How Canada’s New Income Tax Mandatory Disclosure Rules Affect Domestic and Cross-Border Transactions

Introduction

New mandatory disclosure rules implemented via the federal government’s Bill C-47 have added a level of uncertainty and, in certain circumstances, increased the administrative burden for domestic and cross-border transactions. Tax transactions and reorganization that were previously considered standard are now being revisited in light of the new rules. Canadian tax practitioners have been grappling with how and when the new mandatory disclosure rules apply, and the potential implications of the new rules to domestic and cross-border transactions.

This article describes the new mandatory disclosure rules and highlights some of the challenges in their application. We posit that the new rules should be narrowed so as to minimize the ambiguity in their application, particularly in the context of domestic and cross-border transactions.

Mandatory Disclosure Rules

The new mandatory disclosure rules came into effect on June 22, 2023, and may apply to transactions that were started before, but not completed until after, the coming-into-force date. The mandatory disclosure rules are divided into three categories: reportable transactions, notifiable transactions and uncertain tax treatment. Each category will be described in turn.

Reportable Transactions

For a transaction to be a “reportable transaction,” it must be an “avoidance transaction” and one of three hallmarks must be met. An “avoidance transaction” is defined broadly in subsection 237.3(1) of the Income Tax Act (Canada)^[1] to mean “a transaction if it may reasonably be considered that one of the main purposes of the transaction, or of a series of transactions of which the transaction is a part, is to obtain a tax benefit.” Tax benefit has the same meaning as under subsection 245(1). The three hallmarks, as described in the “reportable transaction” definition in subsection 237.3(1), are the “contingent fee” hallmark, the “confidential protection” hallmark and the “contractual protection” hallmark.

The first hallmark is the “contingent fee” hallmark. This hallmark will be met if an advisor or promoter has or had an entitlement to a fee that to any extent is: (i) based on the amount of a tax benefit that results, or would result but for section 245, from the avoidance transaction or series; (ii) contingent upon the obtaining of a tax benefit that results, or would result but for section 245, from the avoidance transaction or series, or may be refunded, recovered or reduced based upon the failure of the person to obtain a tax benefit from the avoidance transaction or series; or (iii) attributable to the number of persons who participate in the avoidance transaction or series, or in a similar avoidance transaction or series, or who have been provided access to advice or an opinion given by the advisor or promoter regarding the tax consequences from the avoidance transaction or series, or from a similar avoidance transaction or series.

The second hallmark is the “confidential protection” hallmark. This hallmark will be met if an advisor or promoter obtains or obtained confidential protection and the prohibition on disclosure provided under the confidential protection provides confidentiality in respect of a tax treatment in relation to the avoidance transaction or series. Moreover, in the case of an advisor, the confidential protection is from a person to whom the advisor has provided any assistance or advice with respect to the avoidance transaction or series under the terms of an engagement of the advisor. And in the case of a promotor, the confidential protection is provided from a person (i) to whom an arrangement, plan or scheme has been promoted or sold, or (ii) to whom a statement or representation that a tax benefit could result from an arrangement has been made, or (iii) from whom a promoter has accepted consideration in respect of an arrangement.

The third hallmark is the “contractual protection” hallmark. This hallmark will be met if either (i) a person has or had contractual protection in respect of the avoidance transaction or series, or (ii) an advisor or promoter in respect of the avoidance transaction or series has or had contractual protection in respect of the avoidance transaction or series. In our experience, the third hallmark has caused the most consternation among Canadian tax practitioners because of how “contractual protection” is defined.

