ONE | A NEW LIBERAL GOVERNMENT
Elected in October 2015, Canada’s new Liberal government has proposed a tax platform featuring significant changes, including a four per cent increase (to 33 per cent) in the federal tax rate for individuals on income over C$200,000 and a 1.5 per cent drop in the middle-income tax rate. The new government has also pledged to limit the amount of employee stock-option gains eligible for capital gains treatment to C$100,000 per year. This could seriously impact many sectors, including the technology sector, which relies heavily on stock-option compensation. The Minister of Finance has advised that existing options will be grandfathered.
Other proposed changes include reversing the previous government’s increase in the annual TFSA (tax-free savings account) contribution limit (reinstating the prior C$5,500 limit), reducing the small-business tax rate from 11 per cent to nine per cent and possibly imposing new limits on the types of corporations and businesses eligible for the small-business deduction.
TWO | BEPS AND THE OECD
In September 2015, the Organisation for Economic Co-operation and Development (OECD) issued its final reports on the Base Erosion and Profit Shifting (BEPS) initiative. These reports have received technical acceptance by the G20 countries and are generally expected to receive political acceptance as well. The reports recommend significant changes to the international tax landscape in such areas as permanent establishments, treaty shopping, interest deductibility, tax reporting and transparency. It will be interesting to see Canada’s reaction to these recommendations, including whether the made-in-Canada anti-treaty shopping rule originally proposed in the 2014 federal budget will be resurrected.
The 2015 federal budget confirmed Canada’s commitment to the new common reporting standard developed by the OECD in connection with the BEPS initiative for automatic exchange of financial account information with foreign tax authorities. On June 2, 2015, Canada became a party to a Multilateral Competent Authority Agreement with more than 60 other countries providing for coordinated implementation. The common reporting standard, which is based on the U.S. Foreign Account Tax Compliance Act (FATCA), will apply to Canadian financial institutions, effective July 1, 2017, with the first information exchange scheduled for 2018. Although the compliance requirements under the common reporting standard are expected to be substantially similar to those under FATCA, we will be monitoring the situation as more details are released.
THREE | BUDGET PROPOSALS AFFECTING THE TAXATION OF INTERCORPORATE DIVIDENDS
Generally, intercorporate dividends are deductible by the recipient to prevent multiple levels of corporate income tax on corporate earnings. The 2015 budget proposed two significant changes to the treatment of intercorporate dividends.
The first change is a broadening of an existing anti-avoidance rule that generally converts tax-free intercorporate dividends into capital gains if one of the purposes of the dividend is to significantly reduce the capital gain that would otherwise be realized on a disposition of a share, except to the extent the dividend is paid from the corporation’s “safe income on hand” (generally, after-tax retained earnings). The budget proposed to expand the “purpose” test that triggers the rule so that the rule will also apply if one of the purposes of the dividend is to significantly reduce a share’s fair market value or increase the cost of property held by the dividend recipient, except in the case of deemed dividends from a share redemption, acquisition or cancellation of a share by the issuer. Arguably, this expanded purpose test could apply to almost any dividend regardless of whether the transaction was motivated by a desire to avoid tax.
The budget proposal also significantly limits application of the “within the group” exception often relied on for comfort that the existing rule does not apply to routine cash movements within a corporate group. Under the proposal, this exception will only apply to deemed dividends resulting from a redemption, acquisition or cancellation.
If enacted as proposed, this amendment will add substantial cost and complexity to the movement of cash within Canadian corporate groups. The proposal’s impact can already be seen in intercorporate dividend transactions that have occurred since the budget announcement. Many such transactions are now being structured to trigger deemed dividends on share redemptions so that the “within the group” exception can still be relied on. The Canada Revenue Agency has offered some administrative comfort that it will not seek to apply the new rule to ordinary course dividends paid by public corporations pursuant to an established dividend policy, but the specific contours of this administrative policy are not clear.
The second change targets structures in which Canadian financial institutions provide synthetic exposure to Canadian dividend-paying shares to Canadian tax-exempt entities (such as Canadian pension funds) or non-residents through derivatives such as total return swaps. In these structures, the financial institution deducts the dividend-equivalent payments on the swap and claims an intercorporate dividend deduction with respect to dividends received, resulting in a loss for tax purposes. The budget indicated that these arrangements significantly erode Canada’s tax base because the counterparties are not subject to Canadian income tax on dividend-equivalent payments received.
Under the budget proposal, such a “synthetic equity arrangement” will be subject to the existing “dividend rental arrangement” rules, and accordingly, dividends received on a share that is the subject of such an arrangement will no longer be eligible for the intercorporate dividend deduction. This rule is proposed to apply to dividends paid after October 31, 2015, subject to limited grandfathering until May 2017 for arrangements entered into before the budget announcement.
Although, to date, the new government has not made any announcements regarding whether it intends to move forward with these proposed measures, they will likely be implemented in some form.