On February 6, 2013 the Honourable Jim Flaherty celebrated his seventh anniversary as Canada’s Minister of Finance, and on Thursday March 21, 2013 he delivered his eighth federal budget. Budget 2013 contained an assortment of tax proposals, including the usual tax “goodies,” but if there is one theme to the proposals, it is probably what the Minister and the officials of the Department of Finance (Department) would call “integrity measures.” This would include what might be described in the vernacular as “loophole closing,” as well as new or extended reporting requirements and new or extended penalty provisions. There is even a new “bounty” for those who report “major international non-compliance” to the Canada Revenue Agency (CRA) that leads to the collection of outstanding taxes due.
The Minister has not been shy to introduce integrity measures in his past budgets, but has raised this to a new level in Budget 2013. This is evident not only from the various integrity measures in the budget, but from the inclusion of a stand-alone document amongst the budget papers that is subtitled “Improving the Integrity of the Tax System.” That document states that “the Government is committed to responsible fiscal management, which … includes continuing to enhance the integrity of the tax system to ensure that everyone pays their fair share of taxes.” The document notes the Minister’s previous seven Budgets have “adopted tough rules to close tax loopholes” and that, with the proposals in Budget 2013, the Government will have introduced “over 75 measures to improve the integrity of the tax system.”
The “goodies”, many of which are described in greater detail below, include items such as a “super credit” for first time donors to registered charities, an increase in the lifetime capital gains exemption (LCGE), the annual one year extension of the mineral exploration tax credit, and the annual expansion of the accelerated capital cost allowance (CCA) for clean energy generation equipment.
The “integrity measures” are many, but include new rules aimed at “synthetic dispositions” (in which a taxpayer seeks to realize the underlying value in an asset without disposing of the asset, thereby deferring the realization of the taxable capital gain on the asset), and new rules aimed at “character conversion transactions” (in which a taxpayer, through the use of derivative contracts, seeks to realize a more “lightly taxed” capital gain rather than a more “heavily taxed” income receipt). They also include enhanced reporting requirements for scientific research and experimental development (SRED), extended reassessment periods for tax shelters and reportable tax avoidance transactions, and a new “Stop International Tax Evasion Program” that will enable the CRA to pay individuals who report “major international tax non-compliance.” These, and others, are described below.
Finally, the Minister announced some new consultations as well as the demise of a consultation announced in Budget 2010. New consultations were announced relating to the tax rates applied to testamentary trusts (such trusts apply the same graduated rates applicable to individuals while inter vivos trusts apply a flat rate equal to the highest rate applicable to individuals) and to so-called “treaty shopping”.
The Budget 2010 consultation related to the potential introduction of a loss transfer or consolidated tax reporting system in Canada. In 1985 such a proposal was pursued, but was never achieved, principally because of resistance from the provinces. This idea was resurrected in Budget 2010. However, it seems that the provinces were no more favourably inclined today than they were 25 years ago and the Minister announced in Budget 2013 that “moving to a formal system of corporate group taxation is not a priority at this time.” The reference to a “formal system” is interesting because it suggests that the “informal system,” in which certain loss transfer transactions have been permitted by the CRA, will continue. However, it remains to be seen whether the provinces will begin to resist this “informal system” the way that they resisted the proposals for a “formal system.”
As noted, Budget 2013 contains a large number of “integrity” measures, including “tightening” measures and reporting and penalty measures. It also proposes consultations in respect of several other potential integrity measures.
Budget 2013 addresses “synthetic disposition arrangements,” also commonly known in the market as “forward sales” or subsection 39(4) “transactions”, which were used to defer capital gains or to obtain other tax benefits (such as avoiding the stop-loss rules) by allowing a taxpayer to economically dispose of a property while continuing to own it from a legal perspective and for income tax purposes.
Generally, a “synthetic disposition arrangement” will include an arrangement under which the taxpayer eliminates its future risk of loss and opportunity for gain or profit in respect of a property and acquires another property (or a right to acquire another property) for a value which approximates what the taxpayer would have received as proceeds of disposition.
