That’s Not Fair

In the last twenty-plus years, I’ve read countless court decisions on income tax. They are an important tool for tax practitioners because they provide guidance in tax planning.
The tax court’s role is to settle disputes between taxpayers and the government. They do that by applying the tax laws as written in the Income Tax Act—a statute passed by the parliament of Canada. They also follow common law principles that includes concepts such the meaning of property or trusts, concepts not specifically defined in the act. The point to understand is the courts do not make the tax laws despite what some might think. The courts interpret and apply them.
Taxpayers can easily fall into a situation where logic says this is fair and this how it should be, but the tax law says otherwise. Moreover, one taxpayer may follow steps A, B & C and achieve certain tax results while another may follow A, C & B and get completely different results.
Taxpayers have stood in court and said, “that’s not fair,” and the judge agrees, but he is left with no alternative but apply the laws as written by parliament. Judges emphasis this point in their decisions. “My hands are tied.”
Because the tax laws are vast, complex and fluid, tax professionals help their clients to avoid tax traps and the refrain, “that’s not fair.”

That’s One Large Tax Bill

In Nowak v. The Queen (2011 TCC 3) [TCC] the Tax Court of Canada addressed the issue of the Canada Revenue Agency's reassessments of an individual with unreported income.
The facts of the case are cloudy for a number of reasons. The taxpayer's records of his income and expenses were incomplete and inconsistent. He was reluctant to answer questions posed by the auditor. And documents provided by the taxpayer raised more doubts and questions in the mind of the judge.
The CRA claimed the taxpayer had unreported income in excess of $290,000 during the two tax years in question. The auditor determined these amounts from an analysis of banking records. In essence, the records showed deposits that were clearly not reported as income.
As the judge notes, the burden is on the taxpayer to demonstrate the money received is not income subject to tax.
In this case the judge writes,
[25] The first issue is whether the Appellant failed to report income in his 2000 and 2001 taxation years. This issue turns mainly on the credibility of the Appellant and his spouse, and for the reasons that follow, I do not believe their testimony concerning the source of the unidentified bank deposits. I find their explanations unconvincing and implausible, and very little in the way of corroboration was presented to the Court. The few documents they did produce raise as many questions as they answer.
[42] I find therefore that the Appellant has not shown on a balance of probabilities that the unidentified bank deposits were not income to him in his 2000 and 2001 taxation years.
It would appear the taxpayer spun a story about where the money came from and it wasn't credible, hence he lost.
The second issue raised was the assessment of the gross negligence penalty under subsection 163(2) of the Income Tax Act. The provision can be summarized as: a 50% penalty of the tax owing where a taxpayer knowingly makes a false statement in a tax return. In this case, did the taxpayer knowingly understate his income?
In citing previous cases on this issue, the judge points out the burden of proof is on the government to show the taxpayer knowingly misrepresented his income.
Once the Ministère establishes on the basis of reliable information that there is a discrepancy, and a substantial one in the case at bar, between a taxpayer's assets and his expenses, and that discrepancy continues to be unexplained and inexplicable, the Ministère has discharged its burden of proof. It is then for the taxpayer to identify the source of his income and show that it is not taxable.
[49] These comments would appear equally applicable in a case such as this one where it has been shown that the taxpayer has had a substantial unexplained increase in his assets. I find that the Respondent has shown that there is a substantial discrepancy between Mr. Nowak’s income in the form of deposits to his bank account and his reported income, and that at the end of the day, this discrepancy remains unexplained.
In losing his appeal, the taxpayer faces a large tax bill. First, there is the tax owing on the unreported income for the 2000 and 2001 tax years. Second, there is arrears interest covering a period of a decade--that's a lot of interest. Finally, there is the 50% penalty. Add up these amounts and it's between two-thirds to 100% of the unreported income.
The lesson. First, don't understate your income. You'll get caught and be subject to a larger tax bill than if you had reported the income and paid tax on it.
Second, if in the past you have unreported income and the CRA hasn't started an investigation, it's time to consider the Voluntary Disclosure Program.

Donations of Services To Registered Charities

As both a board member to a registered charity and tax practitioner, I have had to deal with this issue: I’d like a donation receipt for the contribution of my services. They fully expect to receive one, but a registered charity cannot issue a receipt for the donation of services. A donation receipt can only be issued for the gift of property and services are not property.
Read CRA’s web page on issuing receipts here.

