Investment Fund Mergers
The Budget seeks to expand the scope of rules which apply to generally permit the merger of certain investment funds on a tax-deferred basis. As further explained below, these rules will apply to permit the reorganization of a mutual fund corporation that is structured as a “switch corporation” into multiple mutual fund trusts, as well as the merger of segregated funds.
Merger of Switch Corporations into Mutual Fund Trusts
A mutual fund may be structured as either a trust or as a corporation. For mutual funds structured as corporations, “switch corporations” generally refer to corporations with multiple classes of shares, with each class constituting a distinct investment fund. Currently, under the Tax Act, two mutual fund trusts may merge with one another on a tax-deferred basis. A mutual fund corporation may also be merged into a mutual fund trust, but a mutual fund corporation (such as a “switch corporation”) may not be reorganized into multiple mutual fund trusts.
The Federal Budget 2016 limited the ability of shares of a mutual fund corporation to be transferred or “switched” between different share classes on a tax-deferred basis. The Federal Government’s concern was the appropriate recognition of capital gains and as such considered a “switch” between funds as a disposition at fair market value.
In order to provide the mutual fund industry with some flexibility in reorganizing their funds, the Budget proposes to introduce new measures which will permit “switch corporations” to reorganize themselves on a tax-deferred basis into multiple mutual fund trusts. Under the proposed new measures, in order to be a “qualifying exchange”, all or substantially all of the of the property of the mutual fund corporation must be transferred to one or more mutual fund trusts. Where each class of shares of a mutual fund corporation is or is part of an investment fund, all or substantially all of the assets allocable to that class must be transferred to a mutual fund trust and the shareholders of that class of shares of the corporation must dispose of their shares of the mutual fund corporation to the mutual fund corporation within 60 days and become unitholders of that mutual fund trust. The disposing shareholders cannot receive any consideration other than the aforementioned units of the mutual fund trust.
The new measures permitting “switch corporations” to reorganize themselves into multiple mutual fund trusts will apply to transactions carried out on or after Budget Day.
Segregated Fund Mergers
Life insurance policies in Canada may be organized as segregated funds, which have many characteristics in common with mutual fund trusts. However, segregated funds are not currently permitted to merge with one another on a tax-deferred basis.
To provide consistency in treatment, the Budget proposes to permit segregated funds to merge with one another on a tax-deferred basis in accordance with rules that mirror the mutual fund merger rules.
In general a “qualifying transfer” will occur if: (i) all of the property of a segregated fund becomes the property of another segregated fund; (ii) every person (hereinafter referred to as the “beneficiary”) that had an interest in the transferor segregated fund received no consideration other an interest in the transferee segregated fund; (iii) the trustee of the funds is a resident of Canada; and (iv) the trustee of the funds make the prescribed election.
Both segregated funds will be deemed to have a year end and each beneficiary will be deemed to have disposed of their interest in the transferor segregated fund at cost. In keeping with the
rules which apply to the merger of mutual fund trusts, use of losses that arose prior to the merger will be restricted following a segregated fund merger. For non-capital losses of a segregated fund which arise in taxation years after 2017, in accordance with the Tax Act’s general loss carry forward and carryback rules, a segregated fund will be permitted to carry over the losses and to apply them in determining its taxable income for taxation years beginning after 2017.
In respect of a qualifying transfer, each property of the transferor segregated fund and transferee segregated fund held immediately before the transfer time is deemed to have been disposed of at that time for proceeds of disposition, and to have been acquired by the transferee segregated fund for a cost, equal to the lesser of:
- the fair market value of the property immediately before the transfer time; and
- the greater of:
- the cost amount of the property at that time; and
- the elected amount.
To the extent that the transferor segregated fund or transferee segregated fund realizes a net capital loss on a qualifying transfer, subsection 138.1(3) of the Tax Act will not apply to such capital loss.
The new measures applying to segregated funds will apply to mergers occurring after 2017 and to losses which arise in taxation years after 2017. The delay in the effective date of the new measures is intended to provide the life insurance industry with an opportunity to provide comments on the new rules.
Investment Tax Credit for Child Care Spaces
The Budget proposes to eliminate the investment tax credit for child care spaces in respect of expenditures incurred on or after Budget Day. The credit is currently available on costs incurred to build or expand child care spaces in licensed child care facilities. Transitional relief will be available in respect of eligible expenditures incurred before 2020 where a written agreement has been entered into before Budget Day.
Insurers of Farming and Fishing Property
Insurers of farming and fishing property benefit from a tax exemption based upon the proportion of their gross premium income and that of affiliated insurers that is earned from the insurance of property used in farming or fishing (including residences of farmers or fishers). The Budget proposes to eliminate the tax exemption for insurers of farming and fishing property applicable to taxation years beginning after 2018. Paragraph 149(1)(t) and subsections 149(4.1) to (4.3) are to be repealed as part of the implementation of this proposal.
