Tax Strategy
Shareholder Benefits
Beware the perils of a subsection popular with auditors.
FROM: MAR-APR 2006 ISSUE | BY DAVID NOLKE
Subsection 15(1) of the Income Tax Act (the Act) is a subsection that is frequently used by income tax auditors after discovering a benefit, usually by way of an appropriation, has been conferred on a shareholder by a corporation. Accountants and their clients do not normally use subsection 15(1) in the self-assessment process, presumably because they have calculated the tax on all benefits in a logical fashion, usually as part of a salary or dividend.
But subsection 15(1) is applied by the Canada Revenue Agency (CRA) during audits and the results can be financially painful for taxpayers and accountants alike. The subsection reads as follows:
Where at any time in a taxation year a benefit is conferred on a shareholder, or on a person in contemplation of the person becoming a shareholder, by a corporation ... the amount or value thereof shall ... be included in computing the income of the shareholder for the year.
There are a few benefit exceptions taxed under other sections of the Act which are specifically excluded from the application of subsection 15(1). These exceptions include transactions that give rise to a deemed dividend or capital gain, such as the redemption of shares, the payment of a stock dividend, or the conferring of rights on common shares. Absent these exceptions, a benefit can be taxed under subsection 15(1).
In dealing with subsection 15(1), the first thing to remember is that it is a stand-alone subsection. The shareholder who receives a benefit from a corporation is taxed on the value of the benefit — there is no relieving provision somewhere else in the Act that allows the corporation to claim the value of the benefit as an expense.
This treatment under subsection 15(1) will most always lead to double taxation, since the corporation is precluded from deducting the benefit, and therefore pays tax on the amount, while the shareholder also pays tax on the amount. Let's look at some examples of how subsection 15(1) can really ruin an otherwise sunny day.
Jenny Smith is a public accountant who has just accepted a Notice to Reader engagement with a new client. The client tells Ms. Smith that he uses his personal vehicle about 50 per cent of the time for business purposes, but he doesn't have specific records of his travel.
Ms. Smith could advise her client to do some homework and submit expense reports to the company detailing the business travel and charging an acceptable rate per kilometre. But instead of this treatment, Ms. Smith decides to record one-half of the value of the vehicle on the corporate books and depreciate it for both accounting and tax purposes. The credit side of the entry goes to shareholder loan.
On audit, the CRA takes the position that the vehicle is not owned by the corporation, but rather, is owned by the individual shareholder and should not be recorded as an asset of the corporation. Furthermore, the recording of one-half of the vehicle in the corporation is viewed as bestowing a benefit on the shareholder, equal to the credit entry in his shareholder account. The capital cost allowance claimed is disallowed, and the value of the vehicle recorded in the corporation is taxed to the shareholder.
The second example involves a shareholder who travels throughout Canada, and withdraws cash amounts from ATMs when away from home to pay for meals, taxis, and promotional items. The amounts come out of a corporate bank account and are claimed as business expenses under the heading of travel. The cash withdrawals total $17,000 for the year.
On audit, the CRA disallows the claim on the basis that there is no proof that the withdrawn amounts were used to pay for business expenses. Further, because the shareholder received the amounts, they are taxed to the shareholder pursuant to subsection 15(1) of the Act.
In the third example, a home renovation business purchases supplies for use in renovating the kitchen of the sole shareholder. These expenditures are deducted in the supplies account of the corporation. On audit, the CRA disallows the claim, deems the expenses to be personal, and orders the shareholder to pay taxes on the expenditures in accordance with subsection 15(1) of the Act.
If it could be shown that the taxpayer in this case knew or ought to have known that the expenses were wrongly claimed in the business, penalties for gross negligence could also be applied. And, if additional evidence suggested that invoices or shipping documents were altered to hide the delivery location, the taxpayer might well be a candidate for prosecution.
We can conclude that when preparing books of account or corporate tax returns, practitioners need to be vigilant with respect to individual expense items, and should never allow a client to convince them that something should be deducted when it clearly should not. It is this vigilance by the public accountant that can eliminate a great deal of trouble when it comes to subsection 15(1).
Remember that by the time audit adjustments are made, a number of years have usually elapsed since the initial assessment of the shareholder's personal return. This means that on reassessment, interest will be charged from the date the tax should have been paid on the benefit. In three years time, the interest can approximate the tax itself, compounding the misery.
There are many tax cases where a subsection 15(1) assessment is in dispute, but I would recommend reading two recent Tax Court of Canada judgments that clearly set out the CRA's use of subsection 15(1): Bird v. the Queen [2005 TCC 744] and Gillis v. the Queen [2005 TCC 782].
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David Nolke, FCGA, is proprietor of Nolke & Co., Certified General Accountant, in Calgary, and president of Integrated Business Advisory Services Inc., providing tax and management counsel to industry, government and other professionals. E-mail dgn@shawbiz.ca.
"Tax Strategy" is co-ordinated by J. ThomasMcCallum, CBV, FCGA, a business valuation and income tax consultant based in Whitby, Ontario, and author of several CGA-Canada professional development courses. E-mail jtmc@jthomasmccallum.com.
The information appearing in "Tax Strategy" is provided for the interest of the readers. Neither CGA Magazine nor the column authors and co-ordinator assumes any responsibility or liability to any persons relying on the information in the article to perform tax planning and/or compliance of any kind.