Disposition of Capital Property – Failure to Report at Fair Market Value – TBD
The Tax Court of Canada’s recent ruling in Lauria v. The Queen (2021 TCC 66) serves as a reminder about the potential for broad applications under subsection 152(4), permitting the reassessment of otherwise statute-barred taxation years where a tax filing includes a misrepresentation attributable to carelessness or neglect, regardless of the absence of intentional misstatements at the time of filing. The ruling has broad implications for transactions involving the disposition of capital property, including estate freeze transactions. If taxpayers fail to seek independent valuation advice, then they may be exposed to reassessment with no time limit, because CRA seeks to adjust the proceeds.
Briefly, in Lauria, the individual taxpayers, who were executives and directors of a wealth management corporation, had transferred common shares to personal family trusts prior to an imminent Initial Public Offering (IPO) issuance. An IPO underwriter was engaged on March 2, 2006, the taxpayers settled family trusts on March 31, the share sales to the trusts occurred on April 1, the IPO preliminary prospectus was filed on April 18, and the IPO was completed on May 26, 2006. The taxpayers relied on an internal valuation model under a longstanding shareholders’ agreement, ignoring the possibility of a higher share value from the IPO, and had not obtained independent valuation advice. Nearly 10 years later, the Canada Revenue Agency (CRA) reassessed the sales to the trusts and found that the individual taxpayers’ resulting capital gains from the initial dispositions to the trusts had been substantially underreported. The taxpayers’ arguments that their returns were statute-barred were not accepted by the court. Their appeals were allowed in part to apply a concession reducing the values to match those determined by the Minister’s expert.
The court concluded that the taxpayers had misrepresented the taxable capital gain amounts; hence, a reassessment beyond the ordinary reassessment period was permitted. The consequences included double taxation under paragraph 69(1)(b) given the underlying non-arm’s length transactions. Because CRA was successful, the individual taxpayers were taxed under paragraph 69(1)(b) based on higher sale proceeds determined by the Minister’s expert, but the trusts and beneficiaries would not be able to use an increased cost in determining their capital gains. The court noted that one purpose of subsection 152(4) is to promote the accurate reporting to the CRA of all amounts when filing a tax return.
The CRA first argued that the taxpayers’ returns misrepresented the proceeds when disposing of the shares to the trusts. One of the challenges was to ascertain the fair market value (FMV) of the shares at the time of the dispositions; although FMV is not defined in the Act, guidance can be sought from existing jurisprudence (see Henderson Estate and Bank of New York v Minister of National Revenue (1973),73 D.T.C. 5471). As these were non-arm’s length transactions, successfully establishing FMV was an important first step for an application of subparagraph 152(4)(a)(1) and paragraph 69(1)(b).
The CRA engaged an expert valuator to consider all relevant facts, including the imminent issuances of an IPO. The use of an expert witness by the CRA is not uncommon. The court accepted the detailed analysis provided by the expert witness including the close timing of the IPO following the share sales to the trusts. This is important given the IPO liquidity event clearly had a higher share price than that used by the taxpayers’ when they reported their sales to the trusts. The historical share price formula did not factor in the possible higher share price following the IPO nor was it tested in a wide market, as only employees participated in ownership. These facts led the court to rule that the CRA had established misrepresentation of the share value.
The application of subparagraph 152(4)(a)(i) required the CRA to prove carelessness or neglect; the mere existence of misrepresentation is not sufficient to apply this provision (see Deyab, 2020 FCA 222 (para 23)). The court concluded that, given their experience and familiarity with the valuation process, the taxpayers failed to meet the test for reasonable care. The court commented that the taxpayers’ sincere belief that the values they used reflected FMV was not enough to overcome their carelessness in failing to recognize that the IPO could change the values or in failing to obtain independent advice. The court also indicated that the 2,000% increase in value over the two months between selling the shares to the trusts and the conclusion of the IPO “should have raised a red flag”.
Successful application of subparagraph 152(4)(a)(i) can open up examination under rules of inadequate considerations pursuant to paragraph 69(1)(b). This can lead to several important consequences, including, upon disposition of Qualified Small Business Corporation shares, possible denial of the capital gains deduction under subsection 110.6(7) where assets are acquired by a corporation for less than FMV (see CRA Views Doc: 9220665). Another example of where this could apply is estate freeze transactions undertaken without independent valuation advice, often due to unjustified cost-cutting measures in planning a transaction or a lack of understanding of the valuation process. If failure to apply the provisions of section 69 constitutes misrepresentation, might failure to self-assess under provisions 51(2) or 86(2) as well?
It bears noting that the sales in Lauria had price adjustment clauses (PAC). The court noted that as the clauses applied only to the final determination of the values, any question of their application was not before the court. Clearly, the mere existence of a PAC was not enough to negate the impact of subparagraph subsection 152(4)(a)(i) if the reported value is not at FMV. The authors question whether CRA would apply the PAC, given CRA’s requirement that a bona fide effort is made to determine and transact at FMV (see income tax folio S4-F3-C1, paragraph 1.5). In Lauria, the sales occurred in 2006 and the reassessments in 2016. The tax returns of the trusts and the beneficiaries were likely statute-barred, and the beneficiaries have now also passed the 10year deadline for taxpayer relief under the “fairness” provisions of subsection 152(4.2), so applying the PAC would not assist them.
A wide variety of other provisions also require the use of FMV in determining income tax results. While a detailed discussion is beyond the scope of this article, the Lauria ruling opens up potential for a wider CRA auditing process.
The decision has been appealed to the Federal Court of Appeal.
Balaji (Bal) Katlai, Hugh Neilson,
Kingston Ross Pasnak LLP, Edmonton
Note: First published by the Canadian Tax Foundation in 2022 Vol. 22, no. 2 Tax for the Owner-Manager. The authors, Kingston Ross Pasnak LLP, Edmonton, and DFK Canada sincerely thank the Foundation for permitting us to publish this article.