The Budget continues the Federal Government’s focus on the professional service sector by proposing to eliminate the ability of designated professionals (i.e. accountants, dentists, lawyers, medical doctors, veterinarians, and chiropractors) to exclude the value of work in progress in computing income for tax purposes. Designated professionals must include work in progress in income for the year in computing taxable income for taxation years beginning on or after Budget Day. The Budget terms this as billed-basis accounting.
A transitional period is being provided to phase in the inclusion of work in progress into income. Pursuant to this transitional period, 50% of the lesser of the cost and fair market value of work in progress must be taken into account for the purpose of determining the value of inventory held by a business in the first taxation year that begins on or after Budget Day. The full amount of the lesser of the cost and the fair market value of work in progress must be included in inventory valuation for all subsequent years.
The amendments will be implemented through the addition of subsection 10(14.1) to taxation years ending on or after Budget Day and thereafter the repeal of subsection 10(14) and the new subsection 10(14.1) as of January 1, 2020. The new subsection 10(14.1) applies the transitional rule noted above by deeming the cost and fair market value of work in progress to be one-half of the amounts actually determined (for the first taxation year commencing on or after Budget Day). The repeal of this provision ensures its application on a transitional basis.
Similarly, a new paragraph 34(a) is proposed to be enacted and subsequently repealed as of January 1, 2020. This new provision allows taxpayers to elect to exclude work in progress in computing income for years beginning before Budget Day and triggers the application of transitional subsection 10(14.1) for taxation years beginning on or after Budget Day. Therefore, during the transitional period, an election to exclude work in progress from income for taxation years prior to Budget Day under new paragraph 34(a) will trigger new subsection 10(14.1) for the first taxation year commencing on or after Budget Day such that the excluded work in progress is deemed to be one-half of the lesser of the cost amount or fair market value of the actual work in progress for such later taxation year. This ensures that one-half of the lesser of the two amounts is actually included in the year in which the work is performed if such year is a transitional year.
The Budget does not contain any information about how the cost and fair market value of work in progress is to be determined.
Clean Energy Generation Equipment: Geothermal Energy
Classes 43.1 and 43.2 of Schedule II of the Income Tax Regulations provide accelerated capital cost allowance (“CCA”) rates of 30% and 50%, respectively, on a declining-balance basis for investments in certain clean energy generation and conservation equipment. Budget 2017 proposes three changes to the area of clean energy generation equipment and specifically geothermal energy. First, eligible geothermal energy equipment under Classes 43.1 and 43.2 will be expanded to include geothermal equipment used primarily for the purpose of generating heat or a combination of heat and electricity. Under the current rules, only thermal energy equipment used primarily in the generation of electricity qualifies for these accelerated classes. Eligible costs will include the cost of completing a geothermal well and for systems that produce electricity, the cost of related electricity transmission equipment.
Second, geothermal heating will be made an eligible thermal energy source for use in a district energy system and thereby qualify for the accelerated CCA rates under Classes 43.1 and 43.2. Last, exploration expenses incurred for the purpose of determining the extent and quality of a geothermal resource and the cost of all geothermal drilling, for both electricity and heating projects, will qualify as a Canadian renewable and conservation expense. The 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.
Canadian Exploration Expense: Oil and Gas Discovery Wells
The Budget proposes that eligible drilling or completion expenses in respect of a discovery well (or incurred to build a temporary access road to a well site) will generally be classified as Canadian development expenses (“CDEs”) instead of Canadian exploration expenses (“CEEs”). CDEs may be deducted at a rate of 30% per year on a declining-balance basis while CEEs are deductible in full in the year incurred. The proposal is aimed at ensuring that expenditures linked to successful projects are deducted gradually over time as development expenses.
Drilling expenditures can continue to be classified as CEEs where the well has been abandoned (or has not produced within 24 months) or the Minister of Natural Resource has certified that the relevant costs associated with drilling the well are expected to exceed $5 million and it will not produce within 24 months. Certain other expenses, such as early stage geophysical and geochemical surveying, will continue to constitute CEEs.
The measure will apply to expenses incurred after 2018, including expenses incurred in 2019 that may be deemed to have been incurred in 2018 as a result of the look-back rule. Under the existing look-back rule, eligible expenses in respect of funds raised in a particular calendar year under a flow-through share arrangement can be renounced with an effective date in the year even though the eligible expenditures are incurred during the following calendar year. The measure will not apply to expenses actually incurred prior to 2021 where the taxpayer has, before Budget Day, entered into a written commitment (including a commitment to a government under the terms of a license or permit) to incur those expenses.
