2007 Budget Highlights
March 19, 2007
Toronto, March 19, 2007 – Finance Minister Jim Flaherty today tabled his second Federal Budget of the minority Conservative Government.
The Budget was dominated by new funding initiatives directed at the Government's 2006 campaign promise of restoring fiscal balance among the provinces and territories and implementing the measures outlined in the Government's November 2006 economic plan, including debt reduction and new funding for infrastructure, research and education, and the environment. Other significant funding measures announced in the Budget address health, social programs and security and defence.
The Budget also proposes a number of international, business and personal income tax measures.
The most significant tax-related announcements pertain to international tax. These affect both investment into Canada and investment by Canadian corporations abroad. First, the Budget proposes to eliminate Canadian non-resident withholding tax on interest payments to U.S. residents (irrespective of the relationship between the recipient and payor of the interest) and residents of other countries (where the recipient is not related to the payor of the interest). This will commence with a new protocol to the Canada-U.S. Tax Treaty (these proposals are now agreed to in principle between Canada and the U.S.), followed by an amendment to the Income Tax Act (Canada) (the "Act") to deal with interest paid to residents of other countries. Second, the Budget also proposes the introduction of an "International Tax Fairness Initiative," which notably proposes to effectively disallow an interest deduction to Canadian corporations on money borrowed to acquire shares of a foreign affiliate and proposes amendments to Canada’s foreign affiliate regime. This initiative will erode the competitiveness of Canadian corporations in the expansion of their operations abroad. Inbound and outbound finance structures will need to be reviewed in light of these changes in Canada’s approach to international taxation.
With respect to tax measures for business, the key proposals relate to adjustments to capital cost allowance rates, and temporary capital cost allowance incentives for investments in manufacturing and processing machinery and equipment.
There were many measures on the personal income tax side, most of which were aimed at low and middle-income families and individuals, and seniors.
Absent from the Budget for a second year is the Conservatives’ promise to eliminate capital gains tax for individuals on the sale of certain capital assets when proceeds are reinvested within six months.
International Tax Measures
Elimination of Withholding Tax on Interest
(i) The Canada-U.S. Tax Treaty
The Budget announces that Canadian and U.S. representatives have agreed in principle on the major elements of an updated Canada-U.S. Tax Treaty that will eliminate Canadian withholding tax on interest paid by a resident of Canada to a resident of the U.S. Significantly, the elimination of withholding tax applies where the Canadian and U.S. resident are related or do not deal at arm’s length for purposes of the Act, as well as where they are unrelated or arm’s length.
Under the Act, interest paid by a resident of Canada to a non-resident of Canada is subject to Canadian withholding tax at a rate of 25%, subject to reduction under the terms of a tax treaty between Canada and the recipient’s jurisdiction. The existing Canada-U.S. Tax Treaty limits the Canadian withholding tax on interest to 10% where the beneficial owner of the interest is a resident of the U.S. for purposes of the treaty.
The Act provides an exemption from Canadian withholding tax on interest for certain medium to long-term debt (the "5/25 Exemption"). The exemption applies to interest paid by a Canadian corporation where the non-resident lender cannot force the Canadian borrower to repay more than 25% of the principal amount of the obligation within the first five years of the term of the obligation, except in the case of an event of default. Notably, the exemption applies only where the non-resident lender is dealing at arm’s length with the Canadian corporate borrower.
The elimination of withholding tax on interest under the new protocol to the Canada-U.S. Tax Treaty would apply whatever the term of the obligation (unlike the 5/25 Exemption) and whatever the relationship between the borrower and the lender (again, unlike the 5/25 Exemption).
The elimination of withholding tax on interest paid between arm’s length parties will be effective as of the first calendar year following the entry into force of the revised treaty provisions (which in Canada requires the enactment of a statute that makes the revised treaty part of Canadian law). For interest paid between non-arm’s length parties, it is proposed that the withholding rate on interest will be phased in with the full exemption applying in the third year following entry into force of the revised treaty provisions (and subsequent years). Withholding of 7% and 4% would apply in the first year and second year, respectively, following entry into force of the revised treaty provisions. It should be noted that, where a Canadian corporation pays interest to a non-arm’s length U.S.-resident person, the thin capitalization rules will still apply to potentially restrict the corporation’s deduction of the interest expense paid to the U.S.-resident.
