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3. Evaluating the current law and policy

The previous chapters have outlined the policy considerations that underlie Canada's existing system for taxing the capital gains of non-residents and migrants, and sketched the systems applied in several other countries. This chapter considers whether Canada ought to modify its policies in this area.

To that end, the chapter evaluates the current rules against a three-fold standard. Canada's policy, it is suggested, should balance the objectives of:

It is concluded that while these objectives are for the most part appropriately reflected in the Act, certain adjustments should be considered. The final portion of the chapter lists the Committee's findings and recommendations as to how the objectives listed above can better be met.

(a) A balancing of four criteria

To evaluate the soundness of a complex, multifaceted tax policy, it is necessary to establish the general results the policy is meant to accomplish. The Committee considers that Canada's tax policy with respect to taxpayer migration ought to be based on the following objectives:

The Committee recognizes that developing a coherent policy in this area is a matter of balancing these four objectives, which will in many instances conflict with one another. A single-minded policy of maximizing the taxation of Canadian-source gains, for example, would contradict the basic international principle, which Canada upholds, that a taxpayer's country of residence ought to have the exclusive right to tax most gains. Similarly, if ease of compliance were the overriding goal, many non-residents would have to be excused from paying Canadian tax at all, since language and cultural differences can be real barriers to even the most willing taxpayer.

Still, these four principles provide the indexes against which the existing system and its policy foundation can be measured. The following sections of the Report examine the extent to which these principles are served by the current rules for the taxation of migrants.

(b) The taxation of Canadian-source gains

To what extent does the Act's set of rules on non-residents and taxable Canadian property ensure that gains arising in Canada are taxed here? Are there ways in which this goal could be better achieved? In answering these questions it is helpful to separate the application of the rules to persons who are permanent non-residents from their application to persons who emigrate from Canada.

(i) Canadian tax on TCP held by non-residents

Some types of property, such as real property situated in Canada and shares of private Canadian companies, are TCP irrespective of the property's use by the non-resident owner or the extent of the interest in the property. However, the characterization of other types of property as TCP can turn upon:

Although the Committee has not heard evidence of any specific problems in relation to these sorts of property, it notes the possibility that taxpayers can in some circumstances avoid having a property characterized as TCP. If, for example, a non-resident who owns 25% or more of a class of listed stock wanted to minimize Canadian tax on a gain that has accrued on the shares, the non-resident could sell just enough shares to bring the shareholding below 25%, wait more than 5 years, and sell the balance. Although gains realized on the initial sale would be taxable in Canada, the shares would have ceased to be TCP by the time of the second sale, and no Canadian tax would be payable on the gain realized by that sale. Similarly, a non-resident partner who wanted to avoid being taxed on a gain on the partnership interest can dilute the Canadian proportion of the partnership's property by adding non-Canadian assets. By selling only after more than 12 months have passed since the partnership ceased to have a majority of its value in Canadian property, the partner could avoid Canadian tax on any accrued gain on the partnership interest. (9)

9 - Where the partner has contributed TCP to the partnership, this dilution technique will not work, thanks to the rule that deems the partnership interest to be itself taxable Canadian property.

These inappropriate recharacterizations of property might be preventable through fairly modest changes to the existing rules. It would, in the Committee's view, be worthwhile to consider amendments to:

Recommendation 1: Classification of property

That the Minister of Finance consider amendments to the Income Tax Act to prevent the inappropriate manipulation of a property's status as between "taxable Canadian property" -- the sort of property on which non-residents' capital gains are taxed in Canada -- and other property.

(ii) Canadian tax on property held by emigrants from Canada

As noted earlier, natural persons emigrating from Canada are not taxed at the time of departure on gains on TCP. In addition, if an emigrant elects, and posts security for the tax otherwise payable, the emigrant can defer the tax payable on non-TCP as well. Trusts are not subject to tax on departure on TCP but are taxable at that time on non-TCP gains, and corporations are taxable on departure on gains in respect of all TCP and non-TCP that they hold. All taxpayers are taxable on pre- and post-emigration TCP gains realized after becoming non-resident, and natural persons are also taxable on both pre- and post-emigration gains on non-TCP on which they had elected to defer the Canadian tax otherwise payable at the time of ceasing to be Canadian residents.

