Introduction
Business income tax measures
International tax measures
Introduction
Minister of Finance James Flaherty tabled the government's 2012 Federal Budget on March 29 2012. The 2012 budget is intended to keep the government on track to return to balanced budgets in the medium term through a broad range of selective spending cuts, and repeats themes from previous budgets, such as maintaining Canada's economic advantage, supporting job creation, supporting families and communities and investing in innovation, education and training.
This budget is the first under a majority Conservative government and commits the government to cutting, on average, departmental programme spending by 6.9% (C$5.2 billion). The government is forecasting a deficit of C$33.4 billion for the current year ending March 31 2012. According to the government, the deficit will decrease over the next three years by C$24.9 billion, C$21.1 billion and C$10.2 billion respectively, to a balanced budget by 2014-2015.
The 2012 budget proposes a number of important tax measures in the areas of business income tax and international tax, which are discussed below.
Business income tax measures
Corporate mineral exploration and development tax credit
The budget proposes to phase out the 10% corporate tax credit for pre-production mining expenditures. The length of the phase-out will depend on the type of expense.
For qualifying exploration expenses, the credit will apply at a rate of 10% for expenses incurred in 2012, and at a rate of 5% for such expenses incurred in 2013. The credit will not be available for exploration expenses incurred after 2013.
For qualifying pre-production development expenses, the corporate tax credit will apply at a rate of 10% for expenses incurred before 2014, 7% for expenses incurred in 2014 and 4% for expenses incurred in 2015. The credit will not be available for pre-production development expenses incurred after 2015.
The budget plan notes that additional transitional relief will be provided for qualifying pre-production development expenses in recognition of the long timelines involved in developing mines.
Atlantic Investment Tax Credit
The budget proposes to phase out the Atlantic Investment Tax Credit for oil and gas and mining activities in the Atlantic provinces, the Gaspé Peninsula and their associated offshore regions over a four-year period (the credit will be 10% in 2013; 5% in 2014 and 2015; 0% thereafter). This proposal applies to assets acquired on or after March 29 2012 for use in a broad specified list of oil and gas mining activities. The availability of the credit for assets acquired for use in other activities will not be affected. Transitional relief will be provided in recognition of the long timelines involved in some oil and gas and mining projects. The phase-out of the credit is in response to the government's G20 commitment to phase out inefficient fossil fuel subsidies.
The budget also proposes to amend the Income Tax Act and the Income Tax Regulations so that qualified property eligible for the Atlantic Investment Tax Credit will include electricity generation equipment described in Class 17 or 48 and clean energy generation and conservation equipment described in Class 43.1 or 43.2, provided that such equipment is used in the Atlantic region primarily in an eligible activity set out in paragraph (c) of the definition of 'qualified property' in Section 127(9) of the act. This measure applies to assets acquired on or after March 29 2012 that have not been used or acquired for use before that date, except that the measure will not apply to acquisitions of assets that are used primarily in oil and gas or mining activities.
Scientific research and experimental development programme
In October 2011 the government-appointed expert review panel on research and development submitted a report with a series of recommendations calling for a simplified and more focused approach to the government's support for business research and development, including the scientific research and experimental development (SR&ED) tax incentives programme. To support the key objectives identified in the report, the budget proposes the following changes to the SR&ED tax incentive programme to make it simpler, more cost effective and predictable:
- The budget proposes to reduce the general SR&ED investment tax credit rate applicable to SR&ED qualified expenditure pool balances at the end of a taxation year from 20% to 15%. The 15% rate will apply in respect of taxation years that end after 2013, except that for a taxation year that includes January 1 2014, the 5% reduction in the credit rate will be pro-rated. The enhanced 35% SR&ED credit rate applicable in respect of eligible Canadian-controlled private corporations will remain unchanged on up to $3 million of qualified SR&ED expenditures annually.