Such arrangements will generally include forward contracts, put-call collars, total return swaps, exchangeable indebtedness or other mechanisms used to eliminate the future risk of loss and opportunity for gain or profit in respect of a property. Although the Supplementary Information states that the measure generally will not apply to ordinary hedging transactions, securities lending arrangements or ordinary commercial leasing transactions, the wording of the proposed legislation does not explicitly provide a carve out for such transactions.
Proposed section 80.6 of the Income Tax Act (Canada) (ITA) deems a taxpayer (or a non-arm’s length person) that has entered into a “synthetic disposition arrangement” to have disposed of and reacquired the property for an amount equal to its fair market value. This measure will apply to agreements and arrangements entered into on or after March 21, 2013 and to agreements and arrangements entered into before March 21, 2013 if their term is extended on or after March 21, 2013.
Character Conversion Transactions
Since only 50 per cent of capital gains are included in taxable income, it is not surprising that Canada's financial sector has developed sophisticated structured transactions for the purpose of converting what would otherwise be fully taxable investment income into capital gains. These transactions generally involve an agreement to buy or sell a capital property at a specified future date for a price determined by reference to a portfolio of income producing investments. These character conversion transactions have the effect of converting notional investment income (or losses) from the reference portfolio into capital gains (or losses) realized when the derivative forward agreement is settled.
Budget 2013 proposes to eliminate any tax advantages from these types of derivative forward agreements. For example, if the transaction includes a "forward sale", the taxpayer will have an income inclusion at the time of settlement equal to the amount by which the amount paid for the property under the forward sale agreement exceeds the fair market value of the property on the date of the agreement. Similarly, if the transaction involves a "forward purchase" the taxpayer will have an income inclusion at the time of settlement equal to the amount by which the fair market value of the property delivered on settlement exceeds the amount paid for the capital property. Any losses realized by a taxpayer under these character conversion transactions will also be treated as being on income account.
Budget 2013 proposes to treat the income (or loss) portion of a character conversion transaction as being distinct from the gain (or loss) realized on the disposition of a capital property that is purchased or sold under the derivative forward agreement. To avoid double taxation (or doubling of losses) the proposals provide that the adjusted cost base of the capital property will be increased by the amount of resulting income and reduced by the amount of any resulting loss.
The proposed measures will only apply in circumstances where any return under a derivative forward agreement is not determined by reference to the performance of the capital property being purchased or sold and only where the duration of the agreement exceeds 180 days. The measures will only apply to derivative forward agreements entered into after March 20, 2013 or to prior agreements if the term of the agreement is extended after March 20, 2013.
Loss Trading by Trusts Restricted
Over the past several centuries, trusts have proven to be a creative yet safe and flexible method for families to hold assets and facilitate estate planning. Increasingly, however, trusts have been used as business vehicles. As the use of business trusts has increased, the discrepancy between the income tax rules which apply to trusts and the rules which apply to corporations has become more noticeable.
Budget 2013 continues the steps aimed at addressing these discrepancies (the most significant of which, in the past, was the introduction of the so-called “SIFT Tax” in response to the income trust phenomenon) by extending to trusts both the thin capitalization rules (discussed below in this summary, under “General Tightening Measures”) and the loss trading restrictions that now apply to corporations.
Presently, if a trust incurs a loss in a year that it is unable to use in the year, the unused loss may be carried forward or back to be used in other taxation years, within certain limits. Nevertheless, it might not be feasible for a trust to fully utilize its losses if it is not able to earn sufficient income. Accordingly, transactions have been developed which allow a trust to provide other taxpayers with access to its unused losses and other tax attributes. These are usually referred to as “loss trading transactions.” In a typical loss trading transaction, a taxpayer who wishes to use the trust’s losses will acquire an interest in the trust and the trust will acquire a new business or income-producing asset. This provides the trust with an opportunity to earn income that can be offset by its losses, and the taxpayer who acquires an interest in the trust can benefit by receiving distributions from the trust out of the resulting tax-sheltered profits. More complicated loss trading transactions have also been developed.