(ii) The Income Tax Act (Canada)
The proposed amendments to the Canada-U.S. Tax Treaty deal with withholding tax on payments of interest to residents of the U.S. only. The Budget proposes amendments to the Act to offer more general withholding tax relief on interest payments by Canadian residents.
The Budget proposes to eliminate Canadian withholding tax on interest payments to all non-residents of Canada, provided they deal at arm’s length with the payor of the interest. This will create a situation where residents of the U.S. are exempt from all withholding tax on interest, while residents of other countries will be exempt from withholding tax on interest only if they deal at arm’s length with the payor of the interest.
The Budget proposes the above amendment to the Act once the amendments to the Canada-U.S. Treaty described above are implemented.
Interest Deductibility and Foreign Expansion
The Budget proposes to effectively disallow an interest deduction for a Canadian corporation on money borrowed to acquire shares of a foreign affiliate. This is a dramatic change from Canada’s existing system (which the Department of Finance has repeatedly defended as good tax policy) and will erode the competitiveness of Canadian corporations in the expansion of their operations abroad.
Canada’s foreign affiliate system requires foreign affiliates to track their earnings in pools referred to as "exempt surplus" and "taxable surplus." Where a Canadian corporation receives a distribution from a foreign affiliate out of the foreign affiliate’s exempt surplus, the Canadian corporation is required to include the distribution in income, but is generally entitled to an offsetting tax deduction. Where a Canadian corporation receives a distribution from a foreign affiliate out of the foreign affiliate’s taxable surplus, the Canadian corporation is required to include the distribution in income, but is generally entitled to an offsetting tax deduction based on the foreign taxes paid by the foreign affiliate.
Exempt surplus generally includes the active business income of a foreign affiliate resident in a designated treaty country (generally a country with which Canada has a tax treaty) from the carrying on of an active business in a designated treaty country. Taxable surplus tracks other earnings of a foreign affiliate. The active business income of a foreign affiliate is generally not taxed in Canada until distributed to Canada. Passive earnings of a foreign affiliate are taxed in Canada on an accrual basis (as earned) under Canada’s "foreign accrual property income" or FAPI regime.
Where a Canadian corporation borrows money to purchase shares of a foreign affiliate, the deduction to the Canadian corporation is determined based on the general rules for interest deductibility. Accordingly, a Canadian corporation can generally obtain an interest deduction for interest on money borrowed to acquire shares of a foreign affiliate, even if the distributions from the foreign affiliate will be out of the affiliate’s exempt surplus and thus effectively not taxed in Canada. This mirrors the situation where a Canadian corporation borrows money to buy shares of a Canadian corporation, the dividends on which are generally exempt to the corporate recipient.
Further, the Budget proposes to effectively deny an interest deduction to a Canadian corporation for interest incurred on debt to acquire shares of a foreign affiliate. Interest on debt to fund a foreign affiliate (including to lend money to the affiliate or to assist a related party in acquiring shares of a foreign affiliate) will be tracked in a "disallowed interest pool." This pool will be reduced by the amount of any tax-deductible distributions from the foreign affiliate and the exempt portion of any gains realized on a disposition of the shares of the foreign affiliate. Any remaining balance in the disallowed interest pool will be deductible to the extent of any income realized on the shares or debt of the foreign affiliate, other than any tax-deductible distributions. The rules are cast very broadly and include borrowings by partnerships to acquire shares of a foreign affiliate.
The restriction on interest deductibility will apply to interest payable after 2007 on debt incurred on or after March 19, 2007. Existing non-arm’s length debt will be subject to the restriction only for interest payable after 2008 (or the expiry of its current term, if earlier). The restriction will apply to existing arm’s length debt only for interest payable after 2009 (or the expiry of its current term if earlier).
Canada’s Exempt Surplus Regime
The Budget proposes two changes to Canada’s exempt surplus regime. These relate to earnings of a foreign affiliate in jurisdictions that are not designated treaty countries but with which Canada has entered into a Tax Information Exchange Agreement ("TIEA") and computing exempt surplus in respect of inter-affiliate payments.