A “contractual protection” is, in relevant part, any form of insurance or other protection, including an indemnity, compensation or a guarantee, that (i) protects a person against a failure of a transaction or series to achieve any tax benefit, or (ii) pays for or reimburses any expense, fee, tax, interest, penalty or similar amount that may be incurred by a person in the course of a dispute in respect of a tax benefit. A contractual protection will not be caught by the third hallmark if it is standard professional liability insurance, or

… (B) integral to an agreement between persons acting at arm’s length for the sale or transfer of all or part of a business (either directly or through the sale or transfer of one or more corporations, partnerships or trusts) where it is reasonable to consider that the insurance or protection

(I) is intended to ensure that the purchase price paid under the agreement takes into account any liabilities of the business immediately prior to the sale or transfer, and

(II) is obtained primarily for purposes other than to achieve any tax benefit from the transaction or series…

We will refer to the excerpted text as the Second Carveout.

The Canada Revenue Agency (“CRA”) has stated in recently published guidance (“Guidance”): “Standard representations, warranties and guarantees between a vendor and purchaser, as well as traditional representations and warranties insurance policies, that are generally obtained in the ordinary commercial context of mergers and acquisitions transactions to protect a purchaser from pre-sale liabilities (including tax liabilities), are not expected to give rise to reporting requirements for reportable transactions.” The CRA went on to provide examples of contractual protections that are excluded by the Second Carveout.

One of the examples the CRA provided was: “Indemnities related to existing pre-closing tax issues, or the amount of existing tax attributes (tax pools, capital cost allowance, etc.).” Such indemnities are typically included in standard tax representations and warranties and, provided the requirements in the Second Carveout are met, these indemnities should not be caught by the contractual protection hallmark. What is less clear is whether there will be a reporting obligation where, for example, a vendor implements a pre-closing reorganization that achieves a tax benefit for only the vendor, the reorganization is completed before the transaction closes and the vendor provides a general pre-closing tax indemnity to the purchaser.

In this example, arguably there should not be a reporting obligation because the indemnity is a general tax indemnity, which is integral to the agreement between a vendor and purchaser who are dealing at arm’s length, the indemnity relates to pre-closing tax issues and it is not obtained to achieve any tax benefit (the tax benefit was achieved by the vendor prior to the closing of the transaction). However, the relevant analysis in any particular set of circumstances will almost always be more nuanced and varied. The severity of the penalties is likely to discourage aggressive positions regarding the lack of a disclosure requirement. For corporations with assets of $50 million or more, the maximum penalty is the greater of $100,000 and 25% of the tax benefit. For promoters and advisors, the maximum penalty is the total of $110,000 plus the fees charged by that person in respect of the reportable transaction. Finally, for all other taxpayers, the maximum penalty is the greater of $25,000 and 25% of the tax benefit.

The new mandatory disclosure rules may also impact tax transactions and reorganization that were previously considered standard. Another example the CRA provided in the Guidance was a purchaser corporation that obtains specific contractual covenants and/or indemnities from a target corporation and its significant shareholders with respect to a paragraph 88(1)(d) bump implemented by the purchaser corporation. The example specifically states that the purchaser corporation is a public corporation. It is not clear whether the CRA intended to draw a distinction between public and private corporations or merely used a publicly traded acquiror for illustrative purposes. The paragraph 88(1)(d) bump example should apply equally to public and private corporations as long as the requirements in the Second Carveout are met, but until the CRA provides clarification, there will be uncertainty about whether a paragraph 88(1)(d) bump implemented by a private corporation will attract a reporting obligation.

The CRA concludes its list of examples of contractual protections that are excluded by the Second Carveout by stating: “For greater certainty, this exception would not extend to other insurance or protections that may be obtained to cover specific identified tax risks, including, for example, through the use of tax liability insurance policies in relation to avoidance transactions. The existence of such insurance may often be an indication of aggressive tax planning.” What the CRA appears to be stating is that, other than in the examples provided, the Second Carveout cannot be relied on where there is an avoidance transaction for which a specific tax indemnity is obtained. Until the CRA clarifies this statement, we believe specific tax indemnities should be avoided to the extent it is commercially feasible.

