Despite rising deficits, Budget 2017 does not propose any general tax increases or other game-changing measures that were the subject of much speculation in recent weeks. This is arguably a “holding-pattern” budget, giving the Government of Canada time to gauge external developments prior to deciding whether to implement more significant tax changes at a later time.
From a business perspective, perhaps most newsworthy is what is not in Budget 2017. The Budget did not increase the capital gains inclusion rate. This had been widely speculated and was the impetus for many pre-Budget capital gain realization transactions. Budget 2017 also did not propose changes to the stock option regime, another favorite topic for pre-Budget speculation. The income tax changes with the most significant financial impact on business focused on very specific groups of taxpayers: professionals will be taxed on their work in progress; an anti-avoidance rule will prevent the deferral of income using “straddle transactions”; and deductions will be limited for oil and gas discovery wells.
For individuals, Budget 2017 proposes only minor tweaks to certain tax credit programs and the elimination or reduction of certain tax preferences on the basis of inefficiency or to close perceived tax loopholes. However, in keeping with Budget 2017's theme of “Building a Strong Middle Class,” the Minister of Finance stated very clearly that the Government of Canada remains concerned with income inequality, perceived tax loopholes, and the steps taken by some taxpayers to reduce their taxes.
In particular, tax planning strategies by wealthy individuals using private corporations will be scrutinized and policy responses will be developed. The issues have been known for years and addressed in various ways in prior budgets, but the government is signaling once more that the rules may be further tightened to limit “sprinkling income” and the use of private corporations to accumulate passive investment portfolios. Budget 2017 strongly suggests that additional measures to address these issues are being considered and could be introduced in the near-term. Buckle up!
More Tax Auditors and Enforcement
Budget 2017 enhances measures from Budget 2016, deploying additional and substantial resources to crack down on tax evasion and avoidance. The Budget 2017 document conflates evasion and avoidance, reminiscent of the October 2016 Report of the Standing Committee on Finance and the February 23, 2017 Government of Canada response. A preferred view may have been to seek to address “abusive” tax avoidance.
In any case, over the next five years, the Canada Revenue Agency (“CRA”) will receive $523.9 million to fund increasing verification activities, hire more auditors and specialists focusing on the underground economy, develop robust business intelligence infrastructure and risk assessment systems to target high-risk international tax and abusive tax avoidance cases and improve the quality of investigative work targeting criminal tax evaders. Touting a proven track record of meeting expectations from targeted compliance interventions, the expected five year revenue impact of $2.5 billion results in a five to one “return on investment.”
We have already observed the consequences of this enhanced focus on tax enforcement, by more aggressive CRA audits and collection actions. This is bound to increase.
Private Company Planning Scrutinized
Budget 2017 expresses concern in regard to tax planning strategies using private corporations, which can result in high income individuals gaining what are perceived to be unfair tax advantages. No specific measures are proposed, but a number of tax planning strategies are identified:
- Using private corporations to sprinkle income among family members with lower marginal tax rates;
- Holding passive investments in private corporations to facilitate higher income accumulation due to the fact that the general corporate tax rate is generally lower than personal tax rates; and
- Converting private corporation income into capital gains, instead of realizing it as dividends.
Budget 2017 announces the Government's intention to release a study paper on the issues raised by these strategies and on its proposed policy approach in the coming months. The study paper will review inappropriate results from the perspective of both the tax system and family-owned businesses.
Straddle Transactions Curtailed
“Straddle transactions” involve options and other derivatives to create offsetting positions in shares, commodities or other property where a loss position is realized before a taxation year-end and a gain position is not realized until after the taxation year-end, thus creating a deferral. Budget 2017 proposes a new set of tax rules to eliminate the use of these “straddle transactions” that are subject to taxation on a realization basis.
The new anti-avoidance rule proposed by Budget 2017 will defer the realization of a loss position through a stop-loss rule to the extent of any unrealized gain on an offsetting position. It is intended that the new rule will not apply to certain financial institutions, mutual fund trusts, mutual fund corporations, or to certain normal course hedging activities, where the offsetting gain position is held for specified period of time, or where the loss arises as part of a series of transactions none of the purposes of which was to defer or avoid tax. One might expect that the exceptions will give rise to potential uncertainty in certain circumstances.
The new stop-loss rule will apply to any loss realized on a position entered into after March 22, 2017.
Combating International Tax Avoidance
Budget 2017 is largely silent on international tax measures. This is somewhat surprising in light of the significant work performed by the Government of Canada and international tax community in recent years to combat international tax avoidance and evasion. The only new measure introduced by Budget 2017 in this regard is limited solely to Canadian-resident life insurers and their foreign branches.
