On April 21, 2015, the Minister of Finance presented Canada’s long-awaited 2015 Federal Budget (the 2015 Budget). The 2015 Budget includes a number of taxpayer-friendly measures, including limited relief from Canadian source withholding requirements for some non-resident employers, extension of accelerated tax depreciation rates for machinery and equipment and a phased-in decrease in the small business tax rate. However, the 2015 Budget also includes two significant expansions of existing anti-avoidance rules applicable to intercorporate dividends, which appear to have broad-ranging consequences. Indeed, the principal takeaway from the 2015 Budget is that the applicability of the dividends-received deduction will need to be reconsidered in a broad range of situations.
The 2015 Budget also provides an update on the status of government consultations on the treatment of eligible capital property, the taxation of multinationals and automatic information sharing between countries.
Anti-Avoidance Rules Relating to Tax-Free Intercorporate Dividends
The 2015 Budget proposes broad expansions to existing anti-avoidance rules applicable to intercorporate dividends, which are generally deductible (and therefore effectively tax-free) for purposes of the Income Tax Act(Canada) (Act). The first is an expansion of the “dividend rental arrangement” restriction on the intercorporate dividend deduction. This is expected to have a significant impact on the equity derivatives businesses of Canadian financial institutions. The second change involves an expansion of an existing anti-surplus stripping rule, which applies to recharacterize intercorporate dividends as capital gains in certain circumstances.
Consistent with the Department of Finance’s recent approach to targeted anti-avoidance legislation, the 2015 Budget states that the perceived abuses targeted by the expanded rules could also be challenged under the existing provisions of the Act, and that the new measures are being introduced because such challenges are costly and time-consuming. However, as will be seen, the new measures are drafted very broadly and may in certain cases capture arrangements well outside of the mischief they are intended to address.
Synthetic Equity Arrangement Rules
The intercorporate dividend deduction in the Act is not available in respect of a dividend received by a corporation as part of a “dividend rental arrangement”, which is generally defined as an arrangement entered into by a person where it can reasonably be considered that the main reason for the arrangement was to enable the person to receive a dividend on a share, and someone other than that person bears the risk of loss and enjoys the opportunity for gain or profit with respect to the share in any material respect.
The 2015 Budget proposes to significantly expand this rule to a broader class of situations by introducing extremely complex provisions applicable to arrangements in which a dividend is received on a share by a Canadian corporation where the economic exposure to the share accrues to another person. The expanded rule targets “total return derivative” arrangements in which a corporate taxpayer (such as a Canadian financial institution) uses an equity derivative to contractually transfer the underlying economics of a share to a counterparty that is not subject to tax under the Act on the income from the derivative. Where the existing dividend rental arrangement rules do not apply to such an arrangement, the corporate taxpayer would realize a loss without the counterparty being subject to tax on the corresponding income, resulting in erosion of the Canadian tax base. Contractual arrangements of this nature are widespread in the financial community.
The 2015 Budget proposes to severely limit the viability of these arrangements by expanding the definition of a “dividend rental arrangement” to include a “synthetic equity arrangement”. A synthetic equity arrangement is generally defined as one or more agreements or arrangements entered into by a taxpayer (or a non-arm’s length person) that have the effect of providing all or substantially all of the risk of loss and opportunity for gain or profit in respect of a share owned by the taxpayer to a counterparty. In order for arrangements entered into by non-arm’s length persons to be included, it must be reasonable to conclude that the non-arm’s length person knew, or ought to have known, that the effect described above would result. This exception would not appear to apply, however, where different divisions or business units of the same entity enter into separate transactions that have this effect. If a taxpayer has entered into such a synthetic equity arrangement in respect of a share, the intercorporate dividend deduction would generally not be available in respect of dividends paid on that share.
The definition of a synthetic equity arrangement does not include agreements that are traded on a “recognized derivatives exchange”, unless it is reasonable to consider that the taxpayer knows, or ought to know, the identity of the counterparty to the agreement. (For this purpose, a recognized derivatives exchange is generally defined as a person or partnership that is recognized or registered under the securities law of a province to carry on the business of providing the facilities necessary for derivatives or options trading.) The definition also excludes “synthetic short positions” that have the effect of offsetting all or substantially all of the risk of loss and opportunity for gain or profit in respect of a long position in respect of the share (other than the acquisition of the share itself or a securities lending arrangement), and certain derivatives based on equity indices that include only long positions in at least 75 different shares of which Canadian corporations make up no more than 5% of the fair market value.
