2016 CANADIAN FEDERAL BUDGET COMMENTARY – TAX INITIATIVES
On March 22, 2016 (Budget Day), Finance Minister Bill Morneau tabled in the House of Commons the new Liberal Government’s first budget, Growing the Middle Class (Budget 2016). Consistent with prior budgets, Budget 2016 continues to close perceived loopholes in the tax system, including small business deduction planning, back-to back arrangements, debt parking and life insurance transactions. Contrary to the pre-budget rumours, however, Budget 2016 does not include measures increasing the capital gains inclusion rate, curtailing the favourable taxation of employee stock options or eliminating flow-through shares.
With a weakened economic outlook and some significant spending initiatives, Budget 2016 projects a deficit of $29.4 billion in 2016-17 and a deficit of $29 billion in 2017-18, which gradually declines to a deficit of $14.3 billion in 2020. This compares with a deficit of $5.4 billion in 2015-16. Not surprisingly, the Government proposes the legislative repeal of the Federal Balanced Budget Act.
Our commentary on the tax initiatives in Budget 2016 follows.
Base Erosion and Profit Shifting
Budget 2016 reiterates Canada’s commitment to the Base Erosion and Profit Shifting (BEPS) initiative led by the G20 and the Organisation for Economic Co-operation and Development (OECD). More particularly, it announces that the Government will be moving forward with a number of BEPS-related changes, including the introduction of country-by-country reporting for large multinational enterprises (MNEs), the application by the Canada Revenue Agency (CRA) of revisions to the OECD Transfer Pricing Guidelines recommended as part of the BEPS project, the development of a multilateral instrument implementing treaty-related BEPS recommendations and the spontaneous exchange of certain tax rulings with foreign tax authorities.
The BEPS project’s recommendations included the introduction of a minimum country-by-country reporting standard into the OECD Transfer Pricing Guidelines. The country-by-country report is a form that a large MNE will be required to file with the tax administration of the country in which the MNE’s ultimate parent entity resides. A country-by-country report will include the global allocation, by country, of key variables for the MNE, including revenue, profit, tax paid, stated capital, accumulated earnings, number of employees and tangible assets, as well as the main activities of each of its subsidiaries.
The country-by-country reporting regime is premised on the ability of jurisdictions in which the subsidiaries of an MNE operate to receive a copy of its country-by-country report from the state of residence of the MNE’s parent. Where this is not possible because the parent’s jurisdiction has not implemented country-by-country reporting, because the jurisdictions have not implemented a legal framework for the automatic exchange of information (e.g., a tax treaty or the Multilateral Convention on Mutual Administrative Assistance in Tax Matters) or because the jurisdictions have failed to enter into a competent authority agreement relating to country-by-country reporting, the tax authorities in each subsidiary’s jurisdiction may be able to require the subsidiary to file a country-by-country report. An MNE may avoid having this filing requirement imposed on multiple subsidiaries by designating one subsidiary to be a “surrogate” parent entity. As a result of this designation, provided that the surrogate is located in a jurisdiction that has implemented country-by-country reporting, the surrogate may file the country-by-country report on behalf of the MNE as a whole.
Budget 2016 proposes to implement country-by-country reporting. This measure will apply only to MNEs with total annual consolidated group revenue of €750 million or more. Where such an MNE has an ultimate parent entity that is resident in Canada (or a Canadian resident surrogate), it will be required to file a country-by-country report with the CRA within one year of the end of the fiscal year to which the report relates.
Country-by-country reporting will be required for taxation years that begin after 2015, with first exchanges between jurisdictions of country-by-country reports expected to occur by June 2018.
Revised Transfer Pricing Guidance
The recommendations arising from the BEPS project included revisions to the Transfer Pricing Guidelines aimed at clarifying and improving the arm’s-length principle. The Government believes that the revisions are consistent with the CRA’s current auditing practices and has confirmed in Budget 2016 that they will be adopted and applied on a going forward basis. That said, given that the BEPS project participants are still engaged in follow-up work on the development of a threshold for the simplified approach to low-value-adding services and the definition of risk-free and risk-adjusted returns for minimally functional entities (often referred to as “cash boxes”), the Government will decide on a course of action with regard to these particular measures only after the outstanding work is complete.
Budget 2016 confirms the Government’s commitment to address treaty abuse in accordance with the “minimum standard” recommended as part of the BEPS project. This minimum standard includes the incorporation of an express statement in tax treaties that the parties’ intention is to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, and the adoption of either a general anti-abuse rule in treaties that uses the criterion of whether one of the principal purposes of an arrangement or transaction was to obtain treaty benefits in a way that is not in accordance with the object and purpose of the relevant provision, or a more mechanical and specific anti-abuse rule that requires satisfaction of a series of tests in order to qualify for treaty benefits (a limitation on benefits rule such as that in the current Canada-U.S. Income Tax Convention).
Budget 2016 emphasizes that Canada may seek to implement the standard through both bilateral negotiations and the entering into of a multilateral instrument that will be developed in 2016. The Government notes that Canada is actively participating in the development of such an instrument with a view to streamlining the implementation of this and other treaty-related BEPS recommendations.
Spontaneous Exchange of Tax Rulings
Budget 2016 includes a commitment to implement the BEPS project’s recommendation that certain forms of tax rulings be automatically exchanged between tax authorities. Rulings covered will include (i) rulings related to preferential regimes, (ii) cross-border unilateral advance pricing arrangements, (iii) rulings giving a downward adjustment to profits, (iv) permanent establishment rulings, (v) conduit rulings and (vi) any other type of ruling agreed to in the future.
The exchange of such rulings will commence in 2016 with other jurisdictions that have committed to the minimum standard.
Subsections 212(3.1) to (3.3) of the Income Tax Act (Canada) (Tax Act) contain rules intended to ensure that Part XIII withholding tax is not circumvented by a financing arrangement in which a non-resident of Canada, instead of providing debt funding directly to a taxpayer that is a resident of Canada, provides it through a non-resident intermediary — for example, by lending funds to the intermediary on condition that the intermediary make a loan to the taxpayer. These so-called “back-to-back loan” rules largely parallel subsections 18(6) and (6.1), which are targeted at similar financing arrangements that may otherwise circumvent the thin capitalization rules.
Budget 2016 proposes a number of measures to extend the application of these rules, including to domestic loan transactions. Although draft legislation is not included in the Budget Documents, the new rules are expected to build upon and, in the case of the back-to-back shareholder loan rules, parallel the existing back-to-back loan rules.
Back-to-Back Rules for Rents, Royalties and Similar Payments
Paragraph 212(1)(d) of Part XIII of the Tax Act imposes a 25% withholding tax on rent, royalties and similar payments (collectively referred to as “royalties”) made by Canadian-resident persons to non-residents, subject to reduction under an applicable tax treaty. As the rate reduction is not the same in all of Canada’s tax treaties, and as some countries do not have a tax treaty with Canada, there is an incentive to interpose, between a Canadian-resident payor of royalties and a non-resident payee, an intermediary entity located in a favourable tax treaty country (referred to as the “intermediary”).
As noted in the Budget Documents, while interposing an intermediary in a royalty payment structure may be subject to challenge under existing anti-avoidance rules, Budget 2016 proposes to address these back-to-back arrangements directly by extending the basic concepts of the back-to-back loan rules in Part XIII to royalty payments.
If applicable, the proposed rules will deem the Canadian-resident payor to have made a royalty payment directly to the ultimate non-resident recipient, with the attendant withholding tax implications. For the proposed rules to apply, the arrangement between the Canadian-resident payor and the intermediary (referred to as the “Canadian leg”) must be sufficiently connected to the arrangement between the intermediary (or a person or partnership that does not deal at arm’s length with the intermediary) and the ultimate non-resident recipient (referred to as the “second leg”), in addition to there being a lower rate of Part XIII withholding tax otherwise applicable in respect of the Canadian leg than if the Canadian-resident payor had made the royalty payment directly to the ultimate non-resident recipient.
More specifically, a royalty payment under the Canadian leg will be sufficiently connected to a payment under the second leg (thus triggering the rules) if one of the following conditions is met:
- the amount that the intermediary is obligated to pay is established, in whole or in part, by reference to:
- the royalty payment made by, or the royalty payment obligation of, the Canadian-resident person; or
- the fair market value of property; any revenue, profits, income, or cash flow from property; or any other similar criteria in respect of property, where a right to use the property is granted under the Canadian leg; or
- it can reasonably be concluded based upon all the facts and circumstances that the Canadian leg was entered into or permitted to remain in effect because the second leg was, or was anticipated to be, entered into. In this regard, the fact that the Canadian leg and the second leg are in respect of the same property would generally not be considered sufficient on its own to support the conclusion that this condition has been met.