For a corporation, loss trading transactions are subject to significant restrictions if there is an acquisition of control of the corporation. The acquisition of control rules do not readily apply to trusts because of the significant differences between trusts and corporations. Therefore, Budget 2013 proposes to apply the existing corporate restrictions on using losses to trusts where there is a “loss restriction event.” Such an event will arise when a person who previously was not a “majority-interest beneficiary” of the trust becomes a majority-interest beneficiary or when a group of persons become a “majority-interest group of beneficiaries”.
A beneficiary of a trust will be considered to be a majority-interest beneficiary for this purpose if the beneficiary holds more than 50 per cent of the fair market value of all income interests or more than 50 per cent of all capital interests in the trust. Since there can be separate income and capital beneficiaries, a trust may have more than one majority-interest beneficiary at the same time. Further, in a discretionary trust the tax rules assume the discretion is fully exercised in determining the value of a beneficiary’s interest in the trust. Therefore, in a discretionary trust it is possible that every beneficiary will be a majority-interest beneficiary.
Unless specifically excluded by one of the proposed exempting rules, every change in the make-up of the beneficiaries of a trust or the trust terms that results in a person becoming a majority-interest beneficiary of the trust will result in a loss restriction event for the trust which, in turn, will result in restrictions on the ability of the trust to use its losses and other tax attributes. Certain limited exemptions to the rules have been proposed. The Department expects these exemptions will apply to many of the typical transactions involving changes in the beneficiaries of a family trust by permitting certain transfers of income or capital interests in a trust. However, many trusts allow beneficiaries to be added or changed in other ways without necessarily requiring a transfer of a trust interest. The birth of a child or the addition of a spouse or other beneficiary could result in the trust having a new majority-interest beneficiary without any transfer of a trust interest occurring. If the intent is to prevent the new restrictions from applying to typical changes to a family trust, the proposed rules will require further modification. The Government has invited comments, but has indicated that additional exemptions will not likely be considered for commercial trusts.
The proposals include a number of new anti-avoidance rules to ensure these restrictions on loss trading transactions trusts will be effective. The proposed rules are complex and will have broad application. Any trust with losses should carefully review the proposed rules.
Corporate Loss Trading
Budget 2013 continues the attack on corporate loss trading with the introduction of a new specific anti-avoidance rule aimed at transactions structured to facilitate the use of the tax losses and other tax attributes of a corporation (LossCo) by an arm's length profitable corporation (ProfitCo).
The ITA already contains various restrictions on the use of tax losses and other tax attributes (referred to as "attribute trading restrictions") after an acquisition of control of LossCo by an arm's length party. However, transactions have been structured to avoid the attribute trading restrictions by avoiding an acquisition of control of LossCo. In these transactions ProfitCo would transfer a profitable business or an income-producing asset to LossCo in exchange for LossCo shares which would represent a significant equity interest in LossCo. However, the LossCo shares issued to ProfitCo would not give ProfitCo voting control of LossCo thereby avoiding an acquisition of control and avoiding the attribute trading restrictions in the ITA.
Effective March 21, 2013, a person or group of persons will be deemed to have acquired control of a corporation for purposes of the attribute trading restrictions if they acquire shares that causes the person or group to have more than 75 per cent of the fair market value of all shares of the corporation, but only if it is reasonable to conclude that one of the main reasons that the person or group does not have voting control of the corporation is to avoid the attribute trading restrictions.
The ITA contains rules deeming non-resident trusts to be resident in Canada for tax purposes if a Canadian resident person directly or indirectly contributes property to the trust (NRT Rules).
The ITA also contains a broad and punitive attribution rule (subsection 75(2)) that applies to attribute income and capital gains from property held in a trust (including a non-resident trust) to the transferor of the property in circumstances where the property is held by the trustees on condition that: (i) the property (or substituted property) can revert to the transferor; or (ii) the transferor has direction or control over the transfer or disposition the property.
In response to the Sommerer decision (in which the FCA held that subsection 75(2) did not apply to a transfer of property by a Canadian resident to a non-resident trust, of which he was a beneficiary, in exchange for fair market value consideration), Budget 2013 proposes to amend the NRT Rules to clarify that such an attribution rule will apply to any direct or indirect transfer or loan of property from a Canadian resident to a non-resident trust, regardless of the consideration received on the exchange, where the non-resident trust holds property on the conditions described above.