Currently, the Income Tax Act (Canada) (“ITA”) provides a special exemption to Canadian life insurers from the general rule that Canadian-resident corporations are taxed on their worldwide income. Canadian-resident life insurers are not currently taxed on their income from carrying on business in a foreign jurisdiction through a branch (“Foreign Insurance Branch”). The taxation of the Foreign Insurance Branch currently resembles the taxation of foreign affiliates of Canadian-resident corporations. However, in the case of foreign affiliates, the foreign accrual property income (“FAPI”) rules include a specific anti-avoidance rule regarding the insurance of Canadian risk. That is, pursuant to the FAPI rules, income from the insurance of Canadian risks of a controlled foreign affiliate of a Canadian taxpayer is generally considered FAPI and is therefore taxable in the hands of the Canadian taxpayer on an accrual basis. No analogous rule currently exists to prevent income from the insurance of Canadian risks from being shifted to a Foreign Insurance Branch.
Although other anti-avoidance rules could arguably apply to these situations, Budget 2017 proposes to amend the ITA to ensure that Canadian life insurers are taxable in Canada with respect to their income from the insurance of Canadian risks. The new rule will apply where 10 per cent of more of the gross premium income earned by a Foreign Insurance Branch is premium income in respect of Canadian risks. The rule will deem the insurance of Canadian risks to be part of a business carried on in Canada by the life insurer and the related insurance policies will be deemed to be life insurance policies in Canada.
In addition, complementary anti-avoidance rules will be introduced to ensure that the proposed rule cannot be avoided through either the use of so-called “insurance swaps” or the ceding of Canadian risks. Anti-avoidance rules will also be introduced for situations where it can reasonably be concluded that a life insurer has insured foreign risks through a Foreign Insurance Branch as part of a transaction or a series of transactions one of the purposes of which was to avoid the proposed rule. In such cases, the Canadian-resident life insurer will be treated as if it had insured the Canadian risks. An analogous rule will also be introduced to reinforce the existing anti-avoidance rules in the FAPI regime.
This measure will apply to taxation years of Canadian taxpayers that begin on or after March 22, 2017.
Flow-through Tax Deductions Limited
Flow-through shares are common shares issued by resource companies which provide for the deduction of Canadian exploration expenses ("CEE") (100% deduction in the year incurred) and Canadian development expenses ("CDE") (30% deduction on a declining-balance basis). As a result, companies issuing CEE flow-through shares typically obtain a premium price over issuing CDE flow-through shares.
Budget 2017 proposes that eligible small oil and gas companies (i.e., companies with a taxable capital employed in Canada of not more than $15 million) can no longer treat the first $1 million of CDE as CEE when renounced to shareholders pursuant to a flow-through share agreement. Very generally, this measure will apply in respect of expenses incurred after 2018, 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 March 22, 2017.
Further, Budget 2017 proposes that expenditures related to drilling or completing the first well in a new reservoir (or in building a temporary access road to, or in preparing a site in respect of, any such well) be classified as CDE instead of CEE. However, there will be certain circumstances where such expenditures can continue to be classified as CEE, or reclassified as CEE. Very generally, this measure will apply to expenses incurred after 2018. However, the measure should not apply to expenses actually incurred before 2021 where the taxpayer has, before March 22, 2017, entered into a written commitment to incur such expenses.
The good news is that Budget 2017 confirms the previously announced extension of the mineral exploration tax credit for an additional year, applicable to mining flow-through share agreements entered into on or before March 31, 2018.
Investment Fund Mergers
Mutual Fund Switch Fund Conversions
Budget 2016 eliminated the tax deferral that previously applied to the exchange of shares between different classes of a mutual fund corporation. As a result, the maintenance of multi-class mutual fund corporations became less desirable. Budget 2017 now proposes to permit a tax-deferred reorganization of multi-class mutual fund corporations into a number of separate mutual fund trusts by extending the existing mutual fund merger rules. Such reorganizations will be subject to detailed rules in the ITA and the new rules will apply to reorganizations occurring on or after March 22, 2017.
Segregated funds are life insurance products that, from a tax perspective, are generally subject to taxation under the ITA in a manner that is substantially similar to mutual fund trusts. That said, there has been concern expressed for some time that the existing mutual fund trust merger rules do not clearly apply to segregated funds, thus preventing tax-deferred mergers of segregated funds in cases where it might make commercial sense to do so, for example, on an acquisition of a segregated fund business of one life insurer by another.
Budget 2017 proposes rules that generally parallel the existing mutual fund merger rules to permit the merger of segregated funds. In addition, Budget 2017 proposes to allow segregated funds to carry over non-capital losses, subject to the normal loss carry over restrictions.
