1. Perspective of this paper. The writer of this paper is not deeply familiar with the provisions and application of the Canada Income Tax Act (the "ITA") or of the various regulations made thereunder ("Regulations"). Rather, the writer is a Manitoba lawyer whose practice has included - and continues to include - acting for buyers and sellers of real estate and real estate interests. "Real estate interests" clearly goes beyond fee simple (ie, unlimited or indefinite) ownership of lands or lands with improvements. But in acting for buyers and sellers of real estate interests, the writer's experience has been that overwhelmingly, his clients have sought legal services for the purpose of facilitating sales and purchases of lands or lands and premises owned by - or sought to be owned by - the client in fee simple or freehold ownership. In other words, the writer's experience is similar to that of the vast majority of Manitoba practitioners, most of whom, to a greater or lesser extent, are called on to assist clients in entering into and closing real estate purchase and sale contracts. In most cases, lawyers like the writer (an "average commercial lawyer") does not have to have an in-depth understanding of the ITA or its Regulations. When such knowledge is needed, the average lawyer can seek it out from those who are more expert in the field. But what should the average lawyer know about, at least generally, and in advance, so as to be able to know when she or he has a need to seek out expert advice in the context of the application of the ITA and its Regulations to a sale or purchase of real estate?
As one gains experience in the practice of law, it becomes very obvious that an average lawyer does need to have at least a rudimentary understanding of the application of the ITA and its Regulations in assisting one's clients in various dealings in real estate interests. Failure by an average lawyer to have - and utilize - this rudimentary knowledge, or with such rudimentary knowledge in hand, failure by an average lawyer to consult and retain the assistance of a more expert lawyer (or perhaps an accountant) can result in:
(a) loss to the client (ie, adverse income tax consequences);
(b) loss to the average lawyer arising by virtue of breach of professional duties and responsibilities owed by the average lawyer to her/his client; and
(c) loss suffered by the average lawyer's colleagues, as partners in a law firm, depending of course on whether or not the firm is constituted as a limited liability partnership and the degree of the average lawyer's partners' involvement in/responsibility for the average lawyer's breach of its obligations owed to the average lawyer's client.
2. The ITA "problem". The problem considered in this paper is related to the taxation by the Canadian government (the Canada Revenue Agency or the "Tax Authority") on the increase in value of a real estate holding which is realized by the holder when the holder sells the holding to a buyer for a consideration in excess of the amount that the holder originally paid to acquire the holding plus the value of the improvements made to the holding by the holder during the course of the holder's holding. Thus, if "A" being a resident in Manitoba sells to "B", who is also a resident of Manitoba, "A"'s landholding situated in Manitoba for a price of $1,000,000.00, and, "A" originally acquired the landholding for $100,000.00 and thereafter put another $100,000.00 improvements into the landholding, "A"'s gain in value (ie, "A"'s capital gain) is $800,000.00. Under the ITA, "A" is liable to pay an income tax on one-half of "A"'s gain, namely a tax on $400,000.00. In this situation, assuming the highest marginal rate of income tax being applicable to the calculation of "A"'s income for income tax purposes, "A" would have to pay the Canadian government income tax of $200,000.00.*
The average lawyer does not have to be concerned about ensuring that the gain made by "A" is properly accounted for to the Tax Authority and paid or otherwise satisfied to it. That goes for the average lawyers acting for each respectively of "A" and "B". Of course both lawyers should generally remind their clients to keep track of and maintain appropriate records to reflect the real estate transaction just completed. And lawyers should either advise their clients to consult with their accounting advisors, and, with the clients' authorizations to do so, send particulars of the recently concluded transaction to each party's accountants. There are other"income taxation aspects" to the above-
described real estate transaction which need to be considered by both the clients' accountants and by the clients' lawyers - average or expert - as well, but this paper is focused on the Canadian government income tax treatment of real estate gains.