Capital Losses & Old Age Security Clawback

Here is something to keep in mind when using capital losses for an individual receiving Old Age Security (OAS) benefits.
1. Allowable capital losses in the year reduce taxable capital gains from the same year. To the extent the gains are greater than the losses, the amount is reported on line 127 of the T1 and form part of the taxpayer’s net income (NI).
2. Where the losses exceed the gains in the year, the excess loss has no impact on NI since the losses can only reduce capital gains. (See year of death for exception). This difference (losses less gains) is referred to as net capital losses and can be carried back three years and forward indefinitely.
3. Net capital losses from other years form part of the calculation of taxable income. (See the bottom of page 3 of a T1). They reduce a taxpayer’s taxable income and hence taxes, but not his total income or net income.
4. The OAS clawback is based on a taxpayer’s net income. As you can see, capital losses used in the year they occur reduce NI and impact favourably on the OAS clawback calculation. Losses from other years do not impact NI and may result in a clawback.
5. Given that taxpayers can often control the triggering of capital gains and losses, this bit of knowledge is something to keep in mind when making those decisions. However, tax planning should be a secondary consideration not the prime factor.


If you own a home and a cottage, at some point you will have to decide how to handle these properties in your estate plan. Do you sell your cottage during your lifetime or through your will? Do you give it to your children this year or later or not at all? How do you minimize income taxes and probate fees? And, how do you fund these costs.
There is no one-solution-fits-all approach to answering these questions; however, this discussion will explain the issues you need to consider in order to make the right decision for you.
To understand the financial consequences and options available, let's start with a common situation.
You and your spouse own a home where you live most of the year, but you also spend time at a cottage which you own. You have adult children and, perhaps, grandchildren. Like most real estate the value of these properties has increased over time, and if sold, would result in a gain.
Here are the four things to consider: First, what tax liabilities are created when the properties are sold or transferred? Second, what are the tax consequences of selling or giving your cottage to your child, either during your lifetime or through your will? Third, what probate fees are charged? Finally, where do the funds come from to pay for the income taxes and probate fees?
Income Tax Consequences
First, what would happen if you sold both properties today for cash to a third-party? During the years you own both properties after 1981, one property would be designated as your principal residence for tax purposes and would be exempt from income taxes. The other property would give rise to a capital gain equal to your proceeds of disposition less your adjusted cost base less your selling expenses. Fifty percent of this gain is included in your taxable income and subject to tax at your marginal rates.
The amount of tax you will pay on the gain will depend on what province you reside in, the amount of the gain, and your base level of taxable income. At the high-end, you may owe tax close to 24% of the gain. For example: A selling price of $400,000 with costs of $300,000 results in a $100,000 gain and taxes, at a marginal rate of 44%, of $22,000.
But what if you waited and both properties were sold from your estate for cash to a third-party? On death, the Income Tax Act deems you to have disposed of the properties for proceeds equal to fair market value and the tax consequences are the same: a taxable gain on one of the properties and a principal residence exemption on the other. Note, there is an exception. Property transferred on death to a surviving spouse is done on a tax-deferred basis. The gain will be taxed in that person's hand when the property is sold or on death.
You may think you can avoid the problem of paying tax on the gain by simply giving the cottage to your children or selling it to them at a price much lower than market value, but the answer is no. The Income Tax Act has specific rules governing these situations.
If you gift the cottage to your children, you are deemed to have sold it for proceeds equal to fair market value and your children are deemed to have acquired it for a cost equal to fair market value. The tax consequences are the same as if you had sold it to a third party.
As for selling it at a price below market value, the Act creates a double taxation surprise. You would be deemed to have sold it for proceeds equal to fair market value and thus taxed on the full gain, but the cost base to your children would reflect the amount they paid (i.e., the lower amount). When they sell the property, their gain would include a portion of the gain that was already taxed in your hands hence a portion of the gain is taxed twice.
Probate Fees
Apart from income taxes, there are probate fees. Probate fees vary by province and occur when an estate administrator or trustee presents a will to Probate Court. The court grants authority for the trustee to carry out the wishes of the testator and in return receives a fee that is, in most provinces, a percentage of the estate's value. Assets not forming part of the estate are not subject to probate fees.
For real estate, probate fees can be avoided by selling or gifting the property during one's lifetime (including the use of a family trust). Since the property does not form part of the estate there are no probate fees. Another approach is to own the property jointly with the right of survivorship (JTWROS). Property thus owned, automatically transfers to the surviving owners and does not form part of the deceased's estate.
If you intend to pass your property to your surviving spouse, you should consider owning your home and cottage jointly with your spouse. If one spouse has sole ownership to the real estate, it is possible to transfer ownership to joint tenants with rights of survivorship on a tax-deferred basis (i.e., your cost base is split between you and your spouse).
Given these tax issues and probate fees, here are your options.
