Note: This article was orginally published at the Canadian General Accountant's Magazine site and offers another opinion to those looking at offshore options. The moral here is that you should get a second opinion before acting on advice given to you by an offshore advisors located outside Canada.

TAXATION

"Trouble In Paradise"

Canadians looking for that elusive offshore tax haven may find that it simply doesn’t exist.

BY WILLIAM H. COOPER

This article overviews some of the prevalent offshore schemes used by Canadians to reduce their taxes and discusses certain tax consequences. The rules surrounding the reporting and taxation of foreign income are very complex, however, and readers are advised to consult with an independent tax adviser on any specific situation.

The Smiths were referred to our downtown Vancouver law firm by a large offshore bank. During a recent vacation in the Bahamas, they decided to follow some tax planning advice they’d heard at a recent seminar, so they combined a holiday in the sun with a visit to the Bahamian subsidiary of their favorite Canadian bank. Fortunately, the bank suggested they obtain some Canadian income tax advice before proceeding with their offshore investment plans.

As is the case with many of my clients, the Smiths are fiscally conservative. They built their modest wealth over the years by working long hours in their forest products-based export business and have always been solid, taxpaying citizens.

But, like many Canadians, the Smiths have lost faith in the ability of Canadian governments to control spending and manage resources wisely. Indeed, they are outraged at a system that takes as much as 54% of every dollar they earn as income tax — then extracts federal and provincial sales and a variety of other taxes. They’re looking for a break and felt that investing offshore might be the answer.

The plan they were contemplating was fairly simple — to deposit a quarter of a million dollars to an offshore trust or corporate account in a solid financial institution. Here, the income would accumulate tax free, and the Smiths would achieve tax haven Nirvana. Unfortunately, nothing could be further from the truth. Although many Canadians employ such "tax planning" techniques (often with more modest investments of tens of thousands of U.S. dollars) any success they have is mainly due to Revenue Canada’s inability to track them down.

The Smiths may be fictional, but their circumstances are all too familiar to many experienced tax practitioners. While only a few years ago offshore tax planning was reserved for Canada’s ultra-rich —the E.P. Taylors, DeGroots, Irvings and Bronfmans — the relentless increase in income and other tax rates has led thousands of so-called "ordinary" Canadians to consider the use of offshore tax havens.

Couple this with a burgeoning underground economy, and it’s clear that a groundswell of public opinion supports a new national pastime of reducing taxes by almost any means possible, including evasion. The very fabric of Canada’s self-assessing tax system is being destroyed — not by lack of fairness, but by complex rules and high tax rates.

Hiding or failing to report income is tax evasion, which is illegal and can lead to a variety of penalties under the Income Tax Act. On the other hand, tax avoidance — legally structuring one’s affairs so as to attract the smallest possible amount of income tax — is legal, although Revenue Canada may attempt to find a way to render the results ineffective through the application of a variety of anti-avoidance rules.

As I’ll show in this article, the problem with many offshore tax strategies is that they involve some form of nonreporting, so they fall into the tax evasion category. For example, the Smiths will be able to cut their taxes through their proposed plan only if they fail to report income from their invested funds. This income will be deemed to accrue to them under certain property income accrual rules described below. Canadian residents are required to report their worldwide income, regardless of its source. If income tax is payable in the jurisdiction of source, as well as in the home jurisdiction, a system of tax credits under the Act and international tax treaties may provide varying degrees of relief from double taxation.

INCORPORATING INVESTMENT INCOME

One common scheme for avoiding taxes is to incorporate income in a company formed in a tax haven. The investor places money in share capital in, say, a British Virgin Islands international business corporation (BVICo). Provided appropriate arrangements are made to obtain offshore directors, BVICo may avoid being considered to be resident in Canada.

To the financially unsophisticated, this plan might appear to avoid Canadian tax, but this is not the case. The passive investment income (such as dividends and interest) earned by BVICo would fall into the FAPI trap.