The intercorporate dividend deduction will not be denied in respect of a synthetic equity arrangement if the taxpayer can establish that no “tax-indifferent investor” has all or substantially all (generally interpreted as 90% or more) of the risk of loss and opportunity for gain or profit in respect of the share by virtue of the synthetic equity arrangement itself, or another agreement or other arrangement entered into “in connection with” the arrangement. A “tax-indifferent investor” is generally described in the 2015 Budget as a Canadian tax-exempt or a non-resident of Canada, but also includes discretionary trusts resident in Canada (regardless of the identities of their beneficiaries), and partnerships and trusts more than 10% of the interests in which are owned by other tax-indifferent investors.
The draft legislation includes a presumptive rule under which a taxpayer will be considered to have established that the foregoing exception applies if the taxpayer obtains accurate representations from the relevant counterparty (or each relevant member of a group of affiliated counterparties) that (a) it is not and does not reasonably expect to become a tax-indifferent investor during the period in which the synthetic equity arrangement is in effect and (b) has not and does not reasonably expect to eliminate all or substantially all of its own risk of loss and opportunity for gain or profit in respect of the share in the period. In cases where requirement (b) cannot be satisfied, alternate representations that look to the identity of the party that ultimately retains the risk of loss and opportunity for gain or profit may be obtained, though these provisions are extremely complex.
Because the presumptive rule requires the representations obtained to be accurate, it fails to serve as a due diligence defence. The 2015 Budget is clear that if any of the required representations are determined not to be accurate (even if it was reasonable to rely on them), the intercorporate dividend deduction will be denied. Moreover, even if such representations are accurate at the time given, the draft legislation provides that if a relevant counterparty reasonably expects at any time in the future to become a tax-indifferent investor or to eliminate all or substantially all of its risk of loss and opportunity for gain or profit in respect of the share, the period for which it provided representations is deemed to end at that time.
While it may be possible to obtain these representations in some circumstances, this may not be commercially feasible in many cases.
The expanded definition of “dividend rental arrangement” also includes an anti-avoidance rule to capture certain arrangements that do not fall within the broad definition of a synthetic equity arrangement. The description of the rule in the 2015 Budget states that the anti-avoidance rule will apply where one of the purposes of a series of transactions is to avoid the synthetic equity arrangement rule, but there is no reference to this specific avoidance motive in the draft legislation itself.
This measure is proposed to apply to dividends paid or that become payable after October 31, 2015, with no apparent grandfathering for existing arrangements with terms that extend past that date. The 2015 Budget indicates that the Department of Finance projects that this measure will generate revenues in excess of C$1.2 billion between 2016 and 2019.
While it is understood that this proposal is aimed at certain kinds of base-eroding transactions, the breadth and complexity of the rules will undoubtedly have far-reaching and perhaps unintended effects.
In what appears to be an unprecedented method of discouraging complaints about the technical complexity and commercial viability of the “tax-indifferent investor” carve-out, the 2015 Budget notes that the government would be willing to consider an alternative approach that would apply the synthetic equity arrangement rule more broadly without reference to the tax status of the counterparty to the arrangement. While likely having a broader effect on concerned taxpayers and more generally on the viability of transactions of this nature, the alternative proposal would reduce the complexity of the new rule considerably.
Stakeholders are invited to comment by August 31, 2015 on broadening the scope of the rule based on this alternative proposal. The 2015 Budget does not otherwise invite comments on this measure. Comments should be sent to firstname.lastname@example.org.
The 2015 Budget focuses on the dividend rental arrangement rules in the context of dividends received by a corporation. These rules, however, also affect individuals (including mutual fund trusts). It is not clear how the Department of Finance intends the synthetic equity arrangement proposals to apply to non-corporate taxpayers, particularly given that certain exceptions to the synthetic equity arrangement proposals seem to be only available to corporations.
