Even in cases where tax avoidance or deferral isn’t a main reason for making the investment – in which case the OIFP rules should not apply – the taxman may choose to apply the rule anyway.seb_ra/Getty Images/iStockphoto
Last week I wrote about the offshore investment fund property (OIFP) rules in our tax law, and a recent court decision – Gerbro Holdings Co. v. The Queen – that may help investors who invest with money managers outside of Canada. The OIFP rules are worth avoiding, as Gerbro did. In Gerbro's case, the investor had good reasons for investing offshore that had nothing to do with reducing or deferring tax – and so won the battle. What does all this mean for you?
The rules
If the OIFP rules apply to you, the taxman will add an amount to your income each year that is equal to the cost of your offshore investment multiplied by a specified interest rate – currently 3 per cent. (The rate is actually calculated as two percentage points above the prescribed rate of interest, which is 1 per cent today).
You can subtract from this deemed income amount any income (but not capital gains) reported on your tax return from the offshore investment in the year. Also, any deemed income will be added to the adjusted cost base of your offshore investment. In the end, these rules do two things: First, you'll prepay tax since you'll be reporting income before actually receiving it, and second, the rules effectively convert into regular income what might otherwise be taxed as a capital gain.
For example: Suppose you have $300,000 invested in offshore funds. If the taxman applies the OIFP rules because it's believed that one of your main reasons for making the investment was to save or defer tax, you'll face deemed income of $9,000 (3 per cent of $300,000). That could cost you $4,500 in tax at a 50-per-cent marginal tax rate.
Even in cases where tax avoidance or deferral was not one of the main reasons for making the investment – in which case the OIFP rules should not apply – the taxman may choose to apply the rule anyway, giving you no option but to fight him in court. Most investors will simply give in, pay the tax and change their investments in this situation since the accounting and legal fees to fight the Canada Revenue Agency will surely cost more than the additional tax owing.
The CRA knows this. I've seen CRA attack taxpayers where the imputed income is under $10,000. Therein lies the unjust and abusive approach take by the CRA. CRA should not be taking action that will unfairly increase tax owing, and cause Canadians to settle for investment solutions that may fail to achieve their long-term goals.
Keep in mind, CRA is identifying these investors through Form T1135, which must be filed each year by those holding investments outside of Canada with a cost greater than $100,000. Does the CRA really believe these folks are trying to evade tax? Notice to CRA: If a taxpayer's intent is to evade tax then you can bet they won't be reporting those investments on Form T1135 – so, stop barking up the wrong tree.
The tips
Prepare an investment policy statement (IPS)
A good investment manager should prepare an IPS for you. This document is crucial. It should detail your investment objectives and risk tolerance, among other things. It should be clear that you have good reasons for investing in the offshore funds and that tax reduction or deferral is not one of the main reasons.
Document discussions
Make sure you discuss with your investment adviser your objectives and, if reducing taxes is not one of your main reasons for investing offshore, be sure to speak about that fact and ensure minutes of those meetings are prepared. Keep those minutes on file as evidence of your motivation for making the offshore investment.
Choose Canadian if you can
If there's an investment fund in Canada that is equivalent in all important respects to the offshore fund you're considering, you may want to choose the Canadian investment instead to avoid any questions from the CRA. It's quite probable, however, that you may have difficulty finding an equivalent Canadian fund if the investment is an alternative type of strategy (something esoteric, and not simply a fund that purchases stocks on a long-only basis). If there is no equivalent Canadian investment that you're aware of, be sure to document that fact.
Watch your cost amount
If the cost amount of your offshore property is less than $100,000 in aggregate you won't have to report these assets on Form T1135, which takes you off CRA's radar. Here's hoping that CRA will raise the magical threshold below which they don't particularly care to explore your motivation for investing outside of Canada.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author and founder of WaterStreet Family Offices.
Tim Cestnick