On March 22, 2016, Prime Minister Justin Trudeau’s new federal government released its first budget (“Budget 2016”). Rumours of drastic changes to our tax system had been circulating in the weeks leading up to its release. Some of these rumours were proven accurate (with respect to amendments made to the small business deduction rules and the repeal of the eligible capital property regime), while others were not.
This post summarizes the main highlights from Budget 2016 that may be of particular interest to business owners and their advisors.
Consequential Amendments to the Top Marginal Income Tax Rate
On December 7, 2015, the Government introduced a 33 per cent personal income tax rate on individual taxable income in excess of $200,000, effective for 2016 and subsequent taxation years. Budget 2016 proposes further adjustments to other rates that are meant to reflect the new top marginal rate for individuals, such as: (i) a 33 per cent charitable donation tax credit to trusts that are subject to the top marginal rate (on donations above $200); and (ii) an increase in the tax rate on personal services business income earned by corporations from 28 per cent to 33 per cent.
Small Business Deduction (“SBD”) – No Further Reduction in Tax Rate
Currently, small businesses that qualify as Canadian-controlled private corporations (“CCPCs”) benefit from a reduced federal corporate income tax rate of 10.5 per cent on the first $500,000 of qualifying active business income in a year. This small business rate was to decrease gradually from 10.5 per cent in 2016 to 9 per cent after 2018. Budget 2016 proposes to repeal the gradual rate reductions planned for the 2017 and subsequent taxation years (such that the rate will remain at 10.5 per cent).
Restricting Multiplication of the SBD
Budget 2016 proposes measures to address (and effectively shut-down) certain partnership and corporate structures that multiply access to the SBD.
The specified partnership income rules in the Tax Act require that the SBD be shared among CCPCs that are members of a partnership. Generally, the SBD that a CCPC can claim in respect of its business income from a partnership is limited to its pro-rata share of a notional $500,000 business limit determined at the partnership level. Budget 2016 expands these rules in response to certain structures to which the specified partnership income rules did not apply (such as a structure in which a shareholder of a CCPC is a member of a partnership and the partnership pays the CCPC as an independent contractor under a contract for services).
Budget 2016 also provides new rules that will apply to similar structures that utilize a corporation instead of a partnership. In particular, Budget 2016 proposes to eliminate the SBD for certain active business income earned by a CCPC from providing services or property to a private corporation where 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 receiving the services or property.
Conversion of the Eligible Capital Property (“ECP”) Regime
In the 2014 Federal budget, the Government suggested that it was considering converting the current ECP regime into a new class of depreciable property. With the completion of public consultations on the matter, Budget 2016 proposes this change. Specifically, Budget 2016 proposes to repeal the ECP regime and replace it with a new capital cost allowance (“CCA”) class available to businesses.
As part of this proposal, a new class of depreciable property (Class 14.1) will be created for CCA purposes. Expenditures that are currently added to cumulative eligible capital pool (at a 75 per cent inclusion rate) will now be included in the new CCA class at a 100 per cent inclusion rate. Because of this increased expenditure recognition, the new class will have a 5 per cent annual depreciation rate (instead of 7 per cent of 75 per cent of eligible capital expenditures).
This measure, including transitional rules, will apply as of January 1, 2017.
Taxation of Switch Fund Shares
Canadian mutual funds can be in the legal form of a corporation. Many of these mutual fund corporations are organized as “switch funds”. These offer different types of asset exposure in different funds, but each fund is structured as a separate class of shares within the mutual fund corporation. Investors are able to exchange shares of one class of the mutual fund corporation for shares of another class on a tax-deferred basis, in order to switch their economic exposure between the mutual fund corporation’s different funds. Budget 2016 proposes to amend the Tax Act so that an exchange of shares in this manner will be considered a disposition at fair market value for tax purposes.
Sales of Linked Notes
A linked note is an obligation issued by a financial institution the return on which is linked to the performance of certain reference assets. The reference asset – which can be a basket of stocks, a stock index, a commodity, a currency, or units of an investment fund – is generally unrelated to the operations or securities of the issuer.
The Tax Act currently contains rules that deem interest to accrue on a “prescribed debt obligation”, which includes a typical linked note. These rules require an investor to accrue the maximum amount of interest that could be payable on the note in respect of a given taxation year. However, 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.
Another rule 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. However, investors often sell the linked notes prior to maturity, and take the position that no interest has actually accrued at that time. Accordingly, based on this position, the investors are effectively able to convert the return on the notes from ordinary income (which is fully taxable) to capital gains (of which only 50 per cent is taxable).
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 sold prior to maturity. Specifically, a deeming rule will apply to treat any gain realized on the sale of a linked note as interest that accrued on the debt obligation.
Changes to Treatment of Life Insurance Policies
Budget 2016 proposes new rules intended to address certain life insurance transactions that the Government characterized as resulting in an “artificial increase in a corporation’s capital dividend account balance.”
As background, life insurance proceeds received as a result of the death of an individual are generally not subject to income tax. Where the life insurance proceeds are received by a private corporation, the amount of the proceeds less the corporation’s tax cost in respect of the policy (the “insurance benefit limit”) is added to the corporation’s capital dividend account (“CDA”). The corporation can then pay tax-free capital dividends to its shareholders. Note, there are corresponding rules for partnerships. The Government has indicated that some taxpayers have structured their affairs so that the insurance benefit limit rules do not apply as intended (this could be done, for example, by having the insurance proceeds payable to a private corporation that is not the policyholder, and thus has no cost in respect of the policy).
In order to address this concern, Budget 2016 proposes new rules providing that the insurance benefit limit applies regardless of whether the corporation (or partnership) that receives the policy benefit is a policyholder. These rules will apply to policy benefits relating to deaths occurring after March 21, 2016.
Transfers of Life Insurance Policies
Under current rules in the Tax Act, a life insurance policyholder may generally transfer an interest in the policy to a non-arm’s length person, with the proceeds and cost deemed to be the amount of the cash surrender value (“CSV”) of the policy. Where these rules apply, the amount by which any consideration received by the transferor exceeds the CSV is not taxed as income.
Under these rules, an individual who held a life insurance policy with a fair market value in excess of the CSV could often transfer the policy to a non-arm’s length corporation in order to effectively extract funds from the corporation on a tax-free basis (in an amount equal to the fair market value of the policy). The Canada Revenue Agency (the “CRA”) previously commented on these types transactions (see, for example, IT 2002-0127455). Although the CRA generally confirmed the tax results, they commented that “it is not clear that the [result] is intended in terms of tax policy”.
Budget 2016 proposes amendments that will restrict the type of transaction described above (for example, by including the fair market value of any consideration given for an interest in a life insurance policy in the policyholder’s proceeds of the disposition). The new rules will apply to transfers occurring after March 21, 2016.
Donations of Private Company Shares
Budget 2016 announced the Government’s intention to not proceed with certain rules (announced in the 2015 Federal budget) that would have provided an exemption from capital gains tax for certain dispositions of private corporation shares or real estate where cash proceeds from the disposition were donated to a registered charity, or other qualified donee, within 30 days.
Outstanding Tax Measures
Budget 2016 confirms the Government’s intention to proceed with tax and related measures, as modified, to take into account consultations and deliberations since their announcement or release, relating to: (i) the conversion of capital gains into tax-deductible inter-corporate dividends (section 55); (ii) an exception to the withholding tax requirements for payments by qualifying non-resident employers to qualifying non-resident employees; and (iii) the repeated failure to report income penalty.