Expanded Anti-Surplus Stripping Rule
The 2015 Budget proposes a number of amendments to broaden the existing anti-avoidance rule in the Act that applies where a corporation receives a tax-free intercorporate dividend if one of the purposes of the dividend—or results in the case of a deemed dividend arising on a redemption, acquisition or cancellation of a share—is to reduce a capital gain of the dividend recipient on a disposition of the share on which the dividend was paid. Where the anti-avoidance rule applies, the amount of the dividend that is not attributable to the corporation’s “safe income on hand” (generally after-tax retained earnings) is effectively treated as a capital gain.
The 2015 Budget states that recent case law has given rise to concerns that the existing anti-avoidance rule may not apply where a corporation pays a tax-free intercorporate dividend to effectively create a capital loss on its shares. The proposed amendments are described in the 2015 Budget as being in response to this case law, with related amendments to ensure that the expanded rule cannot be circumvented. However, as is often the case with targeted anti-avoidance measures, the draft legislation appears to capture situations well outside of the specific mischief at which it is directed.
The 2015 Budget proposes to broaden the rule to also apply where one of the purposes of a dividend (other than a deemed dividend arising on a redemption) is to effect either a significant reduction in the fair market value (FMV) of any share or a significant increase in the cost of the dividend recipient’s property. For purposes of determining whether a dividend has resulted in a significant reduction in the FMV of a share, the FMV of the share immediately before the dividend is deemed to be increased by the amount of the dividend. This deeming rule appears to address situations where the FMV of a particular share could be nominal both before and after a dividend is paid or deemed to be paid. This formulation appears problematic, since it can almost always be said that a result of paying a dividend is to diminish the FMV of the share on which the dividend was paid, thus raising the question in a broad range of situations as to whether that diminution in value was a purpose of the dividend.
The amended rule retains the exception for dividends paid out of safe income on hand. However, it is not clear how the exception will apply to a scenario where a share was not in a gain position before payment of the dividend. Indeed, it may be that the “safe income” exception will apply only in a gain situation, raising an asymmetry between the scope of the rule and the scope of the safe income exception. Moreover, as discussed above, the new application rules could potentially capture many scenarios in which it would not previously have been necessary for safe income to be calculated. This could lead to significant added compliance costs to corporations and impact the timing of transactions involving intercorporate dividends.
The amended rule also includes a number of new specific provisions relating to stock dividends. Currently, depending on the circumstances, the amount of a stock dividend that is subject to the anti-avoidance rule may be limited to the increase in the paid-up capital (PUC) of the shares on which the dividend was paid. The 2015 Budget proposes an amendment that would deem the amount of a stock dividend for purposes of the rule to be the greater of (1) the increase in the PUC of the shares as a result of the dividend and (2) the FMV of the shares issued in payment of the dividend. This amendment would appear to preclude the use of “high FMV/low PUC” stock dividends. While perhaps unintended, this provision also seems to interfere with “stock split” transactions effected by way of payment of stock dividends with high FMV and low PUC.
The 2015 Budget also proposes to amend an existing exception to the anti-avoidance rule described above that generally applies to related-party transactions. The 2015 Budget proposes to limit this exception to only apply in respect of deemed dividends resulting from the redemption, acquisition or cancellation of a share.
The amendments described under this heading apply in respect of dividends paid after April 20, 2015. This timing would appear to catch dividends paid on Budget day before the 2015 Budget was released.
Enhanced Small Business Deduction
The 2015 Budget proposes to reduce the corporate income tax rate payable by Canadian-controlled private corporations (CCPCs) by increasing the small business deduction applicable to the first C$500,000 of qualifying active business income earned by such corporations by 2%, with a corresponding change to the gross-up and dividend tax credit mechanism for dividends paid by CCPCs. The increased small business deduction will be phased in over four years, with an incremental increase of 0.5% in each of the next four years resulting in an effective small business income tax rate of 9% by 2019.
The 2015 Budget also announces a review of the circumstances in which income from a business that principally earns income from property, such as a self-storage facility or campground, should qualify as active business income for purposes of the small business deduction.
Accelerated Capital Cost Allowance for Manufacturing and Processing Equipment
Machinery and equipment acquired after March 19, 2007 and before 2016 primarily for use in Canada for the manufacturing or processing of goods for sale or lease qualifies for a temporary accelerated capital cost allowance (CCA) rate of 50%, calculated on a straight line basis (rather than the 30% rate that would otherwise apply). The 2015 Budget creates a new CCA class for manufacturing and processing machinery and equipment acquired after 2015 and before 2026, which will also be eligible for the 50% CCA rate, calculated on a declining balance basis.