This measure will apply to royalty payments made after 2016.
Character Substitution Rules
Budget 2016 proposes measures to prevent the avoidance of the back-to-back rules in Part XIII (in respect of back-to-back loans and, as discussed above, royalty arrangements) by having the arrangement between the intermediary and the ultimate non-resident recipient (i.e., the “second leg”) provide for payments that are not technically, but are economically similar to, interest or royalty payments.
The Budget Documents provide the following examples of the types of arrangements that these so-called “character substitution rules” are intended to address:
- interest is paid by the Canadian-resident person to the intermediary, whereas a royalty is paid by the intermediary to the ultimate non-resident recipient, and vice versa; and
- interest or a royalty is paid by the Canadian-resident person to the intermediary, and the ultimate non-resident recipient holds shares of the intermediary that include certain obligations to pay dividends or that satisfy certain other conditions (e.g., they are redeemable or cancellable).
As is the case with the existing back-to-back loan rules and the proposed back-to-back royalty rules, the proposed rules will require that there be a sufficient connection between the two arrangements (i.e., the Canadian leg and the second leg). If the character substitution rules apply, an additional payment of the same character as that paid by the Canadian resident to the intermediary will be deemed to have been made directly by the Canadian resident payor to the ultimate non-resident recipient from which Part XIII tax will be required to be withheld.
The Budget Documents do not provide detailed commentary as to the tests that will apply to determine whether a sufficient connection exists, but do note that such tests will be similar to those used in the existing back-to-back loan rules and the proposed back-to-back royalty rules, adapted to reflect the particular circumstances of the targeted arrangements.
It is not clear how one would determine if the shares of the intermediary include certain obligations to pay dividends, as it is usually the case that dividends must be declared by the board of directors even if the shares provide for cumulative dividends. It is also not clear whether the reference to holding shares of the intermediary means that the intermediary must be a corporation in order for the rules to apply.
This measure will apply to interest and royalty payments made after 2016.
Back-to-Back Shareholder Loan Rules
The shareholder loan rules contained in subsection 15(2) of the Tax Act generally provide that if a shareholder of a particular corporation (or a person connected with a shareholder) receives a loan from or becomes indebted to the particular corporation in a taxation year, the amount of the loan or indebtedness must be included in computing the income for the year of the shareholder (or connected person), subject to certain exceptions (e.g., subsection 15(2) does not apply if the shareholder is a corporation resident in Canada, if the indebtedness is between non-resident persons, if the loan or indebtedness is a “pertinent loan or indebtedness” or if the loan or indebtedness is repaid within one year after the end of the taxation year of the particular corporation). Where the shareholder is a non-resident of Canada, paragraph 214(3)(a) deems the amount that would otherwise be included in the shareholder’s income under subsection 15(2) if the shareholder were a resident of Canada to be a dividend, subject to withholding tax under subsection 212(2).
Accordingly, there is an incentive to interpose, between the particular corporation and the shareholder, a third party that is not connected to the shareholder (referred to as the “intermediary”) in order to avoid the income inclusion or withholding tax. Budget 2016 proposes to address these back-to-back shareholder loan arrangements by adding to the shareholder loan provisions rules that are similar to the existing back-to-back loan rules, except that the proposed rules will apply to debts owing to Canadian-resident corporations rather than debts owing by Canadian residents.
A back-to-back shareholder loan arrangement will be considered to exist where an intermediary is owed an amount (the “shareholder debt”) by the shareholder (or a person or partnership that is connected with the shareholder or that is a member of a partnership that is a shareholder) and one of the following two conditions is met:
- the intermediary owes an amount (the “intermediary debt”) to the Canadian-resident corporation, and either recourse in respect of the intermediary debt is limited in whole or in part to amounts recovered by the intermediary on the shareholder debt or it can reasonably be concluded that the shareholder debt became owing or was permitted to remain owing because the intermediary debt was or was anticipated to be entered into; or
- the intermediary has a “specified right” (having the same meaning as in the existing back-to-back loan rules) in respect of a particular property that was granted by the Canadian-resident corporation, and either the existence of the specified right is required under the terms of the shareholder debt or it can reasonably be concluded that the shareholder debt became owing or was permitted to remain owing because the specified right was or was anticipated to be granted.
If a back-to-back shareholder loan arrangement exists, the shareholder will be deemed to be indebted to the Canadian-resident corporation in an amount that is equal to the lesser of (i) the amount of the shareholder debt and (ii) the amount of the intermediary debt plus the total fair market value of property over which the intermediary was granted a specified right.
To the extent that the amount of the deemed indebtedness determined in this manner changes at any time after the debt is deemed to arise, (i) in the case of an increase, an additional debt equal to the increase will be deemed to become owing at that time, and (ii) in the case of a decrease, an amount equal to the decrease will generally be deemed to be repaid on the deemed debt on a first-in, first-out basis.
This measure will apply to back-to-back shareholder loan arrangements as of Budget Day. For back-to-back shareholder loan arrangements that are in place on Budget Day, the deemed indebtedness will be deemed to have become owing on Budget Day.
The Budget Documents state that, although the existing back-to-back loan rules in Part XIII can apply to structures that include two or more intermediaries (e.g., back-to-back-to-back structures involving two intermediaries), the manner in which the existing rules apply to certain multiple-intermediary structures may not be entirely clear even though they raise the same tax concerns as structures with only one intermediary.
Budget 2016 proposes to clarify the application of the existing back-to-back loan rules in Part XIII to back-to-back arrangements involving multiple intermediaries. These rules would also apply to the back-to-back royalty rules proposed in Budget 2016.
A back-to-back arrangement will comprise all the arrangements that are sufficiently connected to the arrangement under which a Canadian resident makes a cross-border payment of interest or royalties to an intermediary. The presence of such a connection will be established by applying similar tests to those that are used to establish a sufficient connection in the single intermediary context. If a back-to-back arrangement involving multiple intermediaries exists, an additional payment (of the same character as that paid by the Canadian resident to the first intermediary) will be deemed to have been paid directly by the Canadian resident to the ultimate non-resident recipient. Rules will also be enacted to address multiple intermediary arrangements within the proposed back-to-back shareholder loan rules.
This measure will apply to payments of interest or royalties made after 2016 and to shareholder debts as of January 1, 2017.
Cross-Border Surplus Stripping
Section 212.1 of the Tax Act provides an “anti-surplus-stripping” rule to prevent certain non-resident shareholders from extracting the surplus of a Canadian corporation (Canco) in excess of the paid-up capital (PUC) of its shares free of withholding tax by transferring the Canco shares to another Canadian resident corporation (Purchaser). If the rule applies, the non-resident is deemed to have received a dividend and/or the PUC of the shares of the Purchaser received by the non-resident is suppressed, depending on the consideration received from the Purchaser.
Subsection 212.1(4) of the Tax Act provides an exception to this anti-surplus-stripping rule. It applies where the non-resident shareholder of Canco is a corporation and the Purchaser controlled the non-resident shareholder before the transfer. The exception permits the unwinding of a so-called sandwich structure (i.e., where the Purchaser controls a non-resident corporation that, in turn, owns shares of Canco).
The Budget Documents state that certain reorganizations have been implemented by non-resident corporations with Canadian subsidiaries to create a sandwich structure in order to qualify for this exception.
The Government reiterates its intention to continue to challenge reorganizations completed before Budget Day under the current provisions of the Tax Act, including the general anti-avoidance rule, and notes that the proposed amendments are “intended to promote certainty and clarify the intended scope of the existing exception”.
Budget 2016 proposes to amend the exception in subsection 212.1(4). In addition to the requirement that the Purchaser control the non-resident shareholder, it must not be the case that, at the time of the disposition of the Canco shares, or as part of a transaction or event or series of transactions or events that includes the disposition, a non-resident person or designated partnership (i) owns, directly or indirectly, shares of the capital stock of the Purchaser, and (ii) does not deal at arm’s length with the Purchaser.
Budget 2016 also proposes to clarify the application of the anti-surplus-stripping rules. If no consideration is actually received by the non-resident shareholder from the Purchaser for the Canco shares, the non-resident will be deemed to receive non-share consideration from the Purchaser having a fair market value equal to the amount by which the fair market value of the Canco shares exceeds the amount of any increase because of the disposition in the fair market value of the shares of the Purchaser.
The amendments to section 212.1 will apply in respect of dispositions occurring on or after Budget Day.
