Operating a Business in the U.S.? The IRS is Targeting Smaller Foreign Entities

The IRS has recently noted that they are rolling out campaigns to focus on entities below the “big fish” that have historically been targeted. Such campaigns include:

• Related party transaction campaign – a redefined focus on mid-market entities to determine compliance with U.S. transfer pricing requirements.
• Inbound distributor campaign – reviewing whether S. affiliates distributing imports from other countries are realizing adequate returns based on their assets, risks assumed, and functions performed.
• Form 1120-F non-filer campaign – targeting corporations (the IRS believes there are many) with a U.S. permanent establishment or branch which have not filed U.S. income tax returns. The IRS indicates external data sources will be used to identify these companies, commencing with a “soft letter outreach”. There is no indication of any amnesty, meaning penalties and interest are likely for Canadian corporations which have not complied with any U.S. filing obligations

Tax Changes to Reporting WIP for Dentists, Lawyers, Doctors, & Other Professions

In the past, taxpayers in certain designated professions (i.e., accountants, dentists, lawyers, medical doctors, veterinarians and chiropractors) may have elected to exclude the value of work in progress (WIP) in computing their income for tax purposes. This essentially enabled these professionals to defer tax by permitting the costs associated with WIP to be expensed without including the matching revenues.

However, the 2017 Federal Budget proposed to eliminate this election, effective for the first tax year that begins after March 22, 2017. Transitional rules have been introduced to implement the change over two years. Once fully implemented, WIP, which is valued at the lower of cost or fair market value, will need to be included in income each year.

At present, many professionals either do not account for WIP in their financial accounts or account for WIP at its expected billing amount, using staff and partner billing rates rather than cost. These professionals will be required to determine the cost of their WIP in order to comply with these new provisions. There has been some uncertainty expressed regarding how the cost of WIP is properly calculated.

CRA has stated that the proposed changes are not expected to have any impact on bona fide contingency fee arrangements. That said, some practitioners have expressed concern that this concession has little or no basis in law.

Employee Discounts on Merchandise is Now a Taxable Benefit

Historically, CRA has stated that an employee enjoying a discount on the purchase of merchandise from their employer is only taxable if a limited number of specified situations exist, such as where the employer makes a special arrangement with the employee or group of employees to buy the merchandise at a discount; the employee buys the merchandise for less than the employer’s cost; or the employer makes a reciprocal arrangement with another employer so that the employees of one employer can buy merchandise from the other at a discount.

While the above guidance is still published in certain CRA documents, CRA has recently released updated guidance which appears to limit this administrative position. In CRA Folio S2-F3-C2, CRA noted that where an employee receives a discount on merchandise because of their employment, the value of the discount is generally a taxable benefit. This would apply regardless of whether the discount was provided by the employer or a third-party.

This updated guidance appears to be consistent with a number of Court decisions.

Proposed Tightening to Voluntary Disclosure Program for Businesses

The Voluntary Disclosure Program (VDP) provides taxpayers (individuals, corporations, partnerships, trusts, etc.) the opportunity to fix incorrect or incomplete previously filed tax returns (or returns that should have been filed) with a reduction to penalties and possibly interest.

CRA recently released fairly substantial proposed changes to the current program, effective January 1, 2018. The proposals are expected to be finalized in the fall of 2017.

The proposals will create two tracks for income tax disclosures.

General Program (GP)

The GP is similar to the current VDP. Penalties will be waived, subject to the usual ten-year limit, criminal prosecution will not be considered and interest relief will be considered for years preceding the most recent three years, with 50% of interest generally being waived. Interest for the most recent three years will not be waived.

Limited Program (LP)

The LP will be applicable for disclosures of major non-compliance and will provide reduced relief. Examples of situations where the LP would apply include where there are: active efforts to avoid detection through the use of offshore vehicles or other means; large amounts involved; multiple years of non-compliance; sophisticated taxpayers involved; disclosures after CRA communications such as official statements regarding its intended compliance focus, or following CRA campaigns or correspondence; and other circumstances where a high degree of taxpayer culpability contributed to the non-compliance.

Under the LP, gross negligence penalties will be waived, and criminal prosecution will not be considered. However, all other penalties will be assessed. No interest relief will be provided.

No Relief

In addition to current ineligible submissions, a number of situations will no longer be eligible for the VDP, including, for example where there is: income from proceeds of crime; a disclosure from a corporation with gross revenue in excess of $250 million in at least two of its last five years; and a disclosure related to transfer pricing adjustments or penalties.

Conditions for Valid Disclosure

The current requirements that any disclosure be voluntary, complete, involve a penalty or potential penalty, and include information at least one year past due will remain unchanged. Some further conditions, such as the requirement that the applicant pay the estimated taxes owing on application are proposed. Payment arrangements supported by adequate security may be accepted.

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