Beware these T1135 traps

Clients with more than $100,000 in foreign property need to file Form T1135. It’s one of CRA’s more challenging forms, but even the best accountants can’t ensure proper filing if they don’t have the information they need. Here are the key issues.

Foreign insurance

Some clients may hold foreign-issued life insurance policies. Often that happens because they relocated to Canada from other jurisdictions for work or other reasons, and already had the insurance before the move, notes Zaheed Alibhai, senior manager in Deloitte’s tax practice in Toronto. Inheriting policy ownership from a relative outside Canada is another reason.

The policy needs to be reported in Box 6 of the T1135, “Other Property outside Canada.” But the form asks for “cost amount,” a term that isn’t normally used when doing insurance policy valuations.

CRA addresses the issue in an FAQ: “The adjusted cost basis of an interest in a life insurance policy […] can be considered as a reasonable approximation of the cost amount of the property for the purpose of Form T1135.”

When you need to find out the adjusted cost basis (ACB) of Canadian-issued insurance, you usually ask the policy’s broker, who gets it from the insurer. But when you need the ACB for a foreign-issued policy, the process may be far more complex, Alibhai warns. “The ACB is the amount by which premiums paid by the policyholder exceed the Net Cost of Pure Insurance (NCPI). But NCPI is a Canadian concept, so a lot of foreign insurers won’t have that calculation. They may have their own cost basis calculation, but it doesn’t line up with the Canadian definition.”

That foreign version of cost basis won’t cut it for T1135 reporting purposes, adds Alibhai. “The taxpayer has to figure out what the ACB is in line with the Canadian definition.”

Step one is to ask the insurer that issued the policy. “Some foreign issuers may have systems to advise what the Canadian ACB is, especially if they have substantial Canadian customer bases,” notes Alibhai. If the insurer hasn’t determined the Canadian ACB, the calculation must be done from scratch.

But don’t reach for your calculator. The formula for ACB, detailed in section 148(9) in the Income Tax Act, “is a complex calculation even for a tax professional,” says Alibhai. “Some of the components have an actuarial flavour to them, and there are sub-formulae within the formula.”

This means your client will need to hire accountants and actuaries to crunch the numbers. “And [that] has to be done every year, because the ACB changes every year,” explains Alibhai. “As time goes on, the mortality rate—the chance of dying—increases, and therefore the ACB will [be] reduced.”

While the foreign insurer may not have the Canadian ACB, it will have the raw information needed to do the calculation. Since the T1135 is an annual requirement with late-filing penalties ($25 per day, up to $2,500), it’s critical clients obtain this information promptly at year-end so there’s ample time to do the calculation before the April deadline. Alibhai suggests clients make arrangements with their brokers to provide the necessary information as a matter of routine at the start of every year.

Doing the ACB from scratch every year will definitely hike your client’s accounting bill. “It is without question an administrative burden on the taxpayer,” says Alibhai. But it needs to be put in context of the overall filing requirement, he adds. “It may be a drop in the ocean for a high-net-worth individual whose tax [situation] has so many other components.”

What’s a resident?

Box 2 of the T1135 is for reporting shares of non-resident corporations, other than foreign affiliates. (CRA’s instructions on the T1135 define a foreign affiliate corporation as “a non-resident corporation […] of which you hold at least 1% of the shares individually, and, either alone or with related persons, hold 10% or more of the shares.”)

Dale Franko, managing director at Moodys Gartner Tax Law in Calgary, explains the concept of residency for tax purposes takes two main forms: factual and deemed.

Say your client establishes a corporation in Delaware. “Arguably, it’s factually a non-resident corporation. But CRA also [looks at] central management and control,” Franko notes. This means that while the corporation is factually non-resident, because it’s controlled by persons resident in Canada, it could be deemed resident for tax purposes. So, if the corporation’s deemed resident because the “mind and management” are in Toronto, should it be excluded from the T1135?

How to get reassessed by CRA

Normally the CRA has a three-year window to reassess returns for a given tax year.

But the agency has the authority to extend that period to six years if:

• a taxpayer fails to file the T1135, files it late or fails to correctly report all the necessary information; and
• a taxpayer fails to include some part of his specified foreign income on his tax return.

So, if a client files late, but completes the T1135 flawlessly and includes all foreign income on her tax return, it’s not enough to trigger the extended reassessment period, notes Phil Nadler, a partner at Richter Tax in Montreal. But take this case: she files one day late, fills out the T1135 flawlessly, but on her tax return forgets to report $10 of interest income from a U.S. chequing account she uses when she’s at the condo in Florida. “Being a day late, plus failing to report even a nominal amount could [trigger] that three-year extension.” And the reassessment isn’t just for foreign income: that one-day, $10 mistake opens the entire tax filing to re-evaluation.

CRA has said that for T1135 purposes, clients need to report on a factual basis, says Franko, so the corporation shares go on the form.

Box 3, “Indebtedness owed by non-resident,” can also catch clients off guard. Say your client loaned his sister, who lives in North Dakota, $15,000. Regardless of whether he’s getting interest, it’s a foreign-sourced receivable he should report, says Phil Nadler, a partner at Richter LLP’s office in Montreal. If your client’s receiving distributions from a non-resident trust, he needs to fill out Box 4.

To do so properly, he needs to know what type of beneficiary he is, says Franko. Some beneficiaries are capital-only, some are income-only; others may be both income and capital. Box 4 has separate fields for income and capital, and failure to put the correct amount in the correct field means an incorrect filing (see “How to get reassessed by CRA,” page 24). The trustee’s written declaration of the distribution will specify its type.

Box 5 is a good example of why most clients should never try to complete the T1135 themselves.

It asks for “Real property outside Canada (other than personal use and real estate used in an active business).”

Franko notes most people don’t know CRA’s definition of an active business. So, while the T1135’s instructions say real property should be included in Box 5, the reference to an active business may throw off people who make a lot of money renting out multiple units.

Says Franko: “It’s possible for someone to look at this and say, ‘Is this active? Yes, I rent it out all the time. And is it a business? Yes, it could be.’ So they don’t put it on the form,” even though they should.

ADRs and ETFs

American Depositary Receipts (ADRs) facilitate trading in shares listed on exchanges in non-U.S. markets, such as Europe. The ADRs will be listed on the NYSE, for instance, but the underlying shares in foreign corporations are not.

These investments need to be reported on the T1135—but how? Say your client has an ADR that represents shares in a German-based corporation. CRA’s position, says Franko, is that the client needs to report them as shares in a German corporation, not as U.S.-based property.

The same goes for ETFs that are based in the United States, potentially creating a significant administrative burden. If a U.S.-based emerging markets ETF has 100 underlying holdings in seven countries, your client’s technically required to report on each of those subholdings. “CRA says you have to try to get that information, but a lot of times it’s not available,” explains Jonathan McKearney, a tax advisor at Moodys Gartner Tax Law. In that case, the client can report in aggregate by country.