Even simple things can have nasty endings. A recent case had four brothers, equal shareholders of an operating company, appearing before the Tax Court of Canada. The brothers had arranged for life insurance to be purchased by the corporation in order to fulfill the funding obligation of their buy-sell arrangement. As the owner of the policies, the corporation named itself as beneficiary. The corporation made a substantial deposit into the contracts in order to prefund the coverage during the good economic times of the corporation. The insurance agent had arranged to make a payment to each shareholder for the privilege of placing the business.
The Canada Revenue Agency (“CRA”) sought to tax each of the brothers for a shareholder benefit received. The CRA said that the taxpayers knew that the cash received from the agent was the property of the corporation because it was the owner and paid the premiums on the related policies, and they failed to report the amount of the shareholder benefit received. As well, the CRA sought to impose penalties and interest, saying the taxpayers were grossly negligent in failing to report the shareholder benefit.
The penalty for false statements or omissions is the greater of $100 and 50% of the taxes avoided. In addition to the taxes and penalties sought by the CRA, there would also be interest added to the bill, starting from the date the liability arose and continuing to the time the taxpayers made a payment. The interest rate charged on overdue taxes is the prescribed rate of interest plus 4%. The prescribed rate of interest has been 1% since the second quarter of 2009, meaning that the interest rate currently charged by the government on outstanding taxes would be 5%. Note that the interest would be compounded on a daily basis until a payment is made.
It is important to note that any penalties and interest charged by the CRA are not tax deductible by the taxpayer and would need to be funded from after-tax cash flow. In short, the cost of receiving a personal benefit from your corporation can be very high. Consider the following example:
|$1,600||value received from the corporation|
|$800||assumed taxes avoided because the transaction was not reported|
|$400||potential penalty that could be imposed due to gross negligence|
|$400||potential interest charges (assume simple interest of 5% and 5 years)|
The taxpayer in the above example would end up paying $1,600 in taxes, penalties and interest on $1,600 of income he or she tried to avoid reporting. In addition to the tax on the individual, the corporation will not be able to get any income tax relief for the benefit added to the shareholder’s income. Since shareholder benefits are not tax-deductible, the corporation cannot deduct the $1,600 amount which could have resulted in a savings to the corporation of about $320 in corporate income taxes (assuming a 20% tax rate).
Careful tax planning can make good business sense and is constantly reinforced by the courts. On the other hand, the penalties and interest involved in tax avoidance are significant and may end up costing more than the entire benefit avoided.
E.O. & E.
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Copywrite ISSN 0382-7038
Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.