Now, imagine the same fact scenario as described above, but with "A" not being a resident of Canada. "A" may be a resident of the United States, Australia, Russia, China, France, Iceland, etc. - anywhere but Canada. The taxation rules relating to this alternative scenario are, in one way, exactly the same as they would be where "A" was a Canadian resident. Notwithstanding that "A" is not a resident of Canada, under Canadian law, "A" is liable to pay tax on "A"'s gain on its sale of the Canadian situated real estate holding to "B". Note that the initial responsibility would appear to be placed on "A". This seems logical and reasonable, because that it is "A" who gets the benefit of the gain on the sale, not "B". But "A" is beyond the clutches of the Tax Authority and if "A" ignores "A"'s legal - and arguably moral - responsibility to pay the tax "A" owes, the Tax Authority will lose out. If a large number of non-resident owners of Canadian properties sell their holdings and escape - without paying Canadian taxes - on their, perhaps, substantial gains, the Canadian government will be out a very considerable amount. Arguably, this will strain the resources of the Canadian government to perform the tasks and duties it is allocated by law, its constitution and convention. So what does the Canadian government do, or more accurately, what has the Canadian government done in order to remediate this situation and avoid these potential losses? Clearly, the answer is that, based on a conclusion of what is best "public policy", the government has determined that if it can't make "A" pay the tax it initially owes, it will place the burden on "B" who continues to be resident in Canada and thus within the clutches of the Tax Authority.
But how is this done? Essentially, it is done by Canadian law requiring "B" to either ensure that "A" makes arrangements with the Tax Authority in advance of the closing of the sale and purchase transaction, to pay for or put up security for the tax applicable to the anticipated gain on the sale and purchase, or, it requires "B" to deduct a certain amount of the proceeds of sale that "B" would otherwise pay to "A", and instead, pay those monies to the Tax Authority to be applied by it on account of the taxes to be owed by "A". One could argue that this is not a fair or equitable solution, insofar as "B" is concerned, but it appears to be the only workable solution from the government's perspective. In fact, this rule - or group of related rules - dealing with the taxation of the sales of Canadian property by non-residents has for some time been and continues to be "carved in stone". It is something that we must all accept and deal with.
But how do we deal with it? Fortunately, the ITA has some additional rules relating to what a buyer can do to protect itself from having to be forced to pay twice for the property it buys from the buyer's non-resident seller (the buyer first pays the entire purchase price to the non-resident seller and then later pays the seller's Canadian tax on the seller's gain to the Tax Authority). As noted above, the buyer can protect itself by ensuring that the seller makes its peace with the Tax Authority before the closing; this involves getting a "Certificate of Clearance" from the Tax Authority which the buyer will need to have a copy of to facilitate its own dealings with the Tax Authority. Or, the buyer itself must make a payment on account of the seller's anticipated tax to the Tax Authority, thereby reducing what the buyer has to pay to the seller by that amount. These are the alternatives available to the buyer where the buyer knows that the seller is a non-resident of Canada. But what if the buyer does not know that the seller is a non-resident or is uncertain as to the seller's residency status? The ITA does contemplate this situation, and if a buyer "fits within the rules", the buyer will not be responsible for the seller's tax even though it turns out that the seller was not a resident of Canada and the seller fails to pay the tax.
3. Does or should the buyer know that the seller is a non-resident of Canada? Section 116(5)(a) of the ITA states that "Where in a taxation year a buyer has acquired from a non-resident person any taxable Canadian property (other than depreciable property of excluded property) of the non-resident person, the buyer, unless, after reasonable inquiry, the buyer had no reason to believe that the non-resident person was not resident in Canada … is liable to pay … as tax … on behalf of the non-resident person … (the non-resident person's capital gain tax) …". I believe that there are two situations contemplated here:
(a) where a buyer knows, virtually at the outset, perhaps from past dealings with the seller or from currently available information, that the seller is a non-resident; and
(b) where the buyer does not know, one way or the other, whether the seller is a non-resident person, or, the buyer has some indication/some information which perhaps suggests that the seller is a non-resident person.
In either of these cases, the buyer has to conclude that the seller either is or is not a non-resident person. They buyer may be able to so conclude immediately without any necessary inquiry. If no such inquiry is required, then the writer would argue that no inquiry is a "reasonable" inquiry. But if there is any doubt in the mind of the buyer, the buyer must then make a further inquiry in order to be in a position to make a more definitive conclusion as to the residence or non-residence of the seller. And that inquiry has to be "reasonable". Presumably, "reasonable" means "reasonable in the circumstances".