Small Business Taxation
Currently, a Canadian-controlled private corporation (CCPC) is entitled to a small business deduction that reduces the federal corporate tax rate from 28% to 10.5% on the first $500,000 per year of qualifying active business income (such reduced rate, the small business rate). The $500,000 annual limit is shared among associated corporations, as well as among members of a partnership earning active business income. Access to the small business deduction is phased out on a straight-line basis for CCPCs that, together with corporations with which they are associated, have taxable capital employed in Canada between $10 million and $15 million.
As described below, Budget 2016 proposes to defer indefinitely legislated reductions to the small business rate, and contains measures intended to address a perceived ability of high-net-worth individuals to use private corporations to inappropriately reduce or defer tax.
Small Business Tax Rate
Last year’s budget proposed to lower the federal small business rate by 2%. The decrease was to be phased in over four years in 0.5% increments, commencing on January 1, 2016, such that the rates would have been as follows: 2016 – 10.5%; 2017 – 10%; 2018 – 9.5%; and 2019 and later years – 9%.
Budget 2016 proposes that the small business tax rate remain at 10.5% for 2016 and thereafter. It also proposes that the gross-up factor applicable to non-eligible dividends (generally, dividends from corporate income taxed at the small business rate) be maintained at 17% and that the corresponding dividend tax credit (DTC) rate remain at 21/29 of the gross-up amount. These consequential changes are intended to preserve integration between the corporate and personal income tax system.
Multiplication of the Small Business Deduction
Budget 2016 includes proposals to prevent taxpayers from multiplying access to the small business deduction through the use of partnership and corporate structures. Notably, while Budget 2016 proposes to limit access to the small business deduction, it does not limit access to the general corporate rate on income allocated to a professional corporation, as some had speculated might occur.
The specified partnership income rules in the Tax Act require members of a partnership to share a single business deduction in respect of partnership income. Stated very generally, a CCPC computes its small business deduction for a year based on the sum of (i) its active business income from sources other than a partnership, and (ii) its specified partnership income (i.e., the lesser of (a) the partner’s share of the active business income (ABI) of the partnership, and (b) the partner’s pro rata share of a notional $500,000 business limit determined at the partnership level).
Budget 2016 states that taxpayers have implemented structures to circumvent the application of the specified partnership income rules, and identifies as a typical structure one in which a shareholder of a CCPC is a member of a partnership and the partnership makes payments to the CCPC as an independent contractor under a contract for services. Since the CCPC is not a member of the partnership, the CCPC is able to claim a full small business deduction in respect of its active business income earned under the contract.
To address this planning, Budget 2016 proposes to extend the specified partnership income rules to structures in which a CCPC provides (directly or indirectly, in any manner whatever) services or property to a partnership during a taxation year of the CCPC where, at any time during the year, the CCPC or a shareholder of the CCPC is a member of the partnership or does not deal at arm’s length with a member of the partnership.
Budget 2016 proposes to effect these changes through amendments to the existing rules and the introduction of two new defined terms: “designated member” and “specified partnership business limit”. In general terms:
- A designated member of a particular partnership in a taxation year means a CCPC that provides (directly or indirectly, in any manner whatever) services or property to the particular partnership at any time in the corporation’s taxation year where, at any time in the year:
(a) the corporation is not a member of the particular partnership; and
(i) one of its shareholders holds a direct or indirect interest in the particular partnership, or
(ii) if (i) does not apply,
A. the corporation does not deal at arm’s length with a person that holds a direct or indirect interest in the particular partnership, and
B. it is not the case that all or substantially all of the corporation’s income for the year from an active business is from providing services or property to (I) persons with which the corporation deals at arm’s length, or (II) partnerships (other than the particular partnership) with which the corporation deals at arm’s length, other than a partnership in which a person that does not deal at arm’s length with the corporation holds a direct or indirect interest.
- Active business income of a partner or a designated member arising from providing services or property to the partnership is deemed to be partnership ABI.
- The specified partnership business limit (SPI Limit) of a person for a taxation year, at any particular time, means the amount determined by the formula (K/L) x M – T where, stated generally:
- K is the person’s share of the partnership’s ABI (not including deemed partnership ABI);
- L is the aggregate ABI of the partnership;
- M is the maximum business limit for the year ($500,000), subject to proration for a short year; and
- T is the total of all amounts each of which is an amount, if any, that the person assigns to another person as described below.
- While the SPI Limit of a designated member will initially be nil (since such person is, by definition, not a member of the partnership), Budget 2016 contemplates that a partner may notionally assign to the designated member all or a portion of the partner’s SPI Limit.
The measures are proposed to apply to taxation years that begin on or after Budget Day. However, partners will be entitled to notionally assign all or a portion of their SPI Limit in respect of their taxation year that begins before and ends on or after Budget Day.
A detailed example of how the measures are intended to apply is included the Budget Documents.
Budget 2016 states that a corporation could also be used to multiply access to the small business deduction and gives as an example a structure in which a CCPC earns active business income from providing services or property (directly or indirectly, in any manner whatever) to a private corporation in which the CCPC, one of the CCPC’s shareholders or a person who does not deal at arm’s length with such a shareholder has a direct or indirect interest.
Budget 2016 proposes to address this planning through amendments to the existing rules. In general terms:
- A CCPC’s active business income from providing services or property (directly or indirectly, in any manner whatever) to a private corporation will be ineligible for the small business deduction if, at any time during the year, the CCPC, one of its shareholders or a person who does not deal at arm’s length with such a shareholder has a direct or indirect interest in the private corporation, unless:
- all or substantially all of the CCPC’s active business income is earned from providing services or property to arm’s length persons other than the private corporation, or
- the private corporation assigns to the CCPC all or a portion of the private corporation’s business limit.
- If an assignment is made as described above, the amount of the active business income earned by the CCPC from providing services or property to the private corporation that will be eligible for the small business deduction (subject to the CCPC’s own business limit) will be the least of: (i) the CCPC’s income from providing services or property to the private corporation, (ii) the amount of the assigned business limit, and (iii) the amount determined by the Minister to be reasonable in the circumstances.
The foregoing measure necessitates careful consideration of the impact of acquiring directly or indirectly any interest in a private corporation that is also a client of the CCPC as the income sourced from such client may be ineligible for the small business deduction.
The measures are proposed to apply to taxation years that begin on or after Budget Day. However, a private corporation will be entitled to assign all or a portion of its unused business limit in respect of its taxation year that begins before and ends on or after Budget Day.
Avoidance of the Business Limit and Taxable Capital Limit
As noted above, the $500,000 annual limit is shared among associated corporations, and is phased out on a straight-line basis for CCPCs that, together with corporations with which they are associated, have taxable capital employed in Canada between $10 million and $15 million.
Various technical rules apply for the purpose of determining if two or more corporations are associated with each other, including a rule in subsection 256(2) that deems two corporations (ACo and BCo) that are not otherwise associated to be associated if each corporation is associated with the same third corporation (CCo). There is a limited exception to this deeming rule if (i) CCo is not a CCPC, or (ii) if CCo is a CCPC, it elects not to be associated with the other two corporations for the purpose of determining entitlement to the small business deduction. Where such an election is made, the third corporation (CCo) cannot claim the small business deduction (its business limit is deemed to be nil); however, the other two corporations may each claim a $500,000 small business deduction subject to their own taxable capital limit. Notably, the exception is limited in its application to the determination of the corporation’s entitlement to the small business deduction, and does not apply for purposes of another rule that treats a CCPC’s investment income (e.g., interest and rental income) as active business income eligible for the small business deduction if that income is derived from the active business of an associated corporation (subsection 129(6)).
Budget 2016 notes that perceived misuses are being challenged under existing legislation (including the GAAR), but that any such challenge could be time consuming and costly. Accordingly, Budget 2016 proposes to amend the Tax Act, effective for taxation years that begin on or after Budget Day, to ensure that:
- investment income derived from an associated corporation’s active business that is treated as active business income of the CCPC will be ineligible for the small business deduction and be taxed at the general corporate income tax rate where the exception to the deemed associated corporation rule applies;
- where the exception applies, the third corporation (CCo) will continue to be associated with each of the other corporations for the purpose of applying the $15 million taxable capital limit.
Consultation on Active Versus Investment Business Income
Budget 2015 announced a review of the circumstances in which income from a business, the principal purpose of which is to earn income from property, should qualify as active business potentially eligible for the small business deduction. In Budget 2016, the Government reports that the examination is complete and that it is not proposing any amendments to the rules at this time.