It has also been noted that any property on which pre-departure gains are not taxable upon emigration are subject to Canadian tax, on both pre- and post-departure gains, when sold after the taxpayer has become a non-resident.

Conceptually, this system seems sound enough to the extent that the property in question would have been TCP to a non-resident. In such a case, the same property will be subject to the same amount of Canadian tax, payable at the same point in time, whether the taxpayer in question was a former Canadian resident or was a non-resident throughout the relevant period.

The desirability of consistent results between emigrating taxpayers and "permanent non-residents" leads directly to one of the key policy questions raised by the Auditor General's report: should Canadian residents be considered to hold TCP for the purpose of applying the rules deeming non-TCP to be TCP when acquired in exchange for TCP?

On this question, the Committee starts with the view the system ought to produce the same end result, in terms of overall Canadian tax liability, irrespective of the particular order in which transactions are carried out. For example, it appears to be widely accepted that if a non-resident exchanges TCP -- say, Canadian real estate -- in a rollover transaction for shares in a public corporation, the non-resident will be deemed to hold those shares as TCP, even if the non-resident (and non-arm's length persons) holds less than a 25% interest in the company. Accordingly, any subsequent gain on those shares will be subject to Canadian tax. Similarly, a Canadian resident who emigrates from Canada while owning Canadian real estate will, if the real estate is subsequently exchanged in a rollover transaction for a less-than-25% interest in a public corporation, be treated as holding those shares as TCP and will be subject to Canadian tax on all gains on those shares.

What happens, however, if the Canadian resident exchanges the real estate for the shares before emigrating from Canada? If the shares are not deemed to be TCP (and assuming the taxpayer does not choose to treat them as TCP), then no post-departure gains will be subject to tax. If, on the other hand, the new shares are treated as TCP, on the basis that they were acquired in exchange for TCP, then all gains arising on the shares up to their ultimate dispositions would be taxable in Canada. Since it is consistent both with the treatment accorded to the first taxpayer who is permanently non-resident, and with the treatment of the second taxpayer who emigrates before exchanging the real estate for the public-company shares, the Committee concludes that the treatment of shares as TCP in a Canadian resident's hands is the preferred result.

A second example deals with the actual situation presented in the 1991 ruling request: a Canadian trust exchanges shares of a private Canadian corporation for a less-than-25% interest in shares of a public corporation, and then distributes those shares to a non-resident beneficiary. Based on the evidence before it, the Committee finds a consensus that:

In the Committee's view, it is hard to justify a tax system under which the amount or timing of one's liability for tax depends dramatically on the order in which identical transactions, having the same ultimate non-tax effects, are carried out. The distribution of the private corporation stock to the non-resident beneficiary would clearly have qualified as a non-taxable transaction, because any gains on that stock would be taxable, when it was ultimately sold, as TCP to the beneficiary. The distribution of the private corporation stock to the non-resident beneficiary, followed by the beneficiary's exchange of that stock for public-company stock, would clearly have qualified as non-taxable transactions, because the private stock would constitute TCP to the beneficiary, and the public stock would be deemed to be TCP to the beneficiary. In order to achieve the same tax result where the share exchange occurs before the distribution takes place, the public shares would necessarily have to be treated as TCP in the hands of both the Canadian trust and the non-resident beneficiary.

The Committee concludes, therefore, that the current system supports the view that Canadian residents can hold TCP and thus that the rules treating as TCP property acquired in exchange for TCP should have application both to Canadian residents as well as non-residents.

As the Auditor General's report and the rulings it deals with indicate, this conclusion is not as clearly reflected in the current Income Tax Act as it might be. The Committee recommends that this lack of clarity be rectified.

