It can be frustrating to be held responsible for someone else’s mistakes, particularly when they entail tax penalties. However, under the right circumstances, the Canada Revenue Agency (CRA) has the power to assess a person for another person’s unpaid tax debt. Recently, CRA appears to have increased both the reach of this assessing power and the frequency at which it applies the rule.
The charging provision
Section 160 of the Income Tax Act (ITA) states that the CRA can assess a person (the transferee) for some or all of the tax debt of another person (the transferor) when the following four criteria exist:
- The transferor transferred property to the transferee;
- At the time of the transfer of property, the transferor was liable to pay taxes;
- At the time of the transfer of property, the transferee was either (i) a spouse or common-law partner of the transferor (or has since become the spouse or common-law partner of the transferor), (ii) under 18 years old or (iii) not dealing at arm’s length with the transferor; and
- The transferee paid the transferor less than fair market value for the transferred property.
When these four criteria are satisfied, the transferee is liable to pay the lesser of (1) the transferor’s tax debt at the time of the transfer and (2) the value of the property the transferee received from the transferor less the value of any consideration the transferee paid to transferor for the property at the time of the transfer.
The policy behind section 160 is clear: a taxpayer should not be able to avoid paying a tax liability by transferring assets to a non-arm’s length party at less than fair market value and therefore not having sufficient assets to satisfy its tax debt. Section 160 is designed to shield the CRA from being left without recourse to collect tax debts when a taxpayer has divested itself of assets for less than fair market value consideration, without actually giving up control of the assets (by virtue of a non-arm’s length person owning the divested assets).
Broad interpretation of section 160
Both the CRA and the Tax Court of Canada (TCC) have interpreted and applied section 160 broadly. The following are the key interpretive principles to keep in mind when considering the potential application of section 160:
- There is no limitation period for an assessment under section 160;
- The transferor’s intent is irrelevant to the application of section 160, in other words, there is no requirement that the transferor intend to avoid paying its tax debt at the time of transfer; and
- Section 160 applies regardless of whether the CRA has assessed a tax liability or whether the transferor or transferee knows about a tax liability – e.g., if a transferor transfers property on July 1, 2015 and the CRA reassesses the transferor’s 2015 year on July 1, 2018 to increase the 2015 tax liability, the transferee can be subject to a section 160 assessment (provided the other criteria are satisfied).
In addition, the following recent court cases seem to have increased the reach of section 160:
- In Eyeball Networks Inc. v. The Queen, the TCC held that section 160 applied to a setoff of promissory notes, a setoff that would be commonly used in butterfly transactions or other corporate reorganizations;
- In Borealis Geopower Inc. v. The Queen, the TCC held that a deposit that a taxpayer received for work to be completed in the future constituted a transfer for less than fair market value consideration because, although the taxpayer held the deposit funds in trust until it completed the work, the taxpayer had complete control over the account in which the deposited funds were held;
- In Jefferson v. The Queen, the TCC held that a corporation’s reimbursement of a related individual’s travel and entertainment expenses constituted a transfer of property for less than fair market value consideration because the individual’s expenses did not relate to the corporation’s business; and
- In Canada v. 594710 British Columbia Ltd., the Federal Court of Appeal (FCA) held that a stock dividend followed by a redemption of the stock dividend constituted a transfer without consideration because when the stock dividend and the redemption are looked at together, the result is the same as a cash dividend, which is a transfer without consideration (the FCA overturned the TCC decision; the TCC considered the stock dividend and the redemption in isolation and concluded that each was transacted for fair market consideration).
An example of CRA’s increased use of section 160
The recent court cases identified above are evidence that the CRA is attempting to use section 160 in an increasingly aggressive fashion and, in particular, seeking to broaden the interpretation of the ‘transfer for less than fair market value’ criterion under section 160. A closer look at Eyeball Networks provides detail as to the CRA’s approach.
In Eyeball Networks, the taxpayer group utilized a butterfly transaction to transfer assets worth $30 million from Oldco to Eyeball Networks Inc. (Eyeball Networks) on a tax-deferred basis. Specifically, the individual shareholder exchanged his common shares, worth $30 million, for redeemable preferred shares in Oldco. He then transferred the preferred shares, under subsection 85(1) of the ITA, to Eyeball Networks in exchange for shares in Eyeball Networks. Oldco then transferred the $30 million of assets to Eyeball Networks for $30 million worth of redeemable preferred shares in Eyeball Networks. As result of the butterfly transaction, Oldco held redeemable preferred shares worth $30 million in Eyeball Networks and Eyeball Networks held redeemable preferred shares worth $30 million in Oldco. Each of the corporations redeemed the preferred shares and issued a $30 million promissory note to the other corporation: Oldco issued Eyeball Networks a $30 million promissory note (the Oldco Note) and Eyeball issued Oldco a $30 million promissory note (the Eyeball Note). The parties then setoff the Oldco Note and the Eyeball note. As a result, Oldco was left with nothing and Eyeball Networks owned the assets worth $30 million. Oldco did not have a (known) tax liability at the time the parties completed the butterfly transaction. A year later, the CRA reassessed Oldco to increase its tax debt for years prior to, and unrelated to, the butterfly transaction.
The CRA assessed Eyeball Networks for Oldco’s tax debt under section 160 and, at the TCC hearing, argued that the TCC should use a results-based economic-reality approach when evaluating the potential application of section 160. The CRA’s position was that Oldco owned $30 million of assets before the reorganization and owned nothing after the reorganization and, therefore, Oldco transferred property ($30 million of assets) to a non-arm’s length party (Eyeball Networks) for less than fair market value consideration ($0 consideration). The CRA’s position reveals that it is attempting to expand the already broad interpretation of section 160. In essence, the CRA argued that the TCC should use substance over form when considering the potential application of section 160, i.e., the substance of the transaction was that Oldco had $30 million before the transaction and was left with nothing of value after the setoff of the notes (versus the form of the transaction which was that Oldco transferred the assets to Eyeball Networks for $30 million worth of redeemable preferred shares in Eyeball Networks under the butterfly).
The TCC refused to adopt the CRA’s result-based economic-reality approach. However, the TCC nevertheless applied section 160 for two key reasons. First, the TCC held that a setoff of the notes constituted a ‘transfer’ under section 160. In particular, the TCC concluded that the economic reality of the setoff was that Oldco transferred to Eyeball Networks the Eyeball Note, and that the consideration Eyeball Networks provided to Oldco was the Oldco Note. Second, the TCC held that although the Eyeball Note was worth the stated value of $30 million because it was backed by Eyeball Networks’ assets, the Oldco Note was not, in fact, worth $30 million because Oldco no longer had the assets to support the note. As a result, Eyeball Networks received the Eyeball Note without providing consideration. The TCC seemed to disregard the fact that, immediately before the setoff, Oldco owned the Eyeball Note that was worth $30 million that was backed by Eyeball’s assets.
Eyeball Networks has appealed the TCC decision to the Federal Court of Appeal (FCA). The upcoming FCA analysis will be valuable because it should confirm the reach of section 160 and clarify (1) whether setoff constitutes a transfer under section 160 and (2) whether the cross-redemption of the Eyeball Note and the Oldco Note was for less than fair market value consideration.
Consider section 160 when completing transactions that include a cross redemption of notes
This case suggests that CRA may try to collapse transactions involving multiple steps to support a section 160 assessment under a substance over form theory. In addition, until the FCA issues its decision in Eyeball Networks’ appeal (and unless the FCA reverses the TCC decision), taxpayers should consider whether section 160 may apply to the setoff of notes in corporate reorganizations and should evaluate whether corporations have the assets to support the stated value of issued promissory notes.