The real question here is what should the average lawyer do when confronted with a situation where the average lawyer's client wishes to purchase a real estate holding from a seller and the buyer and the buyer's average lawyer don't have a clue as to the residency (or non-residency) of the seller or one or both of them have information or could easily access information which would - perhaps - enable one or both of them to make a more accurate conclusion as to the residency/non-residency of the seller?
4. Current practice to determine residency/non-residency in real estate sales and purchases. The common practice for lawyers handling real estate transactions is to have the parties agree to include a term in the purchase and sale contract which essentially is a warranty by the seller that the seller is not a non-resident of Canada and will not be such continuously down to closing. This should be accompanied by a further promise by the seller to provide a statutory declaration at closing which states that, at closing, the seller is (or continues to be) not a non-resident of Canada. And a properly completed closing statutory declaration should be obtained.
The question raised in this paper is whether or not it will always be sufficient - to protect the buyer - for the buyer's lawyer to simply require receipt at closing from the seller or the seller's lawyer of a statutory declaration dealing with the seller's residency/non-residency? All lawyers are aware of the concept of "constructive" knowledge. If I have no knowledge of a particular fact ("Unknown Fact") because I have shut my mind to/ignored various other facts or suggestions which, were I to consider/think about them, would likely result in my becoming fully and consciously aware of the Unknown - but then fully known - Fact, a Court will hold that I am in the same position as if I had complete awareness of the fact from the outset. This concept of not being able to intentionally shut one's mind to matters because they are or might be "unpleasant" would apply to buyers and buyers' lawyers relying on residency/non-residency statements in closing statutory declarations.
If the residency/non-residency of a seller is the primary fact or matter to be determined, what sort of warning signs or "red flags" should a lawyer - and in particular, an average lawyer - be on the lookout for in providing legal guidance to a buyer? Before dealing with the Kau case (see hereinbelow), it would be useful to categorize warning signs/red flags as follows:
(a) warning signs/red flags which are evident "up-front", and obvious when the buyer's lawyer first reads the contract, the broker listing agreement, the initial title and other search information obtained by the buyer's lawyer, etc. ("Up-Front Red Flags"); and
(b) warning signs or red flags which are not immediately apparent but become so to the buyer's lawyer as the buyer's lawyer digs more deeply into the subject matter of her/his retainer, including ongoing communications with various parties - including the seller's lawyer and the real estate broker - over the period of time commencing with when the buyer's lawyer first gets the contract, and ending with the closing ("Later Discovered Red Flags").
5. The Federal Court of Canada case Anibal Kau and Her Majesty The Queen, 2018 TCC 156, August 27, 2018, with the Court sitting in Halifax, Nova Scotia. This case (the "Kau Case") deals with a real life scenario impacted by the above-referenced ITA rules regarding the responsibility of a real estate buyer for the buyer's seller's capital gain tax on the sale of the seller's real estate. In particular, it deals with and gives some meaningful guidance as to the sorts of Up-Front Red Flags and Later Discovered Red Flags which average lawyers should be aware of.
These are the pertinent elements of the Kau Case:
(a) Mr. Kau (the "Buyer") entered into a purchase and sale agreement on June 15, 2011 for a Toronto situation condominium unit.
(b) The Buyer retained a lawyer to handle the real estate transaction (the "Buyer's Lawyer"). The Buyer was a Canadian resident, the property was located in Canada and the Buyer's Lawyer was also based in Canada (in Toronto).
(c) The seller was a Mr. Yetka (the "Seller"), and the Seller also engaged Toronto counsel (the "Seller's Lawyer") to handle the Seller's interests in completing the purchase and sale transaction.
(d) The Buyer knew from a prior visit to the condominium unit that the Seller didn't live there and that it was in fact an investment property for the Seller.