- The budget proposes to exclude expenditures of a capital nature (including payments in respect of the use of, or the right to use, property that would, if it were acquired by the taxpayer, be capital property of the taxpayer) from eligibility for SR&ED deductions and investment tax credits. This measure will apply to property acquired on or after January 1 2014, and to amounts paid or payable in respect of the use of, or the right to use, property during any period after 2013. This measure will also apply to exclude otherwise eligible contract payments made by a taxpayer from benefiting from SR&ED tax incentives, to the extent that the payment is in respect of a capital expenditure made in fulfilment of the contract.
- The budget proposes to reduce the inclusion of an allowance for overhead expenditures where the taxpayer makes use of an election to use a proxy rate applied against all overhead costs, rather than trying to itemise expenditures that are directly related to SR&ED activities. The current proxy rate of 65% is to be reduced to 60% for 2013 and to 55% after 2013. The proxy rate that will apply for taxation years that include days in 2012, 2013 or 2014 will be pro-rated.
- The budget proposes to disallow from the expenditure base for investment tax credits the profit element of contract payments made to arm's-length suppliers of SR&ED services. The profit element is determined arbitrarily: only 80% of the amount paid under a contract to an arm's-length supplier will be eligible for SR&ED investment tax credits. This measure will apply to expenditures incurred on or after January 1 2013.
In addition, consistent with the proposed budget measures concerning SR&ED capital expenditures, the amount of an arm's-length contract payment eligible for SR&ED tax incentives for the payer will exclude any amount paid in respect of a capital expenditure incurred by the performer in fulfilment of the contract. SR&ED contract performers will be required to inform the contract payers of these amounts. Once that measure is in force in 2014, the exclusion with respect to capital expenditures will reduce the amount of the contract payment before the 80% eligibility ratio is applied. The amount that the performer is required to net against its qualifying SR&ED expenditures as a result of the contract payment will be reduced by the amount received by the performer that is in respect of capital expenditures by the performer.
Tax avoidance through the use of partnerships
The 2012 budget will negatively impact on package and bump transactions and create a potential new tax liability for the vendor of a partnership interest transferred to a non-resident.
The first budget proposal reflects the Department of Finance's view that it is inappropriate to bump the cost base of a partnership interest to the extent that such partnership holds assets that, if sold, could produce income (versus only capital gains) - namely, eligible capital property, depreciable property, inventory and resource property.
The budget proposes to deny a Section 88 bump in respect of a partnership interest held by a subsidiary corporation, to the extent that the accrued gain in respect of the partnership interest is reasonably attributable to the amount by which the fair market value of income assets held by the partnership exceeds the assets' cost amount.
This measure will apply regardless of whether the income assets are held directly by the partnership or indirectly through another partnership. For this purpose, assets directly owned by a taxable Canadian corporation, shares of which are held by the partnership, will not be considered to be indirectly held by the partnership. This measure applies to amalgamations that occurred, and windings-up that began on or after March 29 2012. An exception will be provided in limited circumstances where a taxable Canadian corporation amalgamates with its subsidiary before 2013 or begins to wind up its subsidiary before 2013.
The second proposal extends the application of Section 100 of the Income Tax Act, which requires a vendor to include the full amount of the gain on a sale of a partnership interest, to sales of a partnership interest to a non-resident entity, unless the partnership is carrying on business in Canada through a permanent establishment in which all of the assets of the partnership are used (since in such cases the income assets remain within the Canadian income tax base). The provision will also explicitly apply to dispositions made directly, or indirectly as part of a series of transactions, to a tax-exempt or non-resident entity. This measure applies to dispositions of interests in partnerships that occur on or after March 29 2012. An exception will be provided for an arm's-length disposition made by a taxpayer before 2013 that the taxpayer is obligated to make pursuant to a written agreement entered into by the taxpayer before March 29 2012.