Taxation of Linked Notes
A linked note is a debt obligation on which the return is linked in some manner to the performance of one or more reference assets or indexes over the term of the obligation. There are many variations in the terms of linked notes. In general, under a principal protected note, the investor will receive the original amount invested plus a return, if any, linked to the performance of the reference asset or index. Under a non-principal protected note, the investor may not receive the original amount invested. The Tax Act contains rules that deem interest to accrue on a prescribed debt obligation. The Budget Documents state that the definition of prescribed debt obligation includes a typical linked note and that the interest accrual rules require an investor in a linked note to accrue the maximum amount of interest that could be payable on the note in respect of a given taxation year. The Budget Documents also state that investors generally take the position that there is no deemed accrual of interest on a linked note prior to the maximum amount of interest becoming determinable. Instead, the full amount of the return on the note is included in the investor’s income in the taxation year when it becomes determinable, which is generally at or shortly before maturity. Although not stated in the Budget Documents, the position taken by investors is derived from administrative positions of the CRA.
Subsection 20(14) of the Tax Act generally provides that interest accrued to the date of sale of a debt obligation is included in the income of the vendor for the year in which the sale occurs. Investors who hold notes as capital property may sell the notes before the date that the interest amount can be determined. Such investors take the position that subsection 20(14) does not apply and that all of the proceeds of the sale are proceeds of disposition of a capital property and effectively treat the return on the note as a capital gain. (Some investors may rely on an election under subsection 39(4) to buttress their position that the note is a capital property.) The Budget Documents note that issuers of linked notes often establish a secondary market where investors can sell their linked notes to an affiliate of the issuer prior to maturity.
Budget 2016 proposes to amend the Tax Act so that the return on a linked note retains the same character whether it is earned at maturity or reflected in a secondary market sale. The amendments will apply to transfers of linked notes that occur after September 2016.
Significantly, no change to the interest accrual rules is proposed to require investors to include any part of the contingent return in income before the amount is determined so that the deferral advantage is preserved.
Budget 2016 introduces a deeming rule that will apply for the purpose of subsection 20(14). The rule treats an amount calculated by formula as interest that accrued on the debt obligation for a period commencing before the time of the sale and ending at that time. The amount is generally the sale price of the note less (i) the price for which the note was issued net of any principal previously repaid by the issuer, and (ii) if the note provides for fixed rate interest payments to be received after the sale, such part of the sale price, if any, as is attributable to any decrease in interest rates from the date of issue to the date of sale. When a linked note is denominated in a foreign currency, foreign currency fluctuations will be ignored for the purposes of calculating this gain.
As the proposed change will apply to transfers of notes after September 30, 2016, persons holding notes with accrued gains may want to explore opportunities to dispose of them before October.
Taxation of Switch Fund Shares
Canadian mutual funds can be structured as a trust or as a corporation.
Many funds are structured as mutual fund trusts because by making appropriate distributions to investors, no net tax will be payable by the trust, and investors will be taxed on their share of the income of the trust that is distributed to them. However, each mutual fund trust is a separate taxpayer and an investor that redeems units of one trust (e.g., a Canadian equity fund) to invest the proceeds in a second trust (e.g., a global equity fund) will realize a gain or loss on the redemption of units of the first trust even though the proceeds are invested in the second trust. If the trust units are capital property, the gain or loss will be a capital gain or loss.
If a mutual fund is structured as a corporation, it may have multiple share classes, each “linked” to a distinct portfolio of assets (e.g., a Canadian equity portfolio or a global equity portfolio). Each such class is treated as a separate mutual fund for securities regulatory purposes. One benefit of this structure is that an investor who holds shares as capital property can switch from one class of shares to shares of a second class, thereby obtaining exposure to a different investment, on a tax-deferred “rollover” basis pursuant to section 51 of the Tax Act.
Budget 2016 will eliminate this deferral benefit applicable to dispositions of shares that occur after September 2016. A switch of shares of a mutual fund corporation or investment corporation will be considered for tax purposes to be a disposition at fair market value except where the shares received in exchange differ only in respect of management fees or expenses to be borne by investors and otherwise derive their value from the same portfolio or fund within the mutual fund corporation (i.e., the switch is between different series of shares within the same class). Presumably the legislation to enact the measure will deem a taxable switch to be a redemption of shares for the purpose of calculating the corporation’s capital gains refund.
While the benefit of tax-deferred switching of shares of mutual fund corporations is emphasized in a fund’s marketing materials, it is not clear that investors make material use of the feature. In addition, if there are net switches from one class, the corporation must dispose of an appropriate portion of the portfolio underlying that class which may result in the recognition of income and loss. However, there are other benefits of the switch corporation structure that flow from the fact that the corporation is a single taxpayer, including that losses from one portfolio within the corporation can be applied against net income from other portfolios and that the corporation’s capital gains refund is not calculated on a class-by-class basis. On the other hand, deriving foreign income and interest income in a mutual fund corporation is less tax-efficient than earning such income directly or through a mutual fund trust.
Because of these benefits, the end of tax-deferred switching may not be the death knell of the mutual fund corporation. However, the legislation to implement the measure should include provisions to allow the classes in a switch corporation to be converted into a corresponding number of separate mutual fund trusts on a tax-deferred basis.
Debt Parking to Avoid Foreign Exchange Gains
Generally, a taxpayer may realize a gain or a loss on the repayment of a debt denominated in a foreign currency as a result of the fluctuation of the foreign currency relative to the Canadian dollar. The gain or loss is considered to have been realized when the debt is settled or extinguished.
The Tax Act contains rules (debt forgiveness rules) that apply if a commercial debt obligation is settled for an amount that is less than the lesser of the amount for which it was issued and its principal amount. The Tax Act also contains rules applicable to a “parked obligation” that deem such an obligation to be settled for its specified cost if the holder’s specified cost is less than 80% of the principal amount of the obligation.
To avoid realizing a gain on the repayment of a foreign currency debt because the Canadian dollar has appreciated against the foreign currency, some taxpayers have entered into arrangements under which a related party purchases the debt from the creditor. As the debt remains outstanding, no gain is realized by the debtor. Although the obligation may be a parked obligation and deemed to be settled, there is the view, which is supported by the CRA, that the amount that is considered to have been paid on such deemed settlement for purposes of determining the forgiven amount should be determined without regard to the decrease in value of the relevant currency by virtue of paragraph 80(2)(k) of the Tax Act.
The Government asserts that debt-parking transactions undertaken to avoid foreign exchange gains can be challenged under the general anti-avoidance rule but is introducing a specific legislative measure so that any accrued foreign exchange gain on a foreign currency debt will be realized when the debt becomes a parked obligation. The Budget Documents contain a summary of the proposed measures but do not include draft legislation.
Under the proposals, the debtor will be deemed to have realized the gain that it otherwise would have realized if it had paid an amount (expressed in the currency in which the debt is denominated) in satisfaction of the principal amount of the debt equal to (i) the amount for which it was acquired if the debt becomes a parked obligation as a result of its acquisition by the current holder; or (ii) in other cases, the fair market value of the debt.
A foreign currency debt will become a parked obligation for the purposes of these rules at a particular time if, at such time, the holder of the debt does not deal at arm’s length with the debtor or, if the debtor is a corporation, has a significant interest in the corporation, and at any previous time, a person who held the debt dealt at arm’s length with the debtor and, if the debtor is a corporation, did not have a significant interest in the corporation.
In general, a person will have a significant interest in a corporation if the person together with non-arm’s length persons own 25% of the shares of the corporation determined either by votes or by value. Rules similar to those contained in the debt forgiveness rules will be introduced to determine whether a creditor is related to, and therefore not dealing at arm’s length with, a debtor where trusts and partnerships are involved.
There are two exceptions to the application of the foregoing rules, which are intended to carve out certain bona fide commercial transactions. First, a foreign currency debt will not be a parked obligation if it is acquired by the current holder as part of a transaction or series of transactions that results in the acquisition of a significant interest in, or control of, the debtor by the current holder (or a person related to the current holder) unless one of the main purposes of the transaction or series of transactions was to avoid foreign exchange gain. Second, a change of status between the debtor and the current holder (i.e., from dealing at arm’s length to not dealing at non-arm’s length or, if the debtor is a corporation, from the current holder not having a significant interest in the debtor to having one) will not cause the debt to become a parked obligation unless one of the main purposes of the transaction or series of transactions that gave rise to the change of status was to avoid a foreign exchange gain.
Related rules will provide relief to financially distressed debtors. This relief will be similar to the deductions currently available to debtors with respect to amounts included in income because of the application of the debt forgiveness rules.
This measure will apply to a foreign currency debt that meets the conditions to become a parked obligation on or after Budget Day. There will be an exception if that occurs before 2017 and results from a written agreement entered into before Budget Day.
Valuation of Derivatives
The Tax Act contains rules for the valuation of property held as inventory for the purpose of computing a taxpayer’s income or loss from a business. In most cases, a taxpayer can choose to value each inventory property at the lower of its cost and its fair market value at the end of the year. The effect of the lower of cost and market method is that losses on inventory property may be recognized on an accrual basis whereas gains on such property are recognized only when it is ultimately sold.