Currently, as stated above, the exempt surplus of a foreign affiliate includes the earnings of the foreign affiliate from carrying on business in a designated treaty country only. The Budget proposes that exempt surplus would include earnings from carrying on business in a jurisdiction with which Canada has concluded a TIEA.
Currently, the exempt surplus of a foreign affiliate of a Canadian corporation includes amounts (such as interest and royalties) that would otherwise be considered income from property but which are received from related foreign affiliates (provided the amounts are deductible in computing the exempt earnings of the payor affiliate). The Budget would allow such treatment only where the Canadian corporation has a qualifying interest in the payor affiliate (generally, a shareholding representing 10% of the votes and value of the payor affiliate).
These changes will apply for taxation years of foreign affiliates that begin after 2008.
Canada’s FAPI Regime
The Budget proposes that income earned by foreign affiliates in countries that have no TIEA and no tax treaty with Canada will be taxed in Canada on an accrual basis.
In the case of TIEA negotiations that begin after March 19, 2007, this treatment will apply if those negotiations are not successfully completed after the passage of five years from the earlier of the commencement of TIEA negotiations and the date on which Canada proposed the negotiations. In the case of a country that is already in the process of negotiating a TIEA with Canada, this treatment will apply if the negotiations are not successfully completed before 2014. Canada will give public notice of its invitations for TIEA negotiations.
Improving Tax Information Exchange
The Budget proposes that all new tax treaties and revisions to existing treaties to which Canada is a party implement new OECD standards to strengthen the exchange of information between the relevant states. Further, the Budget proposes to enter into TIEAs with jurisdictions with which Canada does not have a tax treaty.
Access to Tax Treaty Benefits for U.S. Limited Liability Companies
The Budget announces that Canada and the United States have agreed in principle to extend benefits under the Canada-U.S. Tax Treaty to U.S.-resident limited liability companies as one of the elements of an updated Canada-U.S. Tax Treaty.
Audit and Enforcement
The Budget proposes additional funding for auditing and enforcement by the Canada Revenue Agency in regards to international transactions undertaken by Canadian taxpayers.
Business Income Tax Measures
The following is a summary of the key proposals in the Budget directed at businesses.
Aligning CCA Rates with Useful Life
The Budget proposes to adjust the rates of capital cost allowance ("CCA") in respect of certain types of depreciable capital property in order to better align the rates with the useful life of the assets. The following types of property will have their CCA rates adjusted, generally applicable to assets acquired on or after March 19, 2007, as summarized in the following table:
Buildings used for manufacturing or processing
Other non-residential buildings
Natural gas distribution pipelines
Liquefied natural gas facilities
Temporary Incentive for M&P Machinery and Equipment
The Budget proposes a temporary increase in the CCA rate for machinery and equipment used in manufacturing and processing and included in Class 43 of Schedule II of the Income Tax Regulations to a 50% straight line rate (from 30%) for eligible machinery and equipment acquired on or after March 19, 2007 and before 2009.
The temporary incentive will ensure that eligible assets may be written off over a two year period on average (after taking into account the "half-year rule" for the year of acquisition).
Phase Out of Accelerated CCA for Oil Sands Projects
Currently, certain assets acquired for use in an oil sands project (both mining and in situ projects) are eligible for a base rate of capital cost allowance of 25% plus an additional CCA in the form of an additional allowance up to 100% of the remaining cost of the eligible assets in a particular taxation year. The Budget proposes to phase out the additional CCA that a taxpayer could claim but the regular 25% CCA rate will remain in place.
The accelerated CCA will continue to be available for assets acquired before March 19, 2007 and assets acquired before 2012 that are required to complete a project phase on which major construction began before March 19, 2007.
For assets that do not meet the grandfathering conditions, the availability of the additional allowance will be fully phased out by 2015 (i.e., 90% in 2011, 80% in 2012, 60% in 2013, 30% in 2014, and 0% in 2015).
Accelerated CCA for Clean Energy Generation
Currently, eligible energy generation equipment meeting the requirements for inclusion in Class 43.1 or 43.2 of Schedule II of the Income Tax Regulations qualify for an accelerated capital cost allowance rate of 30% and 50% accelerated CCA rate, respectively.