Recommendation 2: Scope of TCP definition

That the Act be amended to clarify that the definition of taxable Canadian property applies in respect of all taxpayers, both residents of Canada and non-residents.

The Committee also notes the concern expressed during the hearings that the Act's rules allowing a non-taxable distribution of property from a Canadian trust to a non-resident beneficiary may depend only upon the character of the property as TCP to the trust. Where, to take the example of the 1991 ruling, a trust exchanges private corporation shares for stock of a public company, the public stock will be deemed to be TCP to the trust and thus, as the Committee has concluded, both does and should qualify for distribution to a non-resident beneficiary on a non-taxable basis. However, any gains of the beneficiary on the property should also then be subject to tax in Canada; in other words, the public stock should also be deemed to be TCP in the beneficiary's hands. A concern has been raised that the Act is not as clear as it might be in providing that any property treated as TCP in the trust's hands, and thus qualifying for a tax-free distribution, is also to be treated as TCP to the beneficiary. While the Committee is not in a position to assess the validity of this concern, it does consider that further attention should be given to this question.

Recommendation 3: Distribution of trust property

That changes be made, if necessary, to ensure that any accrued gains on trust property distributed to a non-resident beneficiary are taxed either in the hands of the trust or in the hands of the beneficiary.

(iii) summary

The Committee finds that Canada's existing policies do generally accord with the principle that Canada ought to tax non-residents on their gains from sources in Canada. This does not mean that the policies are perfectly reflected in the very technical rules that make up the Income Tax Act. Most notably, non-residents may inappropriately be able to control the characterization of certain property as either taxable Canadian property or non-TCP. Where emigrants from Canada are concerned, the Committee considers the policy case for treating property as being TCP to residents of Canada entirely convincing: if that characterization were not allowed, transactions that were economically identical would have significantly different tax effects. To prevent uncertainty, the Act should be amended to reflect this conclusion more clearly than it currently does. The Committee also notes, and recommends further consideration of, concerns that have been raised regarding the clarity of certain of the Act's rules that deem property to be TCP.

(c) Harmonization with other countries

The chief way in which Canada and other countries harmonize their rules for the income tax treatment of non-residents, including former residents, is the growing network of bilateral income tax treaties. Canada currently has nearly 60 such treaties in force, with a number of others in various stages of negotiation.

The earlier description of the effects of tax treaties on the Income Tax Act's TCP rules noted that Canada's treaties impose significant limits on how those rules apply. Put differently, what the Act proposes to tax and what, when treaties are taken into account, the Act is actually permitted to tax, are often two different things.

(i) treaty limits on Canadian tax

Canadian treaty policy is in large part based on the international norms established by the Organisation for Economic Co-operation and Development. The OECD's Model Income Tax Convention, which Canada has adapted for its own use, generally assigns the right to tax capital gains to the country in which the taxpayer resides. In addition, gains on real estate and some business property may be taxed in the country where the property is located. Many of Canada's treaties also let Canada tax a former resident's gains on other sorts of property, provided the gains are realized within a specified period after leaving Canada.

The Committee notes the widespread acceptance of these principles among Canada's trading partners and other countries, and sees no need for Canada to deviate from its current treaty practice in this regard, at least as it applies to permanent non-residents. The Committee does, however, see a possible problem with the effects of Canada's tax treaties on emigrating taxpayers.

As this report has repeatedly noted, all taxpayers other than corporations are exempt from tax on emigration with respect to TCP. In addition, individuals other than trusts can elect, upon posting adequate security for the tax otherwise payable, to defer the recognition of gains on non-TCP. Where pre-departure gains on property are not required to be recognized at the point of emigration, both pre- and post-departure gains on the property are, according to the Act, subject to tax when the property is ultimately sold.