Where a person has a reporting obligation, that person must file Form RC312. In general, the prescribed form must be filed within 90 days after the earliest of the day on which a person becomes contractually obligated to enter into the reportable transaction, and the day on which the person enters into the reportable transaction. Subsection 237.3(5) provides additional rules for when a return must be filed if a person enters into a transaction for the benefit of another person, or if a person is a promotor or advisor. The 90-day filing window is short, particularly when reporting is required for more complex transactions and reorganizations, which is often the case for domestic and cross-border transactions. Moreover, it is also not always clear when a transaction or series of transactions begins for the purposes of counting the 90 days, but due to the severe penalties for non-compliance, taxpayers and their advisors may be well-served to take a more conservative approach in determining when a transaction or series of transactions starts the 90-day clock.

Notifiable Transactions

The second category of the mandatory disclosure rules is notifiable transactions. As the name implies, a taxpayer is required to notify the CRA if the taxpayer engages in a notifiable transaction. A “notifiable transaction” is defined in subsection 237.4(1) to mean a transaction or a transaction in a series of transactions that is the same as, or substantially similar to, a transaction or a series of transactions that is designated at that time by the CRA (with the concurrence of Finance Canada). Subsection 237.4(2) interprets “substantially similar” to include “any transaction, or series of transactions, in respect of which a person is expected to obtain the same or similar types of tax consequences (as defined in subsection 245(1)) and that is either factually similar or based on the same or similar tax strategy.” Moreover, “substantially similar” is to be interpreted broadly in favour of disclosure.

As of the date of this article, the CRA has not designated any transactions or series of transactions, but Finance Canada has listed six sample notifiable transactions in a backgrounder published on February 4, 2022: (1) manipulating CCPC status to avoid anti-deferral rules applicable to investment income; (2) straddle loss creation transactions using a partnership; (3) avoidance of deemed disposal of trust property; (4) manipulation of bankrupt status to reduce a forgiven amount in respect of a commercial obligation; (5) reliance on purpose tests in section 256.1 to avoid a deemed acquisition of control; and (6) back-to-back arrangements. Although the CRA has not designated the sample notifiable transactions under subsection 237.4(3), one can reasonably expect that it will do so at some point in the (near) future.

The prescribed form for notifiable transactions is Form RC312, which is the same form as for reportable transactions. The filing deadline (generally, within 90 days) and the penalties for notifiable transaction are also the same as for reportable transactions. However, unlike reportable transactions, the filing requirement under the notifiable transaction rules only applies to an advisor or promoter if that advisor or promoter knows or should reasonably be expected to know that a transaction was a notifiable transaction (other persons may rely on the due diligence defence which is discussed below).

Uncertain Tax Treatment

The third category of the mandatory disclosure rules deals with uncertain tax treatment. These rules only apply to a reportable corporation, which is defined in subsection 237.5(1) to mean a corporation that, in general, has audited financial statements for the year, the carrying value of the corporation’s assets is greater than or equal to $50 million at the end of the year, and the corporation is required to file a return of income for the year under section 150. A reporting corporation that has one or more tax treatments in respect of which uncertainty is reflected in the relevant financial statements of the corporation for the year must file a prescribed form on or before the corporation’s filing due date for the year. The prescribed form is Form RC3133. The maximum penalty for non-compliance is $100,000.

Due Diligence Defence

Each category of the mandatory disclosure rules provides a due diligence defence. In general, a person will not be liable for a penalty if the person has exercised the degree of care, diligence and skill to prevent the failure to file that a reasonably prudent person would have exercised in comparable circumstances. Where a person has decided that there is no disclosure obligation under the mandatory disclosure rules, the person should maintain a complete record of how that decision was made in order to support a due diligence defence, if necessary.

Conclusion

The new mandatory disclosure rules came into force almost six months ago and with their introduction came a significant degree of ambiguity for Canadian taxpayers and tax practitioners. In our experience, the Second Carveout to the contractual protection hallmark has been the centre of much of the uncertainty. Canadian taxpayers would benefit from the reportable transaction rules being narrowed to better target the types of transactions that Finance Canada views as offensive, and Canadian tax practitioners would be able to better advise their clients with further guidance being provided by Finance Canada and the CRA.