International tax measures
Transfer pricing secondary adjustments
Under current Canadian transfer pricing rules, transactions between a Canadian corporation and non-arm's-length non-residents can be adjusted (for tax purposes) to reflect arm's-length terms (the 'primary adjustment'). In addition to the primary adjustment, the general policy of the Canada Revenue Agency (CRA) is to assess the non-resident participant on the related benefit (the secondary adjustment) using existing provisions in the Income Tax Act.
The budget proposes to amend the transfer pricing rules in Section 247 of the act to confirm that secondary adjustments will be treated as deemed dividends for purposes of Part XIII non-resident withholding tax. A Canadian corporation subject to a primary adjustment will be deemed to have paid a dividend to each non-arm's-length non-resident participant in the transaction or series of transactions in proportion to the amount of the primary adjustment that relates to the non-resident, regardless of whether the non-resident is a shareholder of the Canadian corporation.
The budget also proposes, consistent with the CRA's administrative practice, to clarify that no deemed dividend will arise where (with the concurrence of the CRA) the non-resident repatriates the amount of the primary adjustment to the Canadian corporation. In addition, no deemed dividend will arise if the non-resident is a controlled foreign affiliate (as defined in Section 17(15) of the act) of the Canadian corporation. In this instance, the benefit conferred on the non-resident is more akin to a capital contribution than a dividend. This measure applies to transactions (including transactions that are part of a series of transactions) that occur on or after March 29 2012.
Thin capitalisation rules
In accordance with several recommendations made by the advisory panel on Canada's system of international taxation, the budget proposes to make several significant changes to the thin capitalisation rules which limit the deductibility of interest expense of a Canadian-resident corporation with respect to debts owing to a specified shareholder (a person or group owning shares representing more than 25% of the votes or value of the corporation) that is not resident in Canada and any other non-resident which does not deal at arm's length with a specified shareholder:
- The budget proposes to reduce the debt-to-equity ratio from 2:1 to 1.5:1, in accordance with the recommendation of the advisory panel. This measure will apply to corporate taxation years that begin after 2012.
- The budget proposes to extend the thin capitalisation rules to debts owed by partnerships of which a Canadian-resident corporation is a member and the debtor is a non-resident specified shareholder of the Canadian corporate partner. Where a corporate partner's permitted debt-to-equity ratio is exceeded, the partnership's interest deduction will not be denied, but an amount will be included in computing the income of the partner from a business or property, as appropriate. The source of this income inclusion will be determined by reference to the source against which the interest is deductible at the partnership level. This measure applies in respect of debts of a partnership that are outstanding during corporate taxation years that begin on or after March 29 2012.
- The budget proposes to re-characterise disallowed interest expense (including for this purpose any amount that is required to be included in computing the income of a corporate member of a partnership) as a dividend for non-resident withholding tax purposes. For these purposes, accrued interest will be deemed to be paid as a dividend to a specified non-resident at the end of the taxation year. Also, the corporation will have the ability to allocate the disallowed interest amount to the latest interest payments made to a particular specified non-resident in the taxation year. This measure applies to taxation years that end on or after March 29 2012. For taxation years that include March 29 2012, the measure applies to an amount of disallowed interest expense that is based on a pro-ration for the number of days in the taxation year that are on or after March 29 2012.
- To prevent double taxation in certain circumstances where a Canadian resident corporation borrows money from its controlled foreign affiliate, the budget proposes to exclude interest expense of a Canadian-resident corporation from the application of the thin capitalisation rules to the extent that a portion of that interest is taxable in the hands of the corporation in respect of the foreign accrual property income of a controlled foreign affiliate of the corporation. This measure applies to taxation years, of Canadian-resident corporations, that end on or after March 29 2012.