These proposals will apply to segregated fund mergers occurring after 2017 and non-capital losses arising in taxation years beginning after 2017, in both cases to allow the life insurance industry to have an opportunity to comment on the proposed rules.
Mark-to-market Election for Derivatives
The decision of the Tax Court of Canada in Kruger v. The Queen in 2015 gave rise to a change to the inventory tax rules proposed in Budget 2016. Now, the decision of the Federal Court of Appeal in Kruger in 2016 has given rise to a further proposed change in Budget 2017.
The Federal Court of Appeal held that the taxpayer, which was not a financial institution, could mark-to-market its derivatives held on income account for income tax purposes. To create more certainty, Budget 2017 proposes to enact a regime to allow taxpayers who hold derivatives on income account to elect to be taxed on those derivatives on a mark-to-market basis, provided that such derivatives are valued at fair market value under accounting principles. Once made, the election would require the taxpayer to report on a mark-to-market basis unless the election is revoked with the consent of the Minister.
The election will be available in respect of taxation years beginning after March 22, 2017.
Overriding the Case Law on Factual Control
The ITA recognizes two forms of corporate control: de jure and de facto (i.e., factual) control. Determining de jure control is straightforward as it exists where a person (or group) has the power to elect a majority of the board of directors. De facto control is less concrete, requiring a determination of whether a person (or group) has direct or indirect influence that, if exercised, would result in de facto control. The de facto control test is relevant for a variety of ITA provisions and, in particular, to determining whether a corporation is a “Canadian-controlled private corporation” and whether corporations are “associated” for ITA purposes.
The de facto control test has historically been ambiguous as Canadian courts placed reliance on a variety of subjective factors in their analysis. However, in 2016 the Federal Court of Appeal narrowed the application of the de facto control test in McGillivray Restaurant Ltd v. The Queen, by finding that for a factor to be considered in determining whether de facto control exists, such a factor must 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 that have the right and ability”. This was a welcome clarification because it limited the scope of the factors that would otherwise have to be considered in making de facto control determinations.
Budget 2017 responds to McGillivray by proposing new subsection 256(5.11). The new rule provides that the determination of whether a taxpayer has any direct or indirect influence that, if exercised, would result in control in fact of the corporation shall:
- Take into account all factors that are relevant in the circumstances; and
- Not be limited to, and the relevant factors to be considered in making the determination need not include, whether the taxpayer has a legally enforceable right or ability to effect a change in the board of directors of the corporation, or the board’s powers, or to exercise influence over the shareholder or shareholders who have that right or ability.
The effect of this proposed amendment is to reinstate the pre-McGillivray case law on de facto control which will restore the unpredictability associated with de facto control determinations. This measure is expected to apply in respect of taxation years that begin on or after March 22, 2017.
Federal Carbon Pricing Backstop
In an effort to make good on commitments made in the Vancouver Declaration of March 2016 and in the United Nations Paris Agreement on climate change at the First Ministers’ Meeting on Clean Growth and Climate Change in December 2016, the Government announced that it would be introducing a federal carbon pricing backstop. Details on the measure were set out in Annex I, to the Pan-Canadian Framework on Clean Growth and Climate Change.
The federal carbon pricing benchmark includes a requirement that all Canadian jurisdictions have carbon pricing by 2018 based on GHG emissions and that such carbon pricing is applied to a common and broad set of sources that, at a minimum, are the same sources as those subject to the British Columbia carbon tax. Provinces and territories have the flexibility to choose between two systems: a direct price on carbon pollution (a carbon tax like British Columbia’s or a carbon levy and performance-based emissions system like in Alberta) or a cap-and-trade system (e.g. Ontario and Quebec). The Government will introduce a backstop pricing system that will apply in provinces and territories that do not meet the federal carbon pricing benchmark.
Budget 2017 announces that, in the coming months, the Government will release a consultation paper containing the technical details of this measure.
GST/HST and Excise Tax Measures
New GST/HST and excise tax measures in Budget 2017 were limited. There are excise tax increases for both alcohol and tobacco. Ride sharing drivers are to be placed on the same footing for GST/HST collection as taxi drivers effective July 1, 2017. In addition, the rebate for GST/HST on accommodation sold as part of a tour package is to be eliminated for accommodations paid for after March 22, 2017, and for all such accommodations from January 1, 2018.
The Budget confirms the Government of Canada’s intention to proceed with the joint venture election amendments announced in Budget 2016, as well as various proposed amendments announced on July 22, 2016, which included amendments to address a “master pension entity” and revisions to the “drop shipment” rules.