An emigrating taxpayer's right to avoid tax on gains accruing while resident is predicated on the application of Canadian tax to those gains (as well as any post-departure gains) when the emigrant disposes of the property. The extensive network of Canada's tax treaties, however, calls the basis for this system into question. Except for direct interests in real property situated in Canada, and property used in connection with a business carried on in Canada, property that the Act would treat as being taxable when sold by the emigrating taxpayer after becoming non-resident will often be exempt from Canadian tax because of a treaty.

(ii) the case for a more comprehensive emigration rule

Should Canada simply accept this result, ceding to its treaty partner exclusive rights to tax all gains other than those arising on property sales occurring within the first few years following the taxpayer's departure? The Committee acknowledges that such an approach is defensible, but questions whether it is in keeping with the basis for the current system.

First, the general rule under the Act is that emigrating taxpayers are subject to tax, at the time they leave Canada, on all pre-departure gains on non-TCP, and are not subject at that time to Canadian tax on pre-departure gains on TCP. But the practical effect of deferring Canadian tax on pre-departure TCP gains, given the treaty rule, is to give the treaty country the right to tax all of a former Canadian resident's gains, including pre-departure gains realized on TCP after the specified number of years. Given that Canada does tax pre-departure gains on non-TCP, the Committee concludes that it would be reasonable for Canada to tax pre-departure gains on TCP as well.

Second, Canada taxes the non-TCP gains of emigrating taxpayers only to the extent that those gains arose while resident. A taxpayer who immigrates to Canada with non-TCP, then emigrates to a treaty country, will be taxable in Canada on gains that accrued while the taxpayer was resident here. This is a sort of deference to the taxpayer's former country of residence, which may have taxed gains that accrued up to the time the taxpayer became resident in Canada. It suggests, however, that Canada might assume that other countries give it the same deference in respect of emigrants from Canada. Adopting this position would mean Canada would tax pre-departure gains of emigrating taxpayers on property that the taxpayers' country of destination might appropriately treat as being the equivalent of non-TCP in relation to its own taxation of pre-residence gains.

If one concludes that Canada should tax emigrating taxpayers on all pre-departure gains that a treaty may shield from later Canadian tax, it becomes necessary to consider how that ought to be done. One approach would be to base the application of tax on the existence and content of any treaty which Canada might have with the particular country to which the taxpayer emigrates. An emigrant moving to a non-treaty country would be able to defer Canadian tax on TCP, since no treaty would interfere with Canada's eventual taxation of both pre- and post-departure gains. An emigrant moving to a country whose tax treaty with Canada precluded Canada from taxing any gains on property other than Canadian real estate, in contrast, would face Canadian departure tax on all gains that had accrued on TCP (other than real estate) and non-TCP alike.

Linking departure taxation to treaties would not, however, be at all reliable. A treaty might come into existence only after the taxpayer has taken up residence, the terms of an existing treaty might change, or the taxpayer might move to a third country with which Canada's tax treaty obligations differ, before the property is sold.

The alternative to a case-by-case determination of the effects of tax treaties is to tax accrued gains on all property that is potentially treaty-protected. Given Canada's treaty policy, this would imply deeming emigrants to have disposed of all of their property other than Canadian real estate, and perhaps Canadian business property.

To alleviate concerns with the requirement to pay tax on such gains before the actual realization of proceeds from the property's sale, emigrating taxpayers could be allowed to provide security for the tax, with payment due only upon actual disposition. Liability for the tax would, however, arise at the time of ceasing to be a Canadian resident, and would thus be unaffected by the terms of any treaty applying to dispositions of property while a resident of another treaty country.

Under such a system, capital losses accruing after departure from Canada would normally have no Canadian tax consequence. The former resident's Canadian tax position would have been determined, at least as far as pre-departure gains are concerned, on emigration, with only the actual payment of tax being deferred. However, if a former resident disposes of TCP over which Canada's right to tax is not limited by a treaty with the country in which the taxpayer is at that time resident, it might be appropriate to allow the taxpayer to offset any gains that arose on emigration with subsequent losses arising on the property. This would effectively allow the taxpayer to ignore the deemed disposition and to treat the property's actual disposition as the only relevant taxation event.