Under the lower of cost and market method, the taxpayer compares the cost of each inventory property with its fair market value at the end of the year. If the fair market value of the property is less than its cost, the difference is deductible in computing the taxpayer’s income for the year. However, if the fair market value of the property at the end of the year is greater than its cost, no amount is added to the taxpayer’s income for the year.
According to the Budget Documents, the asymmetrical nature of this inventory valuation method does not generally raise tax policy concerns when applied to conventional types of inventory, such as tangible goods held for sale. However, a recent decision of the Tax Court of Canada (Kruger Inc. v. R., 2015 TCC 119) held that a derivative that provides rights to a taxpayer and is held on income account would be considered inventory property. On that basis, derivatives held on income account that are not mark-to-market properties (which are deemed not to be inventory) or property of a business that is an adventure or concern in the nature of trade (which must be valued at its cost to the taxpayer) could potentially qualify for the lower of cost and market method under the inventory valuation rules.
The Government is concerned about the application of the lower of cost and market method to these derivatives given their potentially higher volatility and longer holding periods, compared with conventional inventory property.
Accordingly, Budget 2016 proposes that, for the purposes of the rules relating to the valuation of inventory, property of a taxpayer that is a swap agreement, a forward purchase or sale agreement, a forward rate agreement, a futures agreement, an option agreement or any similar agreement is deemed not to be inventory of the taxpayer.
In addition, subsection 18(1) of the Tax Act, which denies deductions in computing income or loss from a business or property, will be amended to provide that no deduction may be claimed in respect of the value of such derivatives if the method used by the taxpayer in computing income is the lower of cost and market value and the property was not disposed of in the year.
These measures will apply to derivatives entered into on or after Budget Day.
Measures Related to the Taxation of Life Insurance Policies
Life insurance proceeds received as a result of the death of an individual insured under a life insurance policy (a “policy benefit”) are generally not subject to income tax.
A private corporation may add to its capital dividend account the amount of a policy benefit it receives less the “adjusted cost basis” of the policy. The adjusted cost basis of a life insurance policy is, subject to a number of adjustments, the amount of premiums paid under the policy less the net cost of pure insurance as determined under the Income Tax Regulations. A private corporation may pay non-taxable capital dividends to its shareholders to the extent of the balance in its capital dividend account.
In the case of a partnership that owns a life insurance policy and receives a policy benefit, a partner may add to the adjusted cost base of the partner’s partnership interest the partner’s share of the amount by which the policy benefit exceeds the adjusted cost basis of the policy. A partner can generally withdraw funds from a partnership tax-free to the extent of the partner’s adjusted cost base.
The Budget Documents state that some taxpayers have structured their affairs so that the amount added to the capital dividend account of a corporation or the adjusted cost base of a partnership interest is artificially increased by having a person other than the corporation or partnership be the policyholder.
The Budget Documents state that the Government is challenging a number of these structures under the existing tax rules.
Nevertheless, Budget 2016 proposes to amend the Tax Act to provide that, with respect to deaths occurring on or after Budget Day, the amount added to a corporation’s capital dividend account will be reduced by the adjusted cost basis of a policyholder’s interest in the policy (and not just that of the recipient of the insurance proceeds). A similar change is proposed in relation to insurance proceeds received by a partnership.
In addition, information-reporting requirements will be introduced that will apply where a corporation or partnership is not a policyholder but is entitled to receive a policy benefit.
Transfers of Life Insurance Policies
If a policyholder disposes of an interest in a life insurance policy to an arm’s length person, the fair market value of any consideration is included in computing the proceeds of the disposition. However, if a policyholder disposes of such an interest to a non-arm’s length person, subsection 148(7) deems the policyholder’s proceeds of disposition, and the acquiring person’s cost, of the interest to be the “value” of the interest, which is in turn defined in subsection 148(10) to be the amount that the policyholder would be entitled to receive in respect of the policyholder’s interest in the cash surrender value if the policy were surrendered (or nil if the interest does not include an interest in the cash surrender value).
The fair market value of a policy will often exceed its cash surrender value and this has been the basis for tax planning. If subsection 148(7) applies, the amount by which any consideration given for the policy exceeds the cash surrender value is not taxed as income to the transferor. In addition, this excess will ultimately be reflected in the policy benefit under the policy. If the policy benefit is received by a private corporation, it can be paid tax-free to that corporation’s shareholders. Where this is the case and consideration to acquire the interest was not recognized under the policy transfer rule, the amount of the excess is effectively extracted from the private corporation a second time (i.e., once upon the purchase of the policy by the corporation and once upon the distribution of the benefit received by the corporation under the policy) as a tax-free, rather than as a taxable, amount. The Government considers these results to be unintended and to erode the tax base. The Government has also identified similar concerns in the partnership context and where an interest in a policy is contributed to a corporation as capital.
Budget 2016 proposes amendments to the Tax Act to address this type of planning in respect of dispositions on or after Budget Day.
Subsection 148(7) will be amended to provide that, for transfers on or after Budget Day, the transferor’s proceeds of disposition of the policy will be increased by the amount by which the fair market value of the consideration received for the policy exceeds its cash surrender value. The acquiror will be deemed to have acquired the policy for an amount equal to the transferor’s proceeds.
If the transferee is a corporation the amount added to the paid-up capital of the shares of the corporation as a result of the disposition will be reduced to the extent that the amount otherwise added exceeds the transferor’s proceeds of disposition of the policy.
If the transferee is a corporation or partnership and the transfer is treated as a contribution of capital, the amount of the contribution of capital is limited to the cash surrender value of the policy for the purpose of applying paragraphs 53(1)(c) and (e) in determining the adjusted cost base of the transferor’s shares or partnership interest. As a complementary rule, any contributed surplus that arises is restricted to the cash surrender value of the policy for the purpose of applying subsection 84(1).
Certain amendments will also apply with respect to transfers of policies made before Budget Day if at least one person whose life was insured under the policy before Budget Day is alive on Budget Day. The provisions adjusting the transferor’s proceeds and the transferee’s cost, described above, will not apply to the transfer. However, the amendments described above relating to the calculation of paid-up capital, the amount of a contribution of capital to a corporation or partnership and the amount of contributed surplus of a corporation will apply as if the transfer had occurred at the start of Budget Day. An adjustment will be made if contributed surplus arising on a pre-Budget Day transfer has been converted into paid-up capital before Budget Day.
Budget 2016 also proposes amendments to the capital dividend account rules for private corporations and the adjusted cost base rules for partnership interests in respect of life insurance proceeds received under a policy where an interest in the insurance policy was disposed of before Budget Day for consideration greater than the cash surrender value.
In the case of a partnership, the amount otherwise permitted to be added to the adjusted cost base of an interest in the partnership will be reduced by the amount of the excess.
In the case of a corporation, the addition to the capital dividend account will be reduced by the fair market value of the consideration given for the transfer less (i) the cash surrender value of the policy, and (ii) any reduction in paid-up capital of shares as result of the transfer.
In addition, where an interest in a life insurance policy was disposed of before Budget Day under the policy transfer rule to a corporation or partnership as a contribution of capital, any increase in the paid-up capital in respect of a class of shares of the corporation, and the adjusted cost base of the shares or of an interest in the partnership, that may otherwise have been permitted will be limited to the amount of the proceeds of the disposition.
This measure will apply in respect of policies under which policy benefits are received as a result of deaths that occur on or after Budget Day.
Expanding Tax Support for Clean Energy
In order to support the Government’s sustainable development strategy, Budget 2016 proposes to expand Class 43.1 and Class 43.2 of Schedule II of the Income Tax Regulations, which provide an accelerated capital cost allowance (CCA) rate (30% and 50% per year, respectively, on a declining-balance basis but subject to the half-year rule), to include certain electric vehicle charging stations and electrical energy storage equipment. Under the current rules, these properties are generally included in Class 8, which provides a less favourable CCA rate of 20% per year on a declining-balance basis.
These measures will apply in respect of property acquired for use on or after Budget Day that has not been used or acquired for use before Budget Day.
Electrical Vehicle Charging Stations
Under the proposals, electric vehicle charging stations set up to supply at least 90 kilowatts of continuous power will be eligible for inclusion in Class 43.2 and those set up to supply more than 10 kilowatts but less than 90 kilowatts will be eligible for inclusion in Class 43.1.
Eligible equipment will include equipment downstream of an electricity meter (including charging stations, transformers, distribution and control panels, circuit breakers, conduits, wiring and related electrical energy storage equipment) owned by an electric utility and used for billing purposes or owned by the taxpayer to measure electricity generated by the taxpayer, provided that more than 75% of the annual electricity consumed in connection with the equipment is used to charge electric vehicles.
