted amount plus any related penalties and interest.
Directors’ Liability for Tax Obligations on Payments to Non-Residents
A company is required to withhold and remit certain amounts from payments made to non-residents of Canada. If a company fails to withhold or remit the required amount from a payment to a non-resident the directors of the company can be held personally liable for the whole of the amount plus any related penalties and interest.
Directors’ Liability for GST/HST Obligations
A company is required to collect and remit GST/HST under the ETA on taxable supplies made by the company. If a company fails to collect and remit the required amount of GST/HST the directors of the company can be held personally liable for the whole of the amount that ought to have been remitted plus any related penalties and interest.
De facto Directors
A person who is not technically a director of a company can be held personally liable as a director in certain circumstances. A person who is, in fact, exercising the responsibilities of a director can be held to be a de facto director. A person who plays a key role in a company or has ultimate decision making authority for the company will be at risk of being found a de facto director. The determination of whether a person is a de facto director is fact specific and requires analysis on a case by case basis.
Defences Against a Directors’ Liability Assessment
If you are personally assessed as a director of a company for the tax obligations of that company there are some potential defences that you should be aware of.
A director can only be held liable for tax obligations of the company if the person was a director “at the time the company was required to deduct, withhold, remit or pay the amount”. If your directorship had not yet commenced or you had resigned prior to the time that the company failed to meet its tax obligation, you should not be personally liable for that failure. Strict compliance with the requirements and procedure for resignation under the relevant corporate legislation is crucial. Documentation evidencing when your directorship commenced and ceased is extremely important.
Where a director “exercised the degree of care, diligence and skill to prevent the failure that a reasonably prudent person would have exercised in comparable circumstances” the director should not be personally liable for the tax obligations of the company. A due diligence defence is supported by examples of you acting prudently and being reasonably well informed as a director. You must show that you took active steps to ensure that the company would make its source deduction remittances.
Two Year Limitation Period
The CRA must commence proceedings to collect against a director within two years of when the director last ceased to be a director. This makes the documentation of your resignation as a director extremely important. The two year limitation period starts to count on the date of your resignation. A formal resignation may not be helpful if you continued to act as a de facto director after the date of formal resignation.
Not a Director
Sometimes a person is listed a director of a company despite the fact that he or she did not consent to be a director of the company. If you can show that you did not consent to be a director of the company and did not participate as a director of the company you may be able to dispute a directors’ liability assessment on the basis that you were not a director of the company.
CRA Did Not Attempt Collection Against Company
The Canada Revenue Agency is required to attempt collection against the company before it seeks to personally assess the directors of the company and recover from the directors. The CRA must show that (1) its execution against the company was returned unsatisfied; (2) prove a claim against the company in dissolution or liquidation; or (3) prove a claim against the company in bankruptcy.
Dispute the Underlying Tax Debt of the Company
A director can also dispute the validity of the underlying assessment against the company if the company did not do so. If the director can show that the underlying assessment was wrong, then the director’s own liability can be avoided.
There are significant obligations that come with being a director of a company and significant risk for liability. Understanding this risk and how to limit the risk is important for any director. If you are acting as a director of a company, or are at risk of being considered a de facto director of a company, it is important to understand the company’s tax obligations and your potential liability for certain tax obligations of the company. This should inform how you carry out your responsibilities of directorship.
Businesses are only required to pay income tax on their net income, which allows businesses to deduct expenses including wages, salaries and benefits. Family-owned and operated businesses will often pay salaries to family members for services provided to the business.
In some cases, the business owner will use salaries as a means of income splitting. Instead of paying a large salary to the business owner (who could be paying as much as 43.7% tax on that salary), salaries are paid to family members such as the business owner’s spouse or children. For example, if the business owner normally takes a salary of $180,000 per year, it is possible for the tax to be reduced substantially by reducing the business owner’s salary by $50,000 and instead paying a $50,000 salary to the spouse and/or children. As a result of the personal exemptions available, and the tax credits for students, it is possible for a family to save up to $22,000 per year with this simple strategy. It works because the tax rate on the high income earners is much higher than the tax paid by low income earners.
The Canada Revenue Agency (CRA) is aware of this strategy CRA auditors routinely examine salaries in family-owned businesses. Under section 67 of the Income Tax Act, there is a special rule that says a deduction for an expense is not deductible unless it is reasonable. This is rarely applied to salaries of unrelated employees, but if the employee is related (for example, the employee is the spouse or child of the business owner), the CRA auditors will examine whether or not the salaries to the family members are “reasonable”. If they are considered unreasonable, the deduction for the salaries will be disallowed. This will increase the income of the business and result in additional tax (and interest) owing by the business. In some cases, the salaries may even be added to the business owner’s income at the highest rate without any corresponding deduction resulting in double taxation. And if it can be shown that the excessive salaries were knowingly paid, or circumstances amounting to gross negligence, 50% penalties may also be applied.
Unfortunately, there are no hard and fast rules as to what level of salary is reasonable and what is unreasonable. The most common test is to consider what services to the business were provided by the spouse and children and then to compare each of their salaries to what a similar business would pay to an unrelated employee to do the same thing.
As a result, detailed job descriptions for each family member are very important. As well, time sheets showing hours worked are important. We have seen problems where business owners pay children while the children are at University in another city. Often, justifying a salary in such circumstances is difficult to support. Or a spouse who does bookkeeping or banking and is paid a fulltime salary (for example $40,000 per year), and evidence shows that such work could actually be done by a part time clerk for a fraction of that cost.
This income splitting strategy has the potential to provide excellent annual tax savings, but must be planned and documented carefully. Planning before the fact is often safer than trying to fight this after you are audited. With the potential downside being double taxation and even penalties, it may not be worth the risk if you are too aggressive.
Income splitting is an excellent tax savings strategy. If this type of income splitting strategy is too difficult to do safely, you may want to consider less risky strategies such as family trusts.