On March 19, 2019 (“Budget Day”), Federal Finance Minister Bill Morneau tabled the Liberal Government’s 2019 Budget in the House of Commons (“Budget 2019”). Perhaps because 2019 is a federal election year, Budget 2019 does not propose to increase tax rates or the capital gain inclusion rate, as some had expected. In addition, Budget 2019 does not propose any initiatives to simplify the Canadian tax system which has become increasingly complex and, in light of US tax reform, decreasingly competitive.
This article provides a summary of selected tax measures proposed in Budget 2019. This article is not intended to cover the many proposed technical changes but is rather intended to highlight some key topics of interest.
Increased access to scientific research tax credits
Under the current Scientific Research and Experimental Development (“SR&ED”) program, a Canadian-controlled private corporation (“CCPC”) is eligible for a refundable tax credit of 35% of up to $3 million of qualified SR&ED expenditures (including for example wages, expenditures for materials, and overhead) per year (“Expenditure Limit”).
CCPCs (for qualified SR&ED expenditures in excess of the Expenditure Limit) and non-CCPCs are only eligible for a non-refundable tax credit of 15% of qualified SR&ED expenditures.
The Expenditure Limit, and therefore the availability of the enhanced refundable 35% tax credit to a CCPC, is currently phased out on a straight line basis where taxable income and taxable capital employed in Canada exceed certain amounts. In particular, the Expenditure Limit:
- is reduced proportionately to the extent taxable income for the previous taxation year exceeds $500,000 and eliminated when taxable income for the previous taxation year equals or exceeds $800,000, and
- is reduced proportionately to the extent taxable capital employed in Canada for the previous taxation year exceeds $10 million and eliminated when taxable capital employed in Canada for the previous taxation year equals or exceeds $50 million.
The taxable income and taxable capital employed in Canada factors are considered on an associated group basis.
Under the current rules, a relatively small increase in an associated group’s taxable income for the previous taxation year can significantly restrict the availability of the enhanced refundable 35% tax credit. For example, consider a CCPC that incurs $3 million in qualified SR&ED expenditures in a taxation year, and that has $10 million in taxable capital employed in Canada and $500,000 in taxable income for the previous taxation year. This CCPC would be eligible for a refundable tax credit of $1,050,000. In contrast, if the CCPC’s taxable income for the previous taxation year was $600,000 instead of $500,000, this CCPC would be eligible for a total tax credit of $850,000, of which only $700,000 would be refundable.
Budget 2019 proposes to remove taxable income as a factor that reduces or eliminates the Expenditure Limit. This is a welcome measure which means that previous year taxable income above $500,000 on an associated group basis will no longer reduce or eliminate the Expenditure Limit and therefore will not restrict the availability of the enhanced 35% refundable tax credit to a CCPC. Returning to the example above, regardless of whether the CCPC’s previous year taxable income was $500,000 or $600,000, the CCPC would be eligible for a refundable tax credit of $1,050,000.
This proposal applies to taxation years that end on or after Budget Day.
Changes to employee stock option rules
Budget 2019 proposes an annual cap of $200,000 on employee stock options granted by “large, long-established, mature firms” that will be eligible for the current preferential tax treatment.
Under the current rules, an employee is deemed to have received a taxable employment benefit equal to the excess of the value of the shares when acquired less the exercise price paid for them. The employment benefit is treated as employment income and taxed at the employee’s normal marginal tax rates. Where certain conditions are met, the employee may claim a deduction equal to one-half of the employment benefit, such that the employment benefit is effectively taxed at the preferential capital gains tax rates.
Budget 2019 states that the policy rationale for the preferential tax treatment of employee stock options is to support “younger and growing Canadian businesses” and not to provide a “tax-preferred method of compensation for executives of large, mature companies”.
Accordingly, Budget 2019 proposes an annual cap of $200,000 per employee on employee stock option grants, based on the value of the shares at the time the option is granted, that will qualify for the current preferential tax treatment (i.e. the one-half deduction of the employment benefit).
The proposed annual cap will only apply to “large, long-established, mature firms” and not to “start-ups and rapidly growing Canadian businesses”.
Budget 2019 does not provide any draft legislation to implement this proposal and accordingly one of the key issues will be how “large, long-established, mature firms” and “start-ups and rapidly growing Canadian businesses” will be defined.
Budget 2019 states that draft legislation to implement this proposal will be announced “before the summer of 2019” and that any changes will only apply to employee stock options granted after this announcement.
Accordingly, for companies that may be affected by this proposal, consideration could be given to granting employee stock options before the announcement of the legislative proposals in the summer of 2019.
Enhanced first-year CCA rate for zero-emission vehicles
Businesses are permitted under the Income Tax Act (Canada) (“Tax Act”) to deduct the cost of depreciable property over a period of several years due to such property wearing out or becoming obsolete. Motor vehicles are ordinarily eligible for a deduction for capital cost allowance (“CCA”) at rates varying from 30 to 45% per year on a declining balance basis. Budget 2019 proposes an enhanced first-year CCA rate of 100% for qualifying zero-emission vehicles.