(e) In short order, the Buyer's Lawyer determined through searches and other preparatory work for the closing that the Seller purchased the property in 2009 and that his then address for service was an address in Danville, California. This (California) address (for service purposes) was the same (California) address given to the Buyer in connection with the current transaction.
(f) On June 17, 2011, the Seller's Lawyer advised the Buyer's Lawyer that the Seller would be signing the closing documents in California. Subsequently (on June 22, 2011), the Seller's Lawyer revised the closing documents and indicated to the Buyer's Lawyer that they too would be signed in California.
(g) On June 22, 2011, the Buyer's Lawyer sent the Seller's Lawyer a list of closing requisitions. Included was a requirement to provide "satisfactory evidence of compliance with … Section 116 of the Income Tax Act (Canada)".
(h) On June 24, 2011, the Seller signed a "one sentence unsworn" statement before a California notary public in Danville, California, which was described as an "affidavit". The Seller's statement therein was that "I am not a non-resident of Canada within the meaning of Section 116 of the Income Tax Act (Canada) nor will I be a non-resident of Canada at the time of closing.". In the jurat section of this "alleged" affidavit, the notary stated that the statement therein had been "Declared before me". There was no reference to the statement being either a sworn declaration or a solemn declaration or that the statement had been declared under penalty of perjury.
(i) On closing (June 30, 2011), the Seller's Lawyer delivered all documentation to the Buyer's Lawyer. The Buyer's Lawyer did not withhold the required (25%) nor indeed any portion of the purchase price. No "Clearance Certificate" was sought or obtained from the Tax Authority.
The Court concluded that the Buyer had "after reasonable inquiry … reason to believe that the non-resident person (ie, the Seller) … was not resident in Canada.
At the hearing, the Buyer's Lawyer stated that it was his understanding that "it was standard practice in Ontario to rely on affidavits for determination of residence.". The writer believes that this is indeed essentially standard practice in Manitoba.
The problem is that in the Kau Case, not only was the so called "affidavit" improperly constituted and completed, but, given the above-described facts, it was also relatively easy for the Court to conclude that the Buyer's Lawyer had ignored or in any event was not sufficiently alert to the existence of a number of Up-Front Red Flags and Later Discovered Red Flags.
So the "lessons" of the Kau Case would appear to be that it is necessary for lawyers - especially buyer's lawyers - to be on the lookout for various Red Flags. The Kau Case illustrates a number of potential Red Flags, but in any given scenario, there may be others.
What to do when you either know for sure that a seller is a non-resident OR you have some suspicion that the seller may be a non-resident? If you know for sure (that is, the facts clearly indicate non-residency), then it is not likely that the seller's lawyer will in any way balk at your requiring - before closing - confirmation that your client can withhold the required portion of the purchase price (and account for it to the Tax Authority) or that you require the seller's lawyer to make peace with the Tax Authority and get a "Clearance Certificate". As previously mentioned, most real estate purchase and sale transactions will not involve a non-resident seller. However there may be some resistance on the part of the seller's lawyer where the buyer's lawyer has some indication of non-residence or the possibility of non-residence, and the buyer's lawyer requests the seller's lawyer to either authorize the appropriate holdback from the purchase price or make arrangements before closing (and in sufficient time before closing) to get a "Clearance Certificate". On the other hand, there may be little resistance on the part of the seller's lawyer where there is a reasonably lengthy period of time between the contract and closing dates. If there is enough time, then it won't be that much of a burden - let alone an impossibility - for the seller's lawyer to make the appropriate arrangements. But where there is a very short time-window between the contract date and the closing, there will no doubt be substantial resistance on the part of the seller's lawyer. Nevertheless, the fact is that if the buyer's lawyer doesn't insist upon the seller's lawyer making the appropriate arrangements by closing and the Tax Authority decides that the buyer's lawyer (and/or the buyer) had sufficient information available which should have triggered further inquiries/due diligence on the part of the buyer's lawyer (and/or the buyer), then the buyer may end up paying the seller's income tax on the seller's capital gain. Needless to say, another Court might hold that the buyer's lawyer was negligent in the performance of his/her duties owed to the buyer, with the resulting cost consequences for the buyer's lawyer.