The Budget proposes to extend eligibility under these classes to equipment acquired on or after March 19, 2007 for generating clean energy using (i) wave and tidal energy equipment, (ii) active solar heating, (ii) photovoltaics, (iv) stationary fuel cells, (v) biogas production from organic waste, and (vi) pulp and paper waste fuels.
Prescribed Stock Exchanges
The Budget proposes to revise the concept of "prescribed stock exchange" that is currently used for a variety of purposes under the Act. The consequences of a share being listed on a prescribed stock exchange include the following:
- the share is a qualified investment for an RRSP and is a prescribed investment for certain registered investments that are limited to holding prescribed investments;
- even if it is a share of a Canadian corporation, the share will generally not be "taxable Canadian property" and, therefore, a non-resident who disposes of the share will not be subject to Canadian income tax on a resulting capital gain;
- if the share is taxable Canadian property, a person who acquires it from a non-resident does not need the non-resident to deliver an appropriate section 116 certificate to be exempted from the usual requirement to withhold and remit a portion of the purchase price on account of the non-resident’s potential Canadian tax liability;
- the share may be lent under a qualifying securities lending arrangement;
- there is a capital gains exemption for certain charitable donations of the share;
- if the prescribed stock exchange in question is located in Canada, the corporation that issued the share is a public corporation for tax purposes; and
- if the share is acquired under an employee stock option, the employee may be able to defer taxation of the associated employment benefit.
The Act’s reliance on prescribed stock exchanges has been criticized, as only a small fraction of the world’s exchanges are prescribed for purposes of the Act and the exercise of having an exchange prescribed is a lengthy process; for example, the Alternative Investment Market ("AIM") on the London Stock Exchange is not a prescribed stock exchange for this purpose.
The Budget proposes to replace the current regime of prescribed stock exchanges with a new three-tier system with the following categories:
- Designated Stock Exchange: This category will consist of stock exchanges that have been designated, by public notice, by the Minister of Finance and will include all stock exchanges that are currently prescribed by the Income Tax Regulations. This designation will initially apply for all purposes of the Act other than section 116 withholding requirements and the securities lending rules and the Government intends to review the appropriateness of having one of the other two tiers apply to provisions that will contemplate designated exchanges at the outset.
- Recognized Stock Exchange: This category will consist of stock exchanges that are located in Canada, or in another OECD-member country that has a tax treaty with Canada, and will include all designated stock exchanges. This category will apply for the purpose of the exception from the section 116 withholding requirement.
- Stock Exchange: This category will generally include any stock exchange and will include all designated and recognized stock exchanges. This category will apply for the purposes of the securities lending rules in the Act.
General Corporate Rate Reductions
The government confirmed its intention to implement previously announced reductions in the general corporate tax rate that would see the rate reduced from 21% to 19% in 2010 and to 18.5% by 2011.
Personal Income Tax Measures
The Budget proposes numerous income tax measures aimed at providing tax relief to individuals, families and seniors. Selected personal income tax measures that may be of interest to business are summarized below.
RRSPs and Other Registered Plans
The Budget proposes to expand the categories of investments that are qualified investments for Registered Retirement Savings Plans ("RRSPs") and other registered plans to include:
- any debt obligation that has an investment grade rating and that is part of a minimum $25 million issuance; and
- any security (other than a futures contract) that is listed on a designated stock exchange.
This proposal will greatly expand the types of investments that can be held by such plans to include, for example, foreign-listed trusts and partnership units.
The Budget proposes to increase the conversion age to 71 years of age from 69 years of age for annuitants of maturing RRSPs, Registered Pension Plans (RPPs), and Deferred Profit Sharing Plans (DPSPs), extending the term in which contributions may be made and benefits may accrue tax-free under these plans before they mature.
To provide employers more flexibility in offering their employees phased retirement programs, the government proposes, beginning in 2008, to allow defined benefit RPPs (other than a designated plan) to simultaneously pay to an employee up to 60% of his or her pension to him or her and, at the same time, provide further pension benefit accruals to the employee. Current rules prohibit employees from accruing further benefits under the plan if they are receiving benefits under the plan. The relief will be available only to employees aged 55 years and over who are entitled to an unreduced pension and who deal at arm’s length with the employer.