To do so, Budget 2019 proposes to create two new CCA classes:
- Class 54 for zero-emission vehicles that otherwise would be included in Class 10 or 10.1 (i.e. passenger vehicles); and
- Class 55 for zero-emission vehicles that otherwise would be included in Class 16 (i.e. taxi cabs, vehicles acquired for short-term renting or leasing, and heavy trucks and tractors).
For passenger vehicles, there will be a limit of $55,000 plus sales tax on the amount of CCA deductible in respect of each vehicle, which is much higher than the limit of $30,000 that currently applies to motor passenger vehicles, in order to offset the higher initial cost of zero-emission vehicles.
A vehicle must meet the following conditions in order to be a qualifying zero-emission vehicle:
- it must be a motor vehicle as defined in the Tax Act;
- it must otherwise be included in Class 10, 10.1, or 16;
- it must be fully electric, a plug-in hybrid with a battery capacity of at least 15kWh, or fully powered by hydrogen; and
- it must not have been used, or acquired for use, for any purpose before it is acquired by the taxpayer.
Finally, Budget 2019 includes amendments to increase the amount of GST/HST that businesses may recover with respect to qualifying zero-emission vehicles.
This proposal will apply to qualifying zero-emission vehicles acquired on or after Budget Day and that become available for use prior to 2028, subject to a phase-out for vehicles that become available for use after 2023.
The first year enhanced CCA rate is not available for zero-emission vehicles in respect of which assistance is received under the new federal purchase incentive program announced in Budget 2019. The details of this new incentive program have not been released but it is expected to include subsidies of up to $5,000 for vehicles costing $45,000 or less.
Changes to mutual fund trust rules
Many mutual fund trusts use the “allocation to redeemers methodology” to prevent the double taxation that can occur when a unitholder redeems its units and the mutual fund trust disposes of its investments to fund the redemption price. Under this methodology, the mutual fund trust can allocate the capital gain resulting from the disposition of its investments to the redeeming unitholder and claim a corresponding deduction. The allocated capital gain is included in the redeeming unitholder’s income but the unitholder’s redemption proceeds from the disposition of its units are reduced by a corresponding amount.
Budget 2019 states that certain mutual fund trusts have been using this methodology to allocate capital gains to redeeming unitholders in excess of the capital gains that the unitholder would have realized on the disposition of its units.
For example, suppose the adjusted cost base of the units is $10 to the unitholder and their fair market value is $14, and suppose the mutual fund trust sells property to fund the redemption and triggers a $10 capital gain.
The mutual fund trust could allocate the $10 capital gain to the redeeming unitholder as part of the redemption price. The unitholder would include a $5 taxable capital gain in its income (i.e. one-half of the $10 allocated capital gain). Since the unitholder’s proceeds of disposition would be reduced by the amount of the $10 allocated capital gain from $14 to $4, it would realize a capital loss of $6 (i.e. $4 - $10), one-half of which (i.e. $3) could be used to reduce its taxable capital gain from $5 to $2, which is the same amount the unitholder would have realized if it had simply redeemed its units for $14.
According to Budget 2019, such planning results in inappropriate tax deferral to the extent that the amount of the capital gain allocated by the mutual fund trust to the unitholder exceeds the amount of the capital gain the unitholder would have realized on the disposition of its units.
Accordingly, Budget 2019 proposes a new rule that will deny a mutual fund trust a deduction in respect of an allocation of a capital gain to a redeeming unitholder where the allocated capital gain exceeds the capital gain the unitholder would have otherwise realized on the disposition of its units. Returning to the example above, the allocated capital gain ($10) would exceed the capital gain the unitholder would have realized on the disposition of its units ($4) by $6, with the result that the mutual fund trust would be denied a deduction in respect of this $6.
Budget 2019 also states that certain mutual fund trusts have been using the allocation to redeemers methodology to convert the returns on an investment that would otherwise have the character of ordinary income into capital gains for remaining unitholders.
Accordingly, Budget 2019 proposes a new rule that will deny a mutual fund trust a deduction in respect of an allocation to a redeeming unitholder where the allocated amount is ordinary income and the unitholder’s redemption proceeds are reduced by the allocation.
These proposals will apply to taxation years of mutual fund trusts that begin on or after Budget Day.
Changes to transfer pricing rules
Section 247 of the Tax Act contains rules that allow the tax department to readjust prices and other terms and conditions of transactions occurring across borders in a related corporate group.
The application of the “arm’s-length principle” allows the CRA to adjust the quantum or nature of amounts under non-arms’ length transactions to an amount which would reflect arm’s-length terms and conditions.
Budget 2019 will introduce a rule that provides that if the transfer pricing rules and another provision of the Tax Act could apply at the same time to adjust amounts, then the transfer pricing rules are to apply in priority. This will clarify and maximize the calculation of penalties imposed under the transfer pricing rules in section 247 of the Tax Act.
A second rule change proposed by Budget 2019 will potentially impact the number of years the CRA may look back to reassess a taxpayer who has entered into a “transaction” with a non-arm’s length non-resident. Budget 2019 proposes to broaden the definition of “transaction” contained in the rules that dictate the lookback period to be consistent with the definition of “transaction” contained in section 247 of the Tax Act. The effect of the change will be to extend the usual three- to four-year lookback period by three more years for all transfer pricing transactions.
Both of these proposals will apply to taxation years that begin on or after Budget Day.