The FAPI (Foreign Accrual Property Income) rules were first introduced in 1972 to prevent Canadian residents from avoiding or deferring Canadian tax on foreign source income of an investment nature. The rules were designed to catch investments held through foreign subsidiaries and their affiliates. In their original form, they applied to all foreign affiliates; that is, all nonresident corporations in which a Canadian resident held a 10% or greater interest, regardless of whether the Canadian controlled the affiliate.

The FAPI rules have since evolved and now generally require a Canadian resident to report property income of a controlled foreign affiliate on an accrual basis; that is, whether or not the resident has actually received the income. "Control" is deemed to include situations where it is concentrated in the hands of not more than five persons, including the taxpayer, all of whom are Canadian residents; or in the hands of the taxpayer and persons with whom the taxpayer does not deal at arm’s length.

Layering foreign companies doesn’t help. Under the FAPI rules, property income is generally deemed to accrue up to the ultimate Canadian resident shareholder through several tiers of companies, provided 10% or more equity ownership is maintained. As a result, in a typical closely held corporate group, it will be difficult — if not impossible — to avoid triggering the FAPI rules. However, as one might expect, schemes have been developed by taxpayers and their advisers to skirt the application of these rules in certain unique circumstances.

OFFSHORE TRUSTS

Offshore trusts have become widespread tax planning tools. Indeed, based on discussions I’ve had with numerous offshore trustees, hundreds — possibly thousands — of offshore trusts have been formed by Canadians over the past few years. The reasons? To avoid Canadian income taxes, creditors and, in some cases, threatened provincial estate taxes.

The use of offshore trusts was recently highlighted in a conflict of interest scandal involving investments made by friends and family members of B.C. Hydro’s then-chairman John Laxton. The transaction included a joint venture with a Cayman Island company and involved a B.C. company, International Power Corporation, in which Laxton and his group of investors acquired shares. In some cases, these shares were reportedly held in offshore trusts.

One of the principal advantages of such arrangements is that the trustee — and, therefore, the trust — is resident in a tax haven jurisdiction. As a result, any gains on the sale of the public company’s shares might be realized free of Canadian tax. In addition, there is complete confidentiality concerning the ultimate "beneficial" owner of the shares.

Many offshore jurisdictions now have legislation that specifically provides trust settlors and donors protection from disclosure and from their creditors through an asset protection trust. Jurisdictions that have enacted or are proposing to enact asset protection legislation include the Bahamas, the Caymans, Cook Islands, Cyprus, the Turks and Caicos, Bermuda and the British Virgin Islands. The discussion of asset protection legislation is well beyond the scope of this article; however, it appears that creditor proofing is a major attraction of offshore trusts.

Asset protection trusts may also be used to avoid estate taxes. As a result, significant numbers of these trusts sprang into existence when the former NDP government in Ontario threatened to impose provincial estate taxes or death duties. However, in many of these cases, the Canadian settlor continues to report the investment income for Canadian income tax purposes.

As you might expect, the FAPI rules also apply to trusts not resident in Canada. Where a person resident in Canada has a direct or indirect beneficial interest in a trust, and the trust has directly or indirectly acquired property from a person resident in Canada or the beneficiaries have directly or indirectly acquired their trust interest from a person resident in Canada, the FAPI rules determine the amount of the foreign accrual property income that must be reported by the Canadian beneficiary.

One exception is the five-year tax holiday for offshore trusts formed by new Canadian immigrants. Essentially, this exemption suspends application of the FAPI rules to foreign trusts until the new Canadian has been resident in Canada for a period (or periods) totaling more than 60 months.

In addition, with careful tax planning, it is possible for offshore trusts to avoid the FAPI rules in circumstances where Canadians receive gifts or bequests from abroad.

"CHARITABLE" TRUSTS

In an effort to circumvent the FAPI rules, many advisers have recommended that Canadian "founders" of offshore trusts name charities as their sole beneficiaries. This type of aggressive planning relies on a very technical interpretation of the Act’s definition of "beneficially interested." Under the terms of a so-called "charitable trust" indenture, the sole beneficiary of the trust would be a particular international charity; for example, the International Red Cross or the World Wildlife Fund. The Canadian founder could then claim that no person resident in Canada is beneficially interested in the trust and, therefore, no reporting is required under the FAPI rules.