Mineral Exploration Tax Credit
Flow-through shares allow companies to flow through tax expenses associated with their Canadian exploration activities to investors, who can deduct the expenses in calculating their own taxable income. The mineral exploration tax credit is an additional benefit, available to individuals who invest in flow-through shares, equal to 15% of specified mineral exploration expenses incurred in Canada and renounced to flow-through share investors. The credit is currently scheduled to expire at the end of March 2007.
The Budget proposes to extend eligibility for the mineral exploration tax credit to flow-through share agreements entered into on or before March 31, 2008. Under the "look-back" rule, funds raised with the benefit of the credit in 2008, for example, can be spent on eligible exploration up to the end of 2009.
Donations of Securities to Private Foundations
Currently, the inclusion rate on capital gains realized on a donation of publicly-listed securities to a registered charity is nil. The Budget proposes to extend this treatment to donations of publicly-listed securities to private foundations for gifts made on or after March 19, 2007.
The Budget also introduces a new set of rules described as the "excessive business holding regime" designed to address the Government's concern that, by virtue of the combined shareholdings of the donor and a private foundation with which the donor has a relationship, the donor might retain influence over donated company shares. The regime contemplates the imposition of a penalty on the foundation if the combined holdings of the foundation and persons with whom the foundation does not deal at arm's length exceed certain thresholds.
The new excessive business holdings regime will be applicable to taxation years of foundations beginning after March 19, 2007, with divestments (if required) to be phased in over a period of up to five years.
Registered Education Savings Plans
The Budget proposes to eliminate the $4,000 annual contribution limit to a Registered Education Savings Plan (RESP), and increase the lifetime contribution limit to $50,000 from $42,000. The maximum annual RESP contribution qualifying for the 20% Canada Education Savings Grant (CESG) will increase to $2,500 from $2,000, and the corresponding maximum CESG per beneficiary will increase to $500 from $400 per year. The maximum CESG for any particular year will increase to $1,000 from $800 if there is unused grant room because of contributions below the maximum CESG-eligible contributions in previous years. However, the $7,200 lifetime CESG limit per beneficiary will remain unchanged.
The Budget also proposes to relax the eligibility requirements on the payment side such that more part-time programs will entitle a student to receive payments from their RESPs.
Sales and Excise Tax Measures
The Budget announced a number of changes to the GST as well as certain excise tax measures. The Budget also reiterated the Conservative Government's objective of encouraging the five provinces that levy retail sales taxes to harmonize those taxes with the GST thereby reducing the consumption tax burden on businesses.
The main Budget proposal in connection with GST is a new zero-rating rule that will apply to exports of intangible personal property. Currently, only limited relief from the GST was available for these types of transactions. The new rule was intended to recognize the increased variety and economic significance of products that can be supplied by way of the internet and was targeted at providing relief on supplies of intangible personal property provided to non-resident who are not GST-registered. Certain types of supplies of intangible personal property are excluded from zero-rating, for example, property supplied to an individual who is not outside Canada and property relating to real property and goods situated in Canada.
The Budget confirmed that the changes to the GST rules applicable to financial institutions announced on January 26, 2007 will be implemented.
Several changes were announced to federal excise taxes. These include the introduction of a "green levy" ranging from $1,000 to $4,000 on passenger vehicles (other than pick-up trucks) with a weighted average fuel consumption of 13 litres or more per 100 kilometers. The levy will be payable effective March 20, 2007 by the manufacturer at the time of delivery to a purchaser or by the importer on importation, but will not apply to existing dealer inventories.
The Budget also proposes a temporary financial incentive for provincial governments to eliminate their capital taxes, the amount which will correspond to the federal corporate income tax revenue gain from qualifying provincial capital tax reductions.
The Budget states that new draft regulations concerning the due-date for the issuance of Trust T3 information slips are expected to be released in the near future. The new draft regulations are intended to more appropriately balance the desire of taxpayers for sufficient time to prepare their tax returns and the desire of commercial trusts (including income trusts) for sufficient time to compute their income and prepare their T3 information slips.
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