Reclassification of Expenses Renounced to Flow-Through Share Investors
The Budget proposes to repeal the treatment of the first $1 million of Canadian development expense (“CDE”) by eligible small oil and gas corporations as Canadian exploration expense (“CEE”). Under current rules, an oil and gas corporation with taxable capital employed in Canada of not more than $15 million can treat up to $1 million of CDEs as CEEs when renounced to shareholders under a flow-through share agreement. This allows for the full deduction of the expense in the year in which it is incurred or in the previous year pursuant to the look back rule (rather than being deductible at the rate of 30% per year on a declining-balance basis, being the rate applicable to CDEs).
This measure will apply in respect of expenses incurred after 2018 (including expenses incurred in 2019 that could have been deemed to be incurred in 2018 because of the look-back rule that allows eligible expenses in respect of funds raised in one calendar year under a flow-through share arrangement to be renounced with an effective date in the year even though the eligible expenditures are incurred during the following calendar year), with the exception of expenses incurred after 2018 and before April 2019 that are renounced under a flow-through share agreement entered into after 2016 and before Budget Day.
Meaning of Factual Control
The Tax Act generally recognizes two types of control:
- De jure (or legal) control; and
- De facto (or factual) control.
De facto control is necessarily broader than de jure control (which is limited to the legal ability to control the corporation, particularly by being able to elect the majority of its board of directors) and is applied within the context of the Tax Act to ensure that certain tax advantages, such as access to the small business deduction and/or scientific research and experimental development tax credits are not inappropriately accessed. A taxpayer may control a corporation on a de facto basis even though the taxpayer does not otherwise have the ability to legally control the corporation. Factual and circumstance considerations apply to this determination. The explanatory notes to the Budget correctly provide that a considerable body of case law exists with respect to the factors to be applied in determining whether a taxpayer factually controls a corporation.
In the recent decision in McGillivray Restaurant Ltd. v. Canada, 2016 FCA 99 (“McGillivray Restaurant”), the Federal Court of Appeal affirmed that “a factor that does not include a legally enforceable right and ability to effect a change to the board of directors or its powers, or to exercise influence over the shareholder or shareholders who have that right and ability, ought not to be considered as having the potential to establish de facto control.” In the Federal Government’s view, the decision limits the scope of the factors to be taken into consideration in determining whether a taxpayer has de facto control of a corporation. Further, the Federal Government expressed the view that, from a policy perspective, it is not intended that the factual control test be dependent on the exercise of a legally enforceable right to change a corporation’s board of directors, or that factors which do not include the legal right to enforce control or to otherwise exercise influence over shareholders who have such control should be disregarded.
In response to the McGillivray Restaurant decision, the Budget proposes the introduction of new subsection 256(5.11) to the Tax Act, which provides that the determination of whether a taxpayer has any direct or indirect influence in respect of a corporation that, if exercised, would result in factual control of the corporation shall take into consideration all of the relevant factors in the circumstances and shall not be limited to the factors specifically identified by the Court in McGillivray Restaurant, which are reproduced in the language of new paragraph 256(5.11)(b).
New subsection 256(5.11) will apply to taxation years that begin on or after Budget Day.
Timing of Recognition of Gains and Losses on Derivatives
Derivatives are securities whose value is derived from the value of an underlying interest. In certain cases, taxpayers may hold derivatives on income account. Presently, there are no specific rules in the Tax Act (except for the market to market rules for financial institutions) which govern the timing of the recognition of gains and losses in respect of derivatives that are held on income account. The Budget proposes two new measures designed to clarify the scheme of the Tax Act with respect to the taxation of derivatives held on income account.
Elective Use of Mark-to-Market Method
First, the Budget proposes to introduce an election which will permit taxpayers to mark-to-market “eligible” derivatives held on income account. The election, once made, will apply to all of the taxpayer’s subsequent taxation years unless it is revoked with the consent of the Minister of National Revenue.
The new mark-to-market election is in response to a recent decision of the Federal Court of Appeal which allowed a taxpayer that was not a financial institution to use the mark-to-market method given that it provided an accurate picture of the taxpayer’s income. According to the Federal Government, the mark-to-market method has a number of advantages both for taxpayers and for the Federal Government. These advantages include, for the taxpayer, the potential reduction of book-to-tax differences and, for the Government, the elimination of the possibility for the selective realization of gains and losses on derivatives held on income account by removing the taxpayer’s control over when these gains and losses are recognized for tax purposes.
An “eligible” derivative will generally be any derivative held on income account which meets certain conditions, including that the derivative must be valued in accordance with accounting principles at its fair value in a taxpayer’s audited financial statements or otherwise has a readily ascertainable fair market value.