Source Withholding for Non-Resident Employers
The 2015 Budget offers limited relief from the existing source withholding requirements in respect of non-resident employees who travel to work in Canada, which the Canada Revenue Agency (CRA) interprets to apply even where the employees are exempt from Canadian tax under an applicable treaty. Currently, a non-resident employer is required to make Canadian employment source withholdings in respect of its employees who work in Canada, unless it obtains a treaty-based waiver from the CRA. Such waivers are available only in limited circumstances and have proved of limited utility in practice, likely leading to widespread non-compliance.
The 2015 Budget proposes an exception to this requirement for payments by “qualifying non-resident employers” to “qualifying non-resident employees”.
A “qualifying non-resident employee” is an employee who:
- Is resident in a country other than Canada;
- Is exempt from Canadian income tax because of a tax treaty with that country; and
- Is not in Canada for 90 or more days in any 12-month period that includes the time of payment.
A “qualifying non-resident employer” is an employer that:
- Is resident in a country with which Canada has a tax treaty, or, if a partnership, allocates at least 90% of its income for the fiscal period that includes the applicable payment to persons who are resident in a treaty country;
- Does not carry on business through a Canadian permanent establishment (as defined in the regulations to the Act); and
- Is certified by the Minister of National Revenue.
In order to be certified, an employer must apply in prescribed form, meet the first two conditions above of a qualifying non-resident employer and meet certain other as of yet unspecified conditions, though the 2015 Budget suggests that these conditions will include general compliance with the Act. The Minister of National Revenue is also given a broad power to revoke an employer’s certification if the employer fails to comply with any of these conditions.
If a qualifying non-resident employer fails to make employment source withholdings in respect of an employee that the employer mistakenly believed to be a qualifying non-resident employee, the employer will not be liable for penalties for failing to withhold if, after reasonable inquiry, the employer had no reason to believe at the time of payment that the employee was not a qualifying non-resident employee.
The 2015 Budget suggests that a non-resident employer that is not required to make source withholdings in respect of a payment made to an employee will still be required to report that payment to the CRA. This requirement, coupled with the certification requirement, may limit the attractiveness of this measure, especially for employers whose employees will have a very limited presence in Canada. Also, it is not clear why the measure does not apply to all employees who are exempt from Canadian tax because of a treaty.
These amendments will apply in respect of payments made after 2015.
The foreign affiliate rules in the Act include a number of anti-base erosion provisions designed to prevent Canadian taxpayers from shifting Canadian-source income to other jurisdictions. Under these provisions, income of a foreign affiliate that would otherwise be considered to be active business income is required to be included in “foreign accrual property income” (FAPI). A taxpayer’s proportionate share of FAPI earned by its controlled foreign affiliate is included in income on a current basis, whether or not such income is distributed to the taxpayer.
One type of income covered by this base erosion regime is income from the insurance of risks in respect of persons resident in Canada, property situated in Canada or businesses carried on in Canada (specified Canadian risks). Where a foreign affiliate earns income from the insurance of specified Canadian risks, this base erosion regime requires such income to be included in FAPI, unless the foreign affiliate’s gross premium revenue (net of reinsurance ceded) from insuring or reinsuring specified Canadian risks is less than 10% of its total gross premium revenue. The 2014 Federal Budget (the 2014 Budget) introduced a specific anti-avoidance rule to deem certain foreign-based risks to be specified Canadian risks where the foreign affiliate in question entered into certain “insurance swap” transactions.
The 2015 Budget further amends the base erosion regime to also apply to embedded profit components earned by foreign affiliates from ceding specified Canadian risks, including an express requirement to include in FAPI any income of the affiliate from services in respect of ceding specified Canadian risks and an amount equal to the difference between the fair market value of the consideration provided to the affiliate in respect of ceding specified Canadian risks and the affiliate’s cost in respect of those risks, in each case to the extent not otherwise included in FAPI under the more general rule.
This measure will apply to taxation years of taxpayers that begin on or after April 21, 2015. Stakeholders are invited to make submissions on this measure by June 30, 2015 by sending comments to email@example.com.