Where this attribution rule applies, a related rule is triggered to prohibit a tax-deferred distribution of the trust property to any beneficiaries other than a distribution of the problematic property to the transferor of such property. Budget 2013 proposes an amendment to clarify that non-resident trusts will also be subject to this related rule.
Stop International Tax Evasion Program
Budget 2013 announces that the CRA will launch the Stop International Tax Evasion Program under which it will pay rewards to individuals of up to 15 per cent of the federal tax collected as a consequence of information leading to additional assessments or reassessments exceeding $100,000 in federal taxes. Awards will be paid only where the non-compliant activity involves foreign property or property located or transferred outside Canada or transactions conducted partially or entirely outside Canada. The CRA will announce further details on the program in coming months.
International Electronic Funds Transfers
Budget 2013 proposes to require certain financial intermediaries to report to the CRA international electronic funds transfers (EFTs) of $10,000 or more. This requirement will apply to the same financial intermediaries that are currently required to report international EFTs to the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) under the Proceeds of Crime (Money Laundering) and Terrorist Financing Act.
Foreign Reporting Requirements – Form T1135
Form T1135 currently only provides for general information regarding where the specified foreign property is located and what income it generates. Budget 2013 announces that the CRA will revise Form T1135 to require more detailed information to be reported. The CRA will also help taxpayers meet their filing obligations with respect to Form T1135 by improving the filing instructions for the Form and reminding taxpayers, on their notice of assessments, of their obligation to file this form. The CRA will also be developing a system to allow electronic filing of Form T1135.
Extended Reassessment Period – Form T1135
After a taxpayer files an income tax return and the CRA raises its initial assessment, the ITA provides the CRA with a limited amount of time to audit and reassess the tax liability. The normal reassessment period is three or four years, depending on the type of taxpayer. The current rules provide the CRA an additional three years beyond the normal reassessment period to raise an assessment where it is made as a consequence of a transaction involving the taxpayer and a non-resident person with whom the taxpayer does not deal at arm’s length. These rules recognize the difficulty CRA has in reviewing foreign transactions in a timely manner.
Budget 2013 proposes to extend the normal reassessment period by three years if the taxpayer fails to report income from a specified foreign property and Form T1135 was not filed on time, or a specified foreign property was not identified, or was improperly identified, on Form T1135. This proposal seems to indirectly modify the existing rule described above by extending its application to all taxpayers, whether arm’s length or non-arm’s length, but in the former case, only to those taxpayers not complying with Form T1135.
Canada has an extensive system of bi-lateral tax treaties intended to facilitate trade with Canada’s treaty partners and to reduce tax evasion and avoidance. The Department has expressed its concern that residents of third countries may establish entities in treaty countries for the purpose of accessing the benefits of particular bi-lateral tax treaties – so-called “treaty shopping”. The Department has also expressed its concern that existing anti-abuse provisions are not sufficient to counter such practices, particularly given the Government’s lack of success in challenging these practices in the tax courts.
Budget 2013 announces the Government’s intention to consult on possible measures to combat treaty shopping. A consultation paper describing these measures will be publicly released to provide stakeholders with an opportunity to comment.
Scientific Research and Experimental Development
Budget 2013 proposes a relatively modest change to the SR&ED program aimed at enhancing compliance. For SR&ED claims filed after January 1, 2014 (or after Royal Assent, if later), it will be necessary to include details about the SR&ED claim preparer, including their Business Number and details about fee arrangements (including contingency arrangements). A new penalty of $1,000 will apply to SR&ED claims which include missing, incomplete or inaccurate information about the taxpayer’s SR&ED claim preparer. In the Budget 2013 papers, the Department states that this information will facilitate the identification of SR&ED claims with a higher risk of non-compliance, although no rationale or details are provided to support this view.
On the spending side, Budget 2013 includes substantial investments in innovation, consistent with certain key recommendations to enhance direct funding of research and development as set out in the October 2011 “Jenkins Report”. However, Budget 2013 indicates that there is less momentum at this time to adopt the significant reductions and fundamental changes to the SR&ED program as recommended in the Jenkins Report.