After first filing the new mark-to-market election, a taxpayer will be required to include in computing its income annually the increase or decrease in value of its eligible derivatives. The recognition of any accrued gain or loss on an eligible derivative (that was previously subject to tax on a realization basis) at the beginning of the first election year will be deferred until the derivative is disposed of.
The new mark-to-market election will be available for taxation years that begin on or after Budget Day.
Second, the Budget proposes to introduce a specific anti-avoidance rule aimed at “straddle” transactions undertaken by taxpayers who hold derivatives on income account. Such taxpayers may, at present, selectively realize gains and losses on these derivatives through the implementation of straddle transactions.
In general, a straddle transaction is a transaction in which a taxpayer enters at the same time into two or more positions (often derivatives) which are expected to give rise to equal and offsetting gains and losses. Just before its taxation year end, the taxpayer realizes a capital loss by disposing of the position with the accrued loss. This loss would be available to be applied by the taxpayer against any gains realized during the taxation year in question. Thereafter, shortly after the start of the following taxation year, the taxpayer disposes of the position with the accrued gain. This gain will be taxed in the following taxation year of the taxpayer, thereby providing the taxpayer with a deferral opportunity.
The Federal Government is concerned with the tax treatment afforded to taxpayers who enter into straddle transactions since, economically, the two positions taken by the taxpayer are economically offsetting. In addition, a taxpayer could attempt to indefinitely defer the recognition of a gain by entering into successive straddle transactions. In the explanatory notes to the Budget, the Federal Government acknowledged that straddle transactions are presently being challenged, including under the Tax Act’s general anti-avoidance rule. However, the Federal Government admitted that these challenges are costly and time-consuming, thereby justifying the need for the introduction of a specific anti-avoidance measure to deal with straddle transactions.
The proposed new anti-avoidance measures will include a stop-loss rule that will effectively defer the realization of any loss on the disposition of a position to the extent of any unrealized gain on an offsetting position. A position, for the purposes of the new stop-loss rule, will be defined to include any interest in actively traded personal properties (e.g., commodities), as well as derivatives and certain debt obligations. In contrast, an offsetting position will be generally defined as a position that has the effect of eliminating all or substantially all of the taxpayer’s risk of loss and opportunity for gain or profit in respect of the position.
There will be several exceptions to the proposed new stop-loss rule. In particular, the rule will not apply to a position if:
- it is held by a financial institution, as defined for the purposes of the mark-to-market property rules, or by a mutual fund trust or mutual fund corporation;
- it is part of certain types of hedging transactions entered into in the ordinary course of the taxpayer’s business;
- the taxpayer continues to hold the offsetting position throughout a specified period that begins on the date of disposition of the position; or
- it is part of a transaction or a series of transactions none of the main purposes of which is to defer or avoid tax.
The new anti-avoidance rules in respect of straddle transactions will apply to any loss realized on a position entered into on or after Budget Day.
Consultation on Cash Purchase Tickets
The Budget launches a consultation on the income tax treatment of deferred cash purchase tickets issued to farmers in respect of deliveries of listed grains (i.e., wheat, oats, barley, rye, flaxseed, rapeseed, or canola) to the operator of a licensed elevator. Presently, pursuant to subsection 76(4), upon making such deliveries, the operator may issue a cash purchase ticket to the farmer or some other form of settlement. If the cash purchase ticket or other form of settlement is payable in the year following the year in which it is issued, it is generally referred to as a “deferred cash purchase ticket”).
At present, the amount of a deferred cash purchase ticket may be included in a taxpayer’s income in the following taxation year to the year in which it was issued. The CRA had previously confirmed this position in Interpretation Bulletin IT-184R – Archived. In the Budget, the Federal Government notes that this is a departure from the general rule under subsection 76(1) of the Tax Act, which applies to other taxpayers (including farmers), regarding the current inclusion in income of a security or other evidence of indebtedness received as payment of a currently-payable debt.
The Federal Government explains that the historical rationale for the tax deferral provided to farmers in respect of deferred cash purchase tickets relates to international grain shipment agreements and the Canadian Wheat Board’s former position as the sole purchaser of listed grain in Manitoba, Saskatchewan and Alberta. However, given the recent deregulation of the grain marketing regime and commercialization of the Canadian Wheat Board, the delivery of listed grains is no longer the responsibility of the Federal Government and is instead in the hands of private businesses. The Federal Government accordingly takes the view that there is arguably no longer a clear policy rationale for maintaining the tax deferral for deferred cash purchase tickets and asks that interested parties provide their comments or submissions on this topic by May 24, 2017, by sending them by e-mail to: [email protected].