The twist is that the foreign trustee — or perhaps the Canadian founder — would be given a power of appointment to change the beneficiary, pursuant to the terms of a letter of wishes directed to the trustee by the Canadian founder at the time the trust is formed. In other words, the Canadian resident founder may effectively appoint him- or herself — or any other Canadian resident — as a beneficiary at any time. A purely technical reading of the Act might conclude that such arrangements skirt the FAPI rules. However, it seems unlikely that Canadian courts would find it difficult to "look through" the arrangements and determine that their true nature is such that any passive income from the trust should be subject to Canadian income tax. Once again, Revenue Canada’s inability to audit such arrangements is probably the prime reason behind their success.

NEW FOREIGN REPORTING REQUIREMENTS

Clearly, lack of audit resources, coupled with inadequate reporting requirements, have slowed Revenue Canada’s attempts to close offshore planning loopholes. Consequently, the 1995 federal budget proposed legislation to implement extensive new foreign reporting requirements that cast a very wide net indeed.

Under these new rules, the following taxpayers will be required to report by way of prescribed form:

1. Those with interests in specified foreign property that costs over $100,000.
2. Persons and partnerships who have lent or transferred property to certain foreign trusts.
3. Persons and partnerships who have received distributions from or have become indebted to a foreign trust in which they have a beneficial interest.
4. Taxpayers resident in Canada, including certain partnerships, for each of their foreign affiliates.

As a result of recent finetuning of the rules, the first date for filing returns pertaining to items 1 through 3 is April 30, 1998, for taxation years commencing after 1995. Taxpayers who fail to file, or who knowingly omit required or substantial information, will incur penalties.

It has been suggested by some tax professionals that these new reporting requirements will do little to flush dyed-in-the-wool tax evaders out of the works. However, these rules may discourage the use of offshore structures that are based on questionable interpretations of the Act, which have allowed honest taxpayers to avoid reporting certain offshore income in the past. Coupled with a more aggressive review of taxpayer filings and the fact that the normal three-year reassment period (that is, the period following the initial assessment within which Revenue Canada must conduct an audit and raise a reassment) becomes unlimited where the taxpayer’s reporting amounts to tax evasion or negligent misrepresentation of his or her financial affairs, this program should give tax evaders more to worry about.

INTERNATIONAL BUSINESSES

One tax planning strategy that makes extensive use of tax haven jurisdictions is the formation of international business divisions of active Canadian businesses. Prior to extensive amendments to the FAPI rules introduced in the 1994 federal budget, it was fairly easy to arrange things so that active business income from international activities was earned in tax havens or low-tax jurisdictions. If the activities were carried on in a country with which Canada has a tax treaty (for example, Barbados), these profits could then be repatriated to Canada, usually through a Canadian holding company, thereby attracting only nominal taxes.

By using some imagination, Canadian importers, exporters and others have, in the past, been able to earn significant portions of their profits in offshore tax havens. One of the principal tax issues concerning such planning relates to transfer pricing. The Act contains special rules designed to prevent the artificial pricing of goods and services designed to transfer Canadian profits offshore, so pricing policies must be carefully worked out.

In the case of inbound goods, in the past, the offshore entity would use its own agents to acquire, on the international market, foreign-sourced products sold by its Canadian parent. The offshore company would resell those products at a marked-up price to the parent, shifting profits from Canada to a tax haven jurisdiction.

Similarly, Canadian exporters have established independent tax haven companies to act as international sales and marketing distributors. All international sales of the Canadian manufacturer’s products would be made through the distributor, which would take the normal mark-up available to arm’s-length distributors. As a result, any profit from the international sales activities would be earned in the tax haven corporation and escape Canadian taxes.

While the use of import structures has been restricted as a result of recent amendments to the Act, the following cases show the kinds of difficulties that will be encountered with export schemes. In the 1960s, for example, Dominion Bridge — a Canadian company that manufactured steel products — formed a wholly owned subsidiary in the Bahamas, which purchased steel from international sources and supplied it to the parent company at marked-up prices. However, the Federal Court of Appeal found this arrangement to be a sham. Because the subsidiary’s activities (such as purchasing ) were wholly controlled by its Canadian parent, the subsidiary was found to be acting as the parent’s agent; therefore, Dominion Bridge was required to report its profits.