Extended Reassessment Period for Tax Shelters and Reportable Transactions
Budget 2013 proposes to extend the usual limitation period for the CRA to reassess a taxpayer, until three years after the date information returns are filed for tax shelters or tax avoidance transactions, instead of the usual limitation period that runs from the date of the initial notice of assessment. These information returns are required to be filed to assist the CRA to identify and audit inappropriate claims. Where those returns are filed late, the current limitation period may prevent the CRA from having adequate time to review the claims. Applying to 2013 and subsequent years, this change will afford the CRA additional time to reassess.
Combating Charitable Donation Tax Schemes by Reduced Stay on Collections
The CRA has been combating aggressive charitable donation tax shelters for years, with protracted and extensive group litigation. The typical “buy low-donate high” schemes result in a charitable donation receipt being issued to a taxpayer in an amount many times greater than their cash outlay. Despite the Courts’ consistently upholding the CRA’s disallowance of these deductions, these schemes have continued to proliferate. Effective for assessments for 2013 and subsequent years, Budget 2013 proposes to permit the CRA to immediately collect half of the disputed tax, interest or penalties, instead of the usual stay on collections of the entire amount of the assessment, while it is under objection or appeal to the Tax Court of Canada. The CRA’s enhanced collection ability will discourage participation in these schemes and enhance the CRA’s ability to collect.
Procedural Streamlining for Information Requirements Regarding Unnamed Persons
Both the ITA and the Excise Tax Act (Canada) (ETA) currently enable the CRA to seek a Court order against a party, without notice to the party, requiring it to provide information or any document relating to unnamed persons. The ability to seek the order without notice to the party was supposed to expedite the CRA’s ability to get the information and documents. The CRA has deployed this tool to commence audits of various groups of individuals, including customers, donors, investment brokers and real estate agents. However, the ITA and the ETA currently allow the party to challenge the order, on bases including that the Minister failed to act in utmost good faith and ensure that full and frank disclosure was made to the Court in obtaining the order. When such a challenge is made, the CRA’s ability to get the information and documents is delayed. Budget 2013 proposes to change this procedure, by requiring the CRA to seek the order with notice to the party. This should enable the CRA to obtain the information sooner and avoid being challenged later for not meeting its obligations to the Court.
Leveraged Life Insurance Arrangements
Budget 2013 proposes measures that are intended to render ‘10/8’ insurance planning and leverage insured annuity (LIA) planning obsolete or nearly obsolete. This type of planning has been of concern to the CRA for a number of years and has been the focus of audits and litigation, including the recently decided Federal Court of Appeal decision in MNR v RBC Life Insurance Company (February 12, 2012).
There are a number of variations in this planning. In a typical LIA plan, a private corporation purchases a life insurance policy (on the life of the principal shareholder) and an annuity contract from an insurer, simultaneously with entering into a borrowing arrangement with the same insurer or with a third party lender working in conjunction with the insurer. The insurance policy and the annuity are used as security for the borrowing. Properly planned, the interest payments and a portion of the premium payments would be deductible, the capital would accumulate in the policy tax free, the value of the shares (on death) would be reduced by the borrowing, and the corporate surplus would be transformed on death into an addition to the capital dividend account.
Under a typical 10/8 plan, the taxpayer funds a life insurance policy in a way that builds up the cash surrender value quickly, then borrows from or against the policy and uses the borrowed funds for some business purpose. Under a proverbial “10/8” plan, the investments inside the policy would earn a return of 8 per cent, which would be exempt from tax, and the taxpayer would pay interest at a rate of 10 per cent on the borrowing, which would be deductible. Properly planned, with a deductible interest rate of 10 per cent, together with an exempt policy return of 8 per cent, the economics of this planning can by quite advantageous to the taxpayer.
The central concepts of the proposed provisions in Budget 2013 are the defined term “LIA policy” and “10/8 policy”. Where a life insurance policy falls under the definition of an “LIA policy”, Budget 2013 proposes to subject the policy to accrual basis taxation, deny deductibility to the premium payments, deny the addition of the death benefit to the capital dividend account and deem the annuity to be worth, on death, the total amount of premiums paid for it. Existing plans are grandfathered.