Option 1. Give The Cottage To Your Children During Your Lifetime
The gifting of the cottage to your children results in a disposition of the property at fair market value. If the property is not designated as your principal residence, there is in an immediate tax hit on the capital gain. Since there is no cash received on the gift, you will have to determine how you will pay the taxes owing. Any future gain in the value of the property will be taxed in your children's hands creating a tax deferral. This strategy eliminates probate fees; however, you no longer control the property. For example, your children could sell the cottage without your approval. Further, the property forms part of their estate with respect to death, divorce, bankruptcy etc.
This option is best suited where you will claim the principal residence exemption on your cottage and not your home, and there is little risk the property will be sold because of events in your children's life.
Option 2. Give The Cottage To Your Children From Your Will
This option is similar to the first option, but with the following changes. Since the property is gifted from your will, it will be subject to probate. Owning the property during your lifetime means you maintain control over the use of the cottage and you avoid potential legal issues your children may encounter. There is no tax deferral benefit from an early transfer to your children.
This approach is favourable if you're concerned about losing control over the cottage, where probate fees are minimal or where the future value on the property will not appreciate quickly.
Gifting the property under options 1 and 2 is appropriate where there is no need for cash to satisfy debts. Further, for single-child families, there is no sibling rivalry or "being equitable" disputes.
Option 3. Sell The Cottage To Your Children During Your Lifetime
The consequences of option 3 are similar to option 1 provided the selling price is the property's fair market value. To avoid double taxation, it is critical the selling price be fair market value.
The key difference between the option 1 and 3 is the consideration received in selling the property. If you receive cash, you will have funds to pay any income taxes that result from the disposition. If you receive debt (e.g., a mortgage or promissory note), it is possible to spread the gain over a five-year period (i.e., one-fifth of the gain is taxed each year). If you are not at the top marginal rate, spreading the gain over five years will result in tax savings. (Note: the debt may or may not bear interest.)
On top of the potential tax savings, the other benefits are the avoidance of probate fees and a tax deferral of the future gain which is taxed in your children's hand and not yours. The critical negatives are the immediate taxes owing, if any, on the disposition and the loss of control over the property.
Selling the property may be necessary in order to satisfy debts, including taxes; however, the five-year tax deferral may reduce your income taxes.
If your estate holds any debt on the cottage, it is possible to forgive the debt in your will. In following this approach, you can achieve tax and probate savings, but with the end result of gifting the cottage to your children.
Option 4. Sell The Cottage From Your Will
If you sell the cottage from your will, you maintain control and use of the cottage during your lifetime. This approach eliminates any legal issues your children may encounter if they owned the property. However, the full amount of the gain in the property's value is taxed in your hands. There is no deferral to your children. Further, since the property transfers from your will, it will be subject to probate.
Selling the property may be necessary in order to eliminate sibling disputes. The child who pays the most for the cottage, gets the cottage. If you desire, the amount paid for the cottage could be forgiven and reduce that child's inheritance in order to maintain equitable treatment among your children.
Option 5. Establish Joint Ownership With Children
It is possible to establish joint ownership with rights of survivorship of your cottage with you, your spouse and you children. Provided there is a change in beneficial ownership (i.e., your children are not holding the property in trust for you), there is a disposition of a portion of the property at fair market value and the potential for an income tax hit. The amount of the gain triggered on the transfer will depend on the number of joint tenants added to the title. The remaining portion will be taxed on death or sale. The primary motivation for following this approach is to avoid probate fees.
This option comes with a long list of potential deficiencies. In certain situations, courts have ruled the transfer was not effective and the child was not a beneficial owner. The property then passed through the will and was subject to probate fees.
As a joint tenant, the title can be split and that owner's portion sold separately. It is possible you could end up with a co-owner you did not want. Further, the property is exposed to legal disputes of your children due to marriage breakdown, creditors etc.
Finally, on death your estate will be liable for any taxes owing on the deemed disposition while the property is not part of the estate and cannot be liquidated to satisfy any debts.
While this option may seem simple and elegant, many times it creates more problems than solutions.
Option 6. Establish A Family Trust
In this option, you establish a discretionary family trust to hold the property for the benefit of you, your spouse and your children. A gain is triggered when the cottage is transferred to the trust; however, there is no further gain on your death. The future gain would be taxed in the trust within 21 years; however, steps can be made to transfer the trust property to your children and tax the gain in their hands.
As the trust property does not pass through your will, there are no probate fees. Further, the trust can be created in such a way to exclude a child as a beneficiary in the event of marriage breakdown, bankruptcy etc. This measure provides a level of protection from creditors. Finally, a trust is an excellent vehicle for allowing multiple family members to enjoy the cottage.
There are however costs involved in formally setting up such a trust as well as annual administration and income tax reporting.