To be effective for tax purposes, the offshore entity must operate independently of any affiliated Canadian company. More recently, for example, the Federal Court of Appeal heard a case involving Irving Oil. This Canadian company, which markets petroleum products, entered into an agreement with Standard Oil of California concerning the construction of a refinery and the long-term supply of crude oil. Irving established a Bermudian subsidiary to transship the crude oil. The subsidiary purchased the oil at the arm’s-length contracted price, then resold it to Irving at prevailing world prices. In this case, however, the arrangement was found to be bona fide — the Court determined that the subsidiary was not an agent of Irving Oil, thus the profits were not attributed to Canada. Here, the subsidiary was nonresident and also independent of the parent company in terms of its board of directors, staff and offices.

What’s crucial is to ensure that these non-arm’s length transactions are constructed on an arm’s length basis, as corporations are now required to file a form reporting all non-arm’s-length transactions with nonresidents. While this reporting provision may have been reasonably successful in enabling Revenue Canada to identify and audit more substantial transfer pricing concerns, many smaller companies and their financial advisers are unaware of these reporting requirements.

The February 1994 budget amendments took direct aim at many of the offshore tax avoidance arrangements formerly available to Canadian businesses. In particular, the definition of nonqualifying property income was broadly expanded, effectively bringing within the FAPI rules all types of property income, including interest, dividends, rents and royalties. The business of trading in investment properties (for example, in the stock of junior mining companies) was also deemed to give rise to passive income (triggering FAPI rules), as were the businesses of developing real estate for sale, leasing or licensing property, or insuring or reinsuring risk, unless the affiliate employs more than five full-time employees to actively conduct the business. In many cases, otherwise active businesses will now trigger the FAPI rules simply because they don’t have enough staff.

For small private entrepreneurs (such as the Smiths), it is possible that the elaborate tax planning strategies formerly available only to their wealthier counterparts may now be viable where there is the possibility of forming a legitimate offshore business. Properly structured, it may be possible to earn income relatively tax free, and then distribute it by dividends to a Canadian holding company — again, tax free — as "exempt surplus" under the FAPI rules. The income would then be taxable only when distributed to individual Canadian shareholders. In many cases, the significant costs will be more than offset by tax rate reductions of 20 to 40%, and more.

GETTING OUT

Obviously, it is getting much harder to legally avoid Canadian income tax. By now, you may be thinking that the simplest solution is to emigrate. Think again.

In response to the Auditor General’s well-publicized criticism concerning the tax-free departure from Canada of what is believed to be a trust established by the Bronfman family, the Minister of Finance recently released major changes to the income tax rules for people leaving the country.

Previously, it was possible for a Canadian to move to a country like the United States (with which Canada has a tax treaty) and ultimately avoid tax on the accrued value of their property at the time of their departure. Under proposed new rules, departing Canadians who own property with a total value of more than $25,000 will be required to list each property owned at the time, (other than personal property worth less than $10,000) and will be treated as having sold each property at its fair market value (other than Canadian real estate and certain other Canadian property). They will then have the option of immediately paying the tax owing or posting security with the Minister of National Revenue.

TOUGH CHOICES

Despite what some "tax planners" claim, tighter rules and reporting requirements have limited — and perhaps eliminated — opportunities for many Canadians to find a tax-free home for their money. In many cases, the benefits promised by tax haven promoters can only be achieved through tax evasion — an illegal option.

The problem as I see it is that tough new reporting requirements will force honest Canadians to choose between leaving Canada (although their departure may not be tax free!) or staying — and paying. And based on what I hear from clients, unless significant reductions are made to our tax rates, many will choose to cut free of the heavy burden of Canada’s tax net.

William H. Cooper, LLB, CGA, is a tax lawyer who, in the past, worked at Revenue Canada’s head office in Ottawa and who now practises in association with Davis & Company, Barristers & Solicitors, which has offices in Vancouver, Toronto, Ottawa, Whitehorse, Yellowknife and Tokyo.

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