Electrical Energy Storage
Currently, only limited types of electrical energy storage equipment ancillary to electricity generation technologies are eligible for inclusion in Class 43.1 and Class 43.2. The eligibility for accelerated depreciation also depends on the technology being used to generate electricity. Electrical energy storage equipment that is not associated with a Class 43.1 or Class 43.2 generation source is not eligible for accelerated CCA.
Budget 2016 proposes two amendments. First, it proposes to clarify and expand the range of electrical energy storage properties that are eligible for accelerated CCA to include a broad range of short- and long-term storage equipment when such equipment is ancillary to eligible generation equipment. The relevant storage equipment will be eligible for the same CCA class (either Class 43.1 or Class 43.2) as the electricity generation system of which it is part.
Second, it is proposed that Class 43.1 be expanded to include stand-alone electrical energy storage property provided that the round trip efficiency of such equipment (i.e., the extent to which energy is maintained in the process of converting electricity into another form of energy and back into electricity) is greater than 50%.
Budget 2016 clarifies that fuel cells which use hydrogen produced by electrolysis equipment, where all or substantially all of the electricity used to power the electrolysis process is generated from specified renewable sources, will, regardless of the round trip efficiency, remain eligible for Class 43.2. The eligible generation sources in relation to hydrogen fuel cells will also be expanded to include electricity generated by the other renewable energy sources currently included in Class 43.2.
Eligible electrical energy storage property will include equipment such as batteries, flywheels and compressed air energy storage, as well as any ancillary equipment and structures, but will not include the following: pumped hydroelectric storage, hydroelectric dams and reservoirs, or a fuel cell system where the hydrogen is produced via steam reformation of methane. Certain uses of electrical energy storage equipment will also be excluded from Class 43.1 and Class 43.2: back-up electricity generation, motive uses (e.g., in battery electric vehicles or fuel cell electric vehicles) and mobile uses (e.g., consumer batteries).
Emissions Trading Regimes
A few years ago, the Québec government implemented an emissions trading regime, and such a regime has also been proposed in Ontario. Very generally, under these regimes, regulated emitters must deliver certain emissions allowances to the government, the amount of which is determined by reference to the amount of production of certain regulated substances (e.g., greenhouse gases). Regulated emitters can acquire these allowances by purchasing them in the market or from governments (e.g., through auctions) or earn them in relation to certain emissions reduction activities. Emissions allowances can also be granted by governments to certain regulated emitters at no cost.
Currently, the tax treatment of the various transactions taking place under the emissions trading regimes is determined under general tax principles. The Tax Act does not deal specifically with emissions trading regimes and neither do Canadian or international accounting standards.
In order to address certain concerns expressed by stakeholders, Budget 2016 proposes to introduce specific rules clarifying the tax treatment of transactions undertaken under emissions trading regimes and eliminating the potential double taxation that could arise from the grant of emissions allowances for no consideration.
Specifically, the new rules will provide that emissions allowances be treated as inventory for all taxpayers, with the exception that, due to the potential volatility in the value of emissions allowances, the “lower of cost and market” method for the valuation of inventory will not be available.
In addition, there will be no income inclusion on receipt of free allowances by a regulated emitter and only the portion of an accrued emissions obligation that exceeds the cost of any emissions allowances that the taxpayer has acquired and that can be used to settle the obligation will be deductible. If a deduction is claimed in respect of an emissions obligation that accrues in one year (e.g., 2017) and that will be satisfied in a future year, the deduction will have to be brought back into income in the subsequent taxation year (e.g., 2018) and the taxpayer will be required to evaluate the deductible obligation again each year, until it is ultimately satisfied. The deduction will be based on the cost of emissions allowances that the taxpayer has acquired and that can be used to settle the emissions obligation, plus the fair market value of any emissions allowances that it still needs to obtain to fully satisfy the obligation.
The disposition of an emissions allowance otherwise than in satisfaction of an obligation of the taxpayer under the emissions allowance regime will give rise to an income inclusion to the extent that the proceeds received exceed the taxpayer’s cost, if any, of the allowance.
These measures will apply to emissions allowances acquired in taxation years beginning after 2016 and to emissions allowances acquired in taxation years ending after 2012, on an elective basis.
Eligible Capital Property
Building on the announcement made in the Budget 2014 and the consultations held with taxpayers in the ensuing years, Budget 2016 proposes a major overhaul of the eligible capital property (ECP) regime and, more specifically, its repeal and incorporation into the regular CCA system.
Budget 2016 introduces a new class of depreciable property for CCA purposes: Class 14.1. Expenditures that are currently added to cumulative eligible capital (CEC) – at a 75% inclusion rate – will be included in the new CCA class at a 100% inclusion rate. Because of this increased expenditure recognition, the new class will have a 5% annual depreciation rate (instead of 7% of 75% of eligible capital expenditures). All existing rules regarding CCA will generally apply to Class 14.1 property, including rules relating to recapture, capital gains and depreciation (e.g., the “half-year rule”).
Budget 2016 draws a distinction between eligible capital expenditures and receipts that relate to acquisitions or dispositions of specific properties other than goodwill, on the one hand, and those that relate to goodwill or to no particular property at all, on the other. The former (which, according to the Budget Documents, include most, but not all, eligible capital expenditures and receipts) will be treated in the same way as depreciable property falling within the existing CCA classes. The latter, however, will be accounted for in the manner described below.
Goodwill will now be deemed to constitute “property” for purposes of the Tax Act. In addition, a taxpayer will be deemed to own a single “goodwill property” in respect of a business for so long as it carries on that business. The cost of the taxpayer’s goodwill property in respect of a business will generally include the cost of any goodwill acquired in respect of the business and any capital expenditures incurred in respect of the business that do not relate to any specific property. When a taxpayer disposes of goodwill, it will be treated as having carried out a partial disposition of its goodwill property in respect of the business. The portion of the goodwill property disposed of will be deemed to have a cost equal to the lesser of the full cost of the taxpayer’s goodwill property and the proceeds received by the taxpayer. A capital gain will be realized to the extent that the proceeds exceed the deemed cost of the portion of the taxpayer’s goodwill property disposed of, and recapture will be realized in the event that the reduction to the UCC of the taxpayer’s Class 14.1 property causes the UCC in respect of the class to go negative. On a go-forward basis, the cost of the remaining portion of the taxpayer’s goodwill property will be deemed to be the full cost of the taxpayer’s goodwill property less the deemed cost of the portion of the goodwill property disposed of (though this deemed cost will presumably continue to be taken into account in determining the amount of element “A” of the taxpayer’s UCC in respect of its Class 14.1 property, since it will constitute the “capital cost to the taxpayer of a depreciable property of the class acquired before that time”). When a taxpayer receives an amount on account of capital in respect of the business that does not relate to a specific property, the taxpayer will generally be deemed to have disposed of a portion of its goodwill property for proceeds equal to the amount received, leading to the application of the above rules.
Budget 2016 provides that CEC pool balances will be calculated and transferred to the new CCA class as of January 1, 2017. The opening balance of the new CCA class in respect of a business will be equal to the balance at that time of the existing CEC pool for that business. For the first 10 years, the depreciation rate for the new CCA class will be 7% in respect of expenditures incurred before January 1, 2017.
Budget 2016 recognizes that some receipts received after the time at which the new rules are implemented could relate to property acquired, or expenditures otherwise made, before that time. In this regard, certain qualifying receipts will reduce the balance of the new CCA class at a 75% rate. Receipts that qualify for the reduced rate will generally be receipts from the disposition of property the cost of which was included in the taxpayer’s CEC and receipts that do not represent the proceeds of disposition of property. The total amount of such qualifying receipts, for which only 75% of the receipt will reduce the new CCA class, will generally equal the amount that could have been received under the ECP regime before triggering an ECP gain.
Budget 2016 also proposes two special rules to simplify the transition for small businesses. First, to allow small initial balances to be eliminated quickly, a taxpayer will be permitted to deduct as CCA, in respect of expenditures incurred before 2017 and for taxation years that end prior to 2027, the greater of $500 per year and the amount otherwise deductible for that year. Second, in order to reduce compliance burdens associated with the depreciation of incorporation expenses under the CCA system, a new lump sum deduction will be provided for in respect of the first $3,000 of such expenditures.
The new ECP regime, including the associated transitional rules, will apply as of January 1, 2017.
PERSONAL TAX MEASURES
Canada Child Tax Benefit
Currently, financial assistance is provided to families with children under age 18 through the Canada child tax benefit (CCTB) and the universal child care benefit (UCCB). The CCTB is a non-taxable benefit that is paid monthly, based on adjusted family net income and the number of children in the family. The UCCB provides a taxable benefit of $160 per month for each child under the age of six and $60 per month for each child older than 5 and younger than 18. Budget 2016 proposes to replace the CCTB and UCCB with a new Canada Child Benefit.