Foreign affiliate dumping
The 2012 budget takes aim at 'debt dumping' by the Canadian subsidiaries of foreign parent corporations. The term refers to circumstances where a foreign-controlled Canadian corporation is financed with related or third-party borrowings and such borrowings are then used by the Canadian corporation to acquire shares of a related, non-resident company. The objective of such transaction is to reduce, by way of a deductible interest expense, the taxable income realised by a Canadian subsidiary from its Canadian operations; similarly, the dividends received from a foreign affiliate are intended to be exempt from tax in Canada. Variations of these transactions are noted in the budget. For example, a Canadian subsidiary may use internal funds to purchase from the foreign parent the shares of a related foreign affiliate, and the purchase would thereby facilitate the repatriation of earnings from the Canadian subsidiary without incurring Canadian dividend withholding tax.
The overall concern is that the financing structure implemented between a Canadian subsidiary and a foreign affiliate would not have a purpose other than to shift deductible tax expenses into Canada. As a result, the structure would reduce the Canadian tax base without generating new economic activity in Canada. Further, in the government's view, existing anti-avoidance rules in the Income Tax Act, including measures such as the thin capitalisation provisions, provide inadequate protection against these foreign affiliate debt-dumping transactions.
Accordingly, the budget proposes to implement a measure that will curtail foreign affiliate debt dumping while at the same time preserving the ability of Canadian subsidiaries of foreign parents to undertake legitimate expansion of their Canadian-based businesses. Specifically, the measure proposes that, where certain conditions are met:
- a dividend will be deemed to be paid by a Canadian subsidiary to its foreign parent equal to the fair market value of the non-share consideration given by the Canadian subsidiary on the acquisition of the foreign affiliate shares;
- any deemed dividend will be subject to non-resident withholding tax, as reduced by any applicable tax treaty; and
- any increase to the paid-up capital of the shares of the Canadian subsidiary for shares issued as consideration to the foreign parent will be ignored.
This measure effectively extends the existing cross-border surplus stripping rule under Section 212.1 of the Income Tax Act to cover transactions involving foreign affiliates.
This measure will not apply to transactions that satisfy a 'business purpose' test. The primary factors to consider in applying this test will be non-tax factors that will be enumerated in the act. One factor will evaluate whether it is reasonable to conclude that the investment in, and ownership of, the foreign affiliate belongs in the Canadian subsidiary rather than in any other entity in the foreign parent's group. Another factor to consider will be whether senior officers of the Canadian subsidiary which resided and worked in Canada exercised principal decision making for the particular investment. If the business purpose test is satisfied, then the foreign affiliate debt-dumping provision will not apply. The budget notes that the government will accept submissions until June 1 2012 as to the specific criteria that should be included within the proposed 'business purpose' test.
This measure will apply to transactions that occur on or after March 29 2012, other than transactions that occur before 2013 between parties that deal at arm's length and that are obligated to complete the transaction pursuant to the terms of an agreement in writing between the parties that is entered into before March 29 2012.
Base erosion rules – Canadian banks
The budget proposes to amend the so-called 'base erosion' rules in the foreign accrual property income provisions of the Income Tax Act to alleviate the tax cost to Canadian banks of using excess liquidity of their foreign affiliates in their Canadian operations. Amendments will also ensure that certain securities transactions undertaken in the course of a bank's business of facilitating trades for arm's-length customers are not inappropriately caught by the base erosion rules. The budget plan indicates that these amendments will be developed in conjunction with industry representatives and will include appropriate safeguards to ensure the Canadian tax base is adequately protected.
For further information on this topic please contact Stephen J Fyfe or Daniel Lang at Borden Ladner Gervais LLP's Toronto office by telephone (+1 416 367 6000), fax (+1 416 367 6749) or email ([email protected] or [email protected]). Alternatively, contact Kevin Scott at Borden Ladner Gervais LLP's Calgary office by telephone (+1 403 232 9500), fax (+1 403 266 1395) or email ([email protected]); or Mark Chartrand at Borden Ladner Gervais LLP's Vancouver office by telephone (+1 604 687 5744), fax (+1 604 687 1415) or email ([email protected]).