The Committee does not consider that it has the time or resources to reach a final recommendation with respect to the scope of the deemed disposition rule for emigrants. It does, however, note that a more comprehensive rule, taxing emigrants' gains on all property that may be exempt from Canadian tax by treaty, would maintain the integration of Canada's tax system with the systems of our treaty partners, while enhancing Canada's ability to tax gains that arise from sources in Canada.

Recommendation 4: Emigrants' accrued gains

That the Minister of Finance consider amendments to the Act to compute an emigrating individual's tax liability on all gains that have accrued up to the time of departure, other than gains that will never be treaty-protected from Canadian tax, with actual payment due only on realization (provided the emigrant has given adequate security).

(iii) trusts - special considerations

A final observation on the effect of tax treaties on the Act's TCP rules concerns trusts. Trusts are treated as individuals under the Act, and thus may, depending on the circumstances, be treated as individuals for the purposes of Canada's tax treaties.

As discussed above, certain of Canada's tax treaties reserve Canada's right to tax former residents of Canada on property they owned while resident; however, this right generally applies for only a limited period following the taxpayer's departure from Canada. In addition, certain treaties limit Canada's right to tax a former resident's gains to individuals who resided in Canada for more than a stipulated period of time. This raises the possibility that if a recently-formed trust emigrates from Canada to a treaty country, the trust may not be subject to Canadian taxation of pre-departure accrued gains on taxable Canadian property.

A rule taxing all potentially treaty-protected gains on all property of emigrating taxpayers would address this concern. If such a rule is not adopted, consideration should be given either to correcting those treaties which provide such a result, to imposing limits under the Act's rollover rules which might lead to such a result, or to treating trusts like corporations in taxing all TCP and non-TCP gains on emigration.

(iv) summary

The Committee does not recommend any major change to Canada's policy of negotiating bilateral income tax treaties that generally accord with the OECD model. The Committee does, however, recommend that consideration be given to a more comprehensive deemed realization of accrued capital gains on emigration. Under such a system, an emigrating individual would be treated as having disposed of all property other than Canadian real property (and possibly Canadian business property), with the option of providing security to delay the actual payment of any resulting tax.

(d) Compliance and enforcement

Even the best-designed income tax system will fail if the revenue authority cannot enforce the system's rules. And where the system is a self-assessing one, it is equally crucial that taxpayers be able to comply.

Canada's administrative rules for the taxation of gains realized by non-residents, as described earlier, amount to a transactions-based structure for compliance and enforcement. Merely owning taxable Canadian property does not impose any special requirement on a non-resident taxpayer; it is disposing of the property that triggers a reporting requirement and a potential tax liability. Similarly, Revenue Canada has no way of knowing which of the world's several billion potential taxpayers actually holds TCP at any given time. Corporate share registers and land titles records may indirectly provide some information, but even that is unlikely to surface otherwise than on a disposition.

In the Committee's view, it is generally appropriate that non-residents be required to report TCP only when it is disposed of. More onerous reporting would serve neither taxpayers nor Revenue Canada, which would likely be buried in paper if every non-resident holding a taxable Canadian investment had to record that fact at regular intervals.

The Committee does, however, consider that an emigrant individual (including a trust) that chooses to take advantage of the deferral of tax on accrued capital gains ought to be required to account for those accrued gains. Currently, as far as the Committee is aware, emigrating individuals need not disclose their holdings of taxable Canadian property. This severely limits Revenue Canada's ability to track the subsequent disposition of that property -- particularly where the property is excluded from the ordinary clearance and withholding requirements.

The Committee recommends that taxpayers be required to identify all of their property holdings on emigration, so that Revenue Canada is better positioned both to review the taxpayers' classification of property as TCP or non-TCP, and to monitor former residents' holdings of property which may give rise to Canadian tax on subsequent dispositions.

Recommendation 5: Information reporting

That all individual emigrants from Canada be required to report all property holdings to Revenue Canada at the time of emigration.

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