The Canada Child Benefit will provide a maximum benefit of $6,400 per child under the age of 6 and $5,400 per child aged 6 through 17. When the adjusted net family income of the taxpayer exceeds $30,000, the benefit will be phased out at specified rates depending on the size of the family and its adjusted net family income.
Budget 2016 also proposes to continue to provide an additional amount of up to $2,730 per child eligible for the disability tax credit. The phase-out of this additional amount will generally align with the phase-out of the Canada Child Benefit.
Budget 2016 proposes to limit a taxpayer’s ability to request retroactive payments of the Canada Child Benefit, CCTB or UCCB to be consistent with the time limit on retroactive claims of other tax amounts.
Canada Child Benefit payments are proposed to start in July 2016. The UCCB and CCTB will be eliminated for months after June 2016.
Income Splitting Credit
The Tax Act currently provides a non-refundable income splitting tax credit for couples with at least one child under the age of 18. The credit allows a higher-income spouse or common-law partner to notionally transfer up to $50,000 of taxable income to his or her spouse or common-law partner to reduce the couple’s total income tax liability by up to $2,000.
Budget 2016 proposes to eliminate the income splitting tax credit for the 2016 and subsequent taxation years.
Northern Residents Deduction
Individuals who live in prescribed areas in northern Canada for at least six consecutive months beginning or ending in a taxation year may claim the northern residents deduction in computing their taxable income for that year. These include both a residency deduction and a travel benefits deduction.
Budget 2016 proposes to increase the maximum residency deduction.
Labour-Sponsored Venture Capital Corporations Tax Credit
Labour-sponsored venture capital corporations (LSVCC) are mandated under their authorizing legislation to provide venture capital to small and medium-sized businesses.
However, the federal LSVCC tax credit was reduced to 5% for the 2016 taxation year and was scheduled to be eliminated for the 2017 and subsequent taxation years.
Budget 2016 proposes to restore the federal LSVCC tax credit to 15% for share purchases of provincially registered LSVCCs prescribed under the Tax Act for the 2016 and subsequent taxation years. Budget 2016 also proposes that newly registered LSVCCs under existing provincial legislation be eligible for prescription under the Tax Act if the provincial legislation is currently prescribed for purposes of the federal LSVCC tax credit. New provincial regimes will also be eligible provided that the enabling provincial legislation is modelled on currently prescribed provincial legislation.
The federal LSVCC tax credit for federally registered LSVCCs will remain at 5% for the 2016 taxation year and be eliminated for the 2017 and subsequent taxation years.
Teacher and Early Childhood Educator School Supply Tax Credit
Budget 2016 proposes to introduce a teacher and early childhood educator school supply tax credit. This measure will allow an employee who is an eligible educator to claim a 15% refundable tax credit based on an amount of up to $1,000 in expenditures for eligible supplies made by the employee in a taxation year.
This measure will apply to supplies acquired on or after January 1, 2016.
Ontario Electricity Support Program
The Ontario government’s Ontario Electricity Support Program (OESP) provides assistance to low-income households in Ontario for the cost of electricity. The OESP reduces the cost of household electricity by providing a monthly credit on a recipient’s electricity bill. The credit depends on household income and how many people live in the household.
Amounts received may affect income-tested federal or provincial/territorial benefits under the Tax Act, such as child benefits. To ensure that income-tested benefits are not reduced as a result of OESP amounts, Budget 2016 proposes to exempt from income amounts received under the program for the 2016 and subsequent taxation years.
Mineral Exploration Tax Credit for Flow-Through Share Investors
Resource companies can renounce or “flow through” tax expenses associated with their Canadian exploration activities to investors who acquire flow-through shares. The mineral exploration tax credit provides a further income tax benefit for individuals who invest in mining flow-through shares. This credit is equal to 15% of specified mineral exploration expenses incurred in Canada and renounced to flow-through share investors.
Budget 2016 proposes to extend eligibility for the mineral exploration tax credit for one year to flow-through share agreements entered into on or before March 31, 2017.
Education and Textbook Tax Credits
Budget 2016 proposes to eliminate the education and textbook tax credits, but not the 15% non-refundable tax credit on eligible fees for tuition and eligible examination fees paid to certain educational institutions.
This measure will apply effective January 1, 2017. Unused education and textbook credit amounts carried forward from years prior to 2017 will remain available to be claimed in 2017 and subsequent years.
Children’s Fitness and Arts Tax Credits
Budget 2016 proposes to phase out the children’s fitness and arts tax credits by reducing the 2016 maximum eligible amounts to $500, from $1,000, for the children’s fitness tax credit and to $250, from $500, for the children’s arts tax credit. The supplemental amounts for children eligible for the disability tax credit will remain at $500 for 2016. Both credits will be eliminated for the 2017 and subsequent taxation years.
TOP MARGINAL INCOME TAX RATE – CONSEQUENTIAL AMENDMENTS
On December 7, 2015, the Government announced a reduction of the second personal income tax rate to 20.5% from 22% and the introduction of a 33% personal income tax rate on individual taxable income in excess of $200,000, effective for the 2016 and subsequent taxation years.
In addition to the previously proposed consequential amendments, Budget 2016 proposes the following further amendments to reflect the new top marginal income tax rate for individuals:
- a 33% charitable donation tax credit (on donations above $200) for trusts that are subject to the 33% rate on all of their taxable income;
- a 33% top rate on excess employee profit sharing plan contributions;
- a 33% the tax rate on personal services business income earned by corporations;
- a reduction in the relevant tax factor from the current 2.2 to 1.9 in the foreign affiliate rules;
- an amendment to the capital gains refund mechanism for mutual fund trusts to reflect the new 33% top rate in the formulas that are used in computing refundable tax;
- a 40% Part XII.2 tax rate on the distributed income of certain trusts; and
- an amendment to the recovery tax rule for qualified disability trusts to refer to the 33% rate.
Budget 2016 proposes changes to the agreement powers of the Pension Benefits Standards Act (PBSA) and, like Budget 2015, announces a consultative process on the rule that restricts federally regulated pension funds from holding more than 30% of the voting securities of a corporation (30% Rule).
If the Government were to amend or eliminate the 30% Rule, the changes would not only apply to federally registered pension plans, but would also affect pension plans registered in Alberta, British Columbia, Manitoba, Newfoundland and Labrador, Ontario and Saskatchewan because the pension legislation of those provinces incorporates the federal 30% Rule, as amended from time to time, by reference.
On March 14, 2016, the Ontario government released for comment its own proposals on the elimination of the 30% Rule. These proposals were originally announced last fall and reiterated in the 2016 Ontario budget. It will be interesting to monitor how the federal and Ontario provincial consultative procedures interact.
Budget 2016 offers little for charities in terms of tax measures. It contains the following:
- the 33% charitable donation tax credit for certain trusts (referred to above);
- an announcement that the Government will not proceed with the measure contained in Budget 2015 that would have provided an exemption from the taxation of capital gains realized on certain dispositions of private corporation shares or real estate where the cash proceeds from the disposition are donated to a registered charity or other qualified donee within 30 days of the disposition; and
- a commitment that the CRA, in consultation with the Department of Finance, will engage with charities to clarify the rules governing their political activities.
TAX COMPLIANCE AND COLLECTION
Budget 2016 proposes to spend nearly $450 million over five years for the CRA to enhance its efforts to crack down on tax evasion and combat tax avoidance through, among other things, the hiring of additional auditors and specialists, developing robust business intelligence infrastructure and increasing verification activities. The expected revenue impact from these measures is $2.6 billion over five years.
The Government also proposes in Budget 2016 to provide $351.6 million over five years for the CRA to improve its ability to collect outstanding tax debts. The proposal is expected to result in the collection of an additional $7.4 billion in tax debts over five years.
SALES AND EXCISE TAX MEASURES
De Minimis Financial Institutions
Special Goods and Services Tax/Harmonized Sales Tax (GST/HST) rules apply to financial institutions, particularly in determining their entitlement to input tax credits. Financial institutions include banks, insurance companies, investment dealers and investment plans. The GST/HST legislation also includes rules to include “de minimis” financial institutions as financial institutions for purposes of the GST/HST if the person’s income for the preceding taxation year from interest, fees or other charges with respect to the lending of money, the granting of credit, the making of an advance or credit card operations exceeds $1 million.