OTHER SELECTED MEASURES
Measures Affecting Canadian Registered Charities
Registered charities are generally prohibited from engaging in business activities, except in certain cases where the business qualifies as a related business. Because a partnership is defined as a relationship among persons carrying on business in common with a view to profit, this prohibition has generally been interpreted to restrict the ability of registered charities to invest in partnerships. This limitation has historically limited registered charities’ ability to invest in pooled investment vehicles structured as limited partnerships, including those used to structure social impact investments. The 2015 Budget proposes to amend the Act to specifically provide that a registered charity will not be considered to carry on a business solely because it makes a passive investment in a limited partnership, provided certain conditions are satisfied. In order to ensure that the measure is limited to passive investments, it will not apply if the registered charity—together with non-arm’s length entities—holds more than 20% of the interests in the limited partnership or does not deal at arm’s length with any general partner of the partnership. This measure will apply in respect of investments in limited partnerships made on or after April 21, 2015.
The 2015 Budget also proposes to extend the existing exemption from capital gains tax on a disposition of publicly listed securities donated to registered charities to apply to certain arm’s length dispositions of private company shares and real estate where cash proceeds are donated to a registered charity within 30 days of the disposition. The exception will apply pro rata where only a portion of the proceeds are donated and be subject to specific anti-avoidance rules intended to prevent abuse where certain related transactions occur within five years of the disposition. This measure will apply for donations made in respect of dispositions occurring after 2016.
Alternate Arguments in Support of Assessments
In response to a recent decision of the Federal Court of Appeal (FCA), the 2015 Budget proposes to clarify an existing rule in the Act that provides that the Minister of National Revenue may advance an alternative argument in support of a tax assessment at any time.
In Canada v. Last, the FCA held that because the Minister had assessed the taxpayer on the basis that the taxpayer realized a gain on capital account, the Minister was precluded from increasing its assessment of the taxpayer’s business income even though the court held that the taxpayer held the relevant property on income account.
The 2015 Budget proposes to amend the Act to clarify that the Minister and the courts may increase or adjust an amount included in an assessment that is under objection or appeal at any time, regardless of the source of the amount, provided the total amount of the assessment does not increase. Similar amendments are proposed to be made to the Excise Tax Act (Canada) and certain other federal tax statutes.
These amendments will apply in respect of appeals instituted after royal assent to the enacting legislation.
Tiered Specified Foreign Property Reporting (T1135s)
Canadian residents who own certain kinds of foreign investment property with a total cost of more than C$100,000 are required to provide specified information to the CRA each year in respect of such property on Form T1135. In 2013, these reporting requirements were expanded to require more detailed information, resulting in an increased compliance burden for taxpayers investing in foreign property.
The 2015 Budget proposes to introduce a tiered reporting system whereby a simplified reporting regime will apply to taxpayers holding foreign property with a total cost of less than C$250,000. The current expanded requirements will continue to apply to taxpayers holding specified foreign property having a total cost of C$250,000 or more.
The new tiered regime is proposed to apply for taxation years that begin after 2014.
UPDATE ON ONGOING CONSULTATIONS
In the 2014 Budget, the government announced a public consultation process aimed at replacing the existing rules in the Act relating to “eligible capital property” (generally, intangibles such as goodwill that do not otherwise qualify for the existing CCA regime) with a new CCA class. The 2015 Budget states that the government has received and continues to receive submissions on this proposal and intends to release detailed draft legislative proposals for stakeholder comment before their inclusion in a formal bill. No timeline was given for these proposals.
Also in the 2014 Budget, the government requested input from stakeholders on issues related to international tax planning by multilateral enterprises in order to inform Canada’s participation with the Organisation for Economic Co-operation and Development (OECD) and the G-20 in relation to their Base Erosion and Profit Shifting (BEPS) initiative. The 2015 Budget states that the government is looking forward to the conclusion of the BEPS project and discussions with the international community on the implementation of its recommendations. No timeline was given for any concrete proposals.
The 2015 Budget also provides an update on the new “common reporting standard” developed by the OECD for the automatic exchange of tax information among G-20 countries. The new standard is similar to the United States “FATCA” rules and would require the CRA to automatically exchange information with foreign tax authorities in respect of financial accounts in Canada held by residents (not citizens) of their jurisdictions. The 2015 Budget states that Canada proposes to implement this standard on July 1, 2017, allowing for a first exchange of information in 2018. The Department of Finance will release draft legislative proposals in the coming months in furtherance of that goal.