In order to allow a person to engage in basic deposit-making activity without that activity causing it to be a financial institution for GST/HST purposes, Budget 2016 proposes that interest earned in respect of demand deposits, as well as term deposits and guaranteed investment certificates with an original date to maturity not exceeding 364 days, not be included in determining whether a person exceeds the $1 million threshold.
This measure is proposed to apply to taxation years of a person beginning on or after Budget Day and to the fiscal year of a person that begins before Budget Day and ends on or after that day for the purposes of determining if the person is required to file the Financial Institution GST/HST Annual Information Return.
Application of GST/HST to Cross-Border Reinsurance
GST/HST imported supply rules for financial institutions, including insurance companies, with a presence outside Canada, require financial institutions to self-assess GST/HST on certain expenses incurred outside Canada that relate to their Canadian activities. Uncertainty has existed in relation to the application of these self-assessment rules to reinsurance premiums. Budget 2016 proposes to clarify that two specific components of the premium for imported reinsurance services, ceding commissions and the margin for risk transfer, do not form part of the tax base that is subject to self-assessment, and to set out specific conditions under which the special rules for financial institutions do not impose GST/HST on reinsurance premiums charged by a reinsurer to a primary insurer.
This measure is proposed to apply on a retroactive basis as of the introduction of the special GST/HST imported supply rules for financial institutions (i.e., in respect of any specified year of a financial institution that ends after November 16, 2005). In addition, this measure will allow a financial institution to request a reassessment by the Minister of the amount of tax owing by the financial institution under the special GST/HST imported supply rules for a past specified year of the financial institution, as well as any related penalties or interest, but solely for the purpose of taking into account the effect of this measure. A financial institution will have until the day that is one year after the day that the amendments receive Royal Assent to request such a reassessment.
Closely Related Test
Under section 156 of the Excise Tax Act, special relieving rules allow members of a group of closely related corporations or partnerships to neither charge nor collect GST/HST on certain intercompany supplies. Currently, in order for the rule to apply to transactions between a parent corporation or partnership and a subsidiary corporation, the parent must own 90% or more of the value and number of the shares of the subsidiary corporation that have full voting rights under all circumstances.
With the intention of ensuring that “the closely related test applies only in situations where nearly complete voting control exists”, Budget 2016 proposes to require that, in addition to meeting the conditions of the current test, a corporation or partnership must also hold and control 90% or more of the votes in respect of every corporate matter of the subsidiary corporation (with limited exceptions) in order to be considered closely related.
This measure is proposed to apply generally as of the day that is one year after Budget Day. The measure is proposed to apply as of the day after Budget Day for the purposes of determining whether the conditions of the closely related test are met in respect of elections under section 150 and section 156 of the Excise Tax Act that are filed after Budget Day and that are to be effective as of a day that is after Budget Day.
Definition of Capital Property
For GST/HST purposes, “capital property” is currently defined to generally parallel the definition of capital property in the Tax Act. With the exception of property belonging to Class 12, 14 or 44 of Schedule II to the Income Tax Regulation, capital property of a person for income tax purposes will qualify as capital property for GST/HST purposes. ECP that is excluded from capital property under the Tax Act is also excluded for GST/HST purposes.
In order to ensure that the proposed overhaul of the ECP regime for purposes of the Tax Act (as described above) does not affect the application of GST/HST, the definition of “capital property” under the Excise Tax Act will be amended to exclude property described in new Class 14.1.
This measure is proposed to come into force on January 1, 2017.
GST/HST on Donations to Charities
The GST/HST does not apply to a donation if the donor does not receive any consideration in return. However, subject to a number of exceptions, if the donor receives property or services in exchange for the donation, even if the value of the donation exceeds the value of the offered property or services, the GST/HST generally applies on the full value of the donation. To harmonize the GST/HST treatment of this type of exchange with the split-receipting rules under the Tax Act, Budget 2016 proposes a relieving change to provide that when a charity supplies property or services in exchange for a donation and when an income tax receipt may be issued for a portion of the donation, only the value of the property or services supplied will be subject to GST/HST. The proposal will apply to supplies that are not already exempt from GST/HST, and is intended to ensure that the portion of the donation that exceeds the value of the property or services supplied is not subject to the GST/HST.
This proposal will apply to supplies made after Budget Day. Additionally, certain transitional relief will be made available where a charity did not collect GST/HST on the full value of donations made in exchange for an inducement, for supplies made between December 21, 2002 (when the Tax Act split-receipting rules came into effect) and Budget Day.
Generally, medical and assistive devices that are specially designed to assist an individual in treating or coping with a chronic disease or illness or a physical disability are zero-rated under the GST/HST. Budget 2016 proposes to add insulin pens, insulin pen needles and intermittent urinary catheters to the list of zero-rated medical devices.
Supplies of purely cosmetic procedures are not considered to be supplies of basic health care and are generally intended to be subject to the GST/HST regardless of the status of the supplier. Budget 2016 proposes to “clarify” that the GST/HST generally applies to supplies of purely cosmetic procedures provided by all suppliers, including registered charities.
Exported Call Centre Services
Budget 2016 proposes to modify the zero-rating rules for certain exported supplies of call centre services. In particular, the supply of a service of rendering technical or customer support to individuals by means of telecommunications (e.g., by telephone, email or web chat) will generally be zero-rated for GST/HST purposes if: (i) the service is supplied to a non-resident person that is not registered for GST/HST purposes, and (ii) it can reasonably be expected at the time the supply is made that the technical or customer support is to be rendered primarily to individuals who are outside Canada at the time the support is rendered to those individuals.
Reporting of Grandparented Housing Sales
The special reporting by builders of grandparented housing is proposed to be simplified for HST purposes by: (i) limiting the reporting requirement to those grandparented housing sales for which the consideration is equal to or greater than $450,000; and (ii) providing builders with an opportunity to correct past misreporting and avoid potential penalties by allowing them to elect to report all past grandparented housing sales for which the consideration was equal to or greater than $450,000.
Restricting the Relief on Excise Tax on Diesel and Aviation Fuel
Budget 2016 proposes to limit the excise tax relief for diesel fuel oil used as heating oil or to generate electricity. Specifically, Budget 2016 proposes to define heating oil, for excise tax purposes, as fuel oil that is consumed exclusively for providing heat to a home, building or similar structure, and is not consumed for generating heat in an industrial process. Additionally, Budget 2016 proposes to remove the generation of electricity exemption for diesel fuel used in or by a vehicle, including a conveyance attached to the vehicle, of any mode of transportation. As such, no relief will apply to fuel used to produce electricity in any vehicle (e.g., trains, ships, airplanes), irrespective of the purpose for which the electricity is used.
These measures will generally apply to diesel fuel delivered or imported after June 2016.
Enhancing Certain Security and Collection Provisions in the Excise Act, 2001
Under the Excise Act, 2001, tobacco manufacturers and other prescribed persons that import tobacco products must provide and maintain security with the CRA in order to be issued a tobacco licence or any duty-paid stamps. Budget 2016 proposes to increase the maximum amount of security required for a person to be issued a licence or any duty-paid stamps to $5 million, from $2 million.
In general, when a person objects to, or appeals, an assessment of an amount payable under the Excise Act, 2001, the CRA is restricted from taking certain collection actions while a decision or judgment is pending, and there is no obligation under the Excise Act, 2001 on the person to ensure payment of an amount that has been assessed. Budget 2016 proposes to give the CRA the authority to require security for payment of assessed amounts and penalties in excess of $10 million that are not otherwise collected under the Excise Act, 2001. If the requested security is not furnished, Budget 2016 also proposes that the CRA be provided with the authority to collect an amount equivalent to the amount of security that the CRA had required.
STATUS OF OUTSTANDING TAX MEASURES
Budget 2016 confirms the Government’s intention to proceed with the following tax and related measures that were announced in the current session of Parliament:
- the common reporting standard established by the OECD for the automatic exchange of financial account information between tax authorities; and
- legislative proposals on the income tax rules for certain trusts and their beneficiaries (draft legislative proposals were released for comment on January 15, 2016).
In addition, Budget 2016 confirms the Government’s intention to proceed with a number of tax measures previously proposed, including the following:
- “synthetic equity arrangements” under the dividend rental arrangement rules;
- the conversion of capital gains into tax-deductible inter-corporate dividends (section 55);
- the offshore reinsurance of Canadian risks;
- alternative arguments in support of an assessment;
- an exception to the withholding tax requirements for payments by qualifying non-resident employers to qualifying non-resident employees;
- the repeated failure to report income penalty;
- the acquisition or holding of limited partnership interests by registered charities;
- the qualification of certain costs associated with undertaking environmental studies and community consultations as Canadian exploration expenses;
- the sharing of taxpayer information within the CRA to facilitate the collection of certain non-tax debts; and
- the GST/HST joint venture election.