Where a life insurance policy falls under the definition of a “10/8 policy”, Budget 2013 proposes to deny deductibility to the premium payments and interest payments and deny the addition of the death benefit to the capital dividend account. There are no grandfathering rules. Instead, Budget 2013 proposes transitional arrangements intended to facilitate the termination of existing 10/8 plans and alleviate the tax consequences of policy withdrawals to repay the borrowing.
Budget 2013 introduces new monetary penalties into the ETA and ITA for acquiring, possessing or using so-called “zapper” software, which is more formally known as “electronic suppression of sales” software. As the name suggests, the software can be used by a business to suppress or “zap” sales from its records with a view to evading tax compliance. The penalties are $5,000 for a first infraction and $50,000 for a subsequent infraction. The monetary penalties are double for manufacturing, developing or selling such software, with accompanying new criminal offence provisions providing for additional fines of between $10,000 and $1 million, as well as imprisonment of up to five years.
In recent years, Revenu Quebec has led the way in countering “zapper” software by imposing similar offences, as well as requiring the installation of sales recording devices into restaurant cash registers and requiring restaurants to issue a copy of the bill to every customer. These efforts alone have reportedly increased annual revenues by $160 million and resulted in fines of $1.3 million.
Consultation on Graduated Rate Taxation of Trusts and Estates
Budget 2013 proposes a consultation to review the graduated rate system that applies to testamentary trusts. Inter vivos trusts are subject to a flat rate of federal tax of 29 per cent. Testamentary trusts are subject to graduated or progressive rates, with the consequence that income earned in a testamentary trust can be retained by the trustees in the trust and subjected to a lower aggregate rate of tax than if it had been distributed to a beneficiary. Budget 2013 suggests that this result is anomalous and leads to planning, such as the artificial creation of multiple testamentary trusts that might be inappropriate.
Testamentary trust planning is such a common feature of Canadian estate planning, it is not hard to see why the Government is proposing a “trial balloon” consultation paper approach. It will be interesting to see how the Canadian estate planning industry will respond, and whether this balloon can fly.
General Tightening Measures
Budget 2012 also proposes a number of other “tightening” measures.
The thin capitalization rules in the ITA restrict the deductibility of interest payments made by a Canadian resident corporation on debt owing to certain specified non-residents. In its 2008 report, the Advisory Panel on Canada’s System of International Taxation recommended that these rules be extended to partnerships, trusts and Canadian branches of non-resident corporations and that the maximum debt-to-equity ratio be reduced from 2:1 to 1.5:1. In Budget 2012, the thin capitalization rules were extended to partnerships with a Canadian-resident corporate partner, the maximum debt-to-equity ratio was reduced to 1.5:1 for taxation years that begin after 2012, and disallowed interest expense was deemed to be a dividend paid to the specified non-resident for Part XIII withholding tax purposes.
Budget 2013 further extends the application of the thin capitalization rules to apply to Canadian-resident trusts and to non-resident corporations and trusts that operate in Canada. The proposed changes will apply for taxation years that begin after 2013 to existing and new borrowings.
Budget 2013 modifies the thin capitalization rules to reflect the legal nature of trusts. Beneficiaries take the place of shareholders in determining whether a debt owed by the trust to a non-resident should be included in the trust’s 1.5:1 debt-to-equity ratio. The “equity” for purposes of the ratio will generally consist of contributions to the trust from specified non-residents plus the tax-paid earnings of the trust, less any capital distributions to specified non-residents.
If interest is not deductible by the trust under these thin-capitalization rules, the trust may designate the non-deductible interest as a payment of trust income to the non-resident beneficiary and deduct the payment from the trust’s income. The payment of the trust income will be subject to Part XIII withholding tax. Part XII.2 tax may apply to the payment if the trust has income from certain sources and the trust is not otherwise exempt from such tax (mutual funds, testamentary trusts and certain other trust are exempt from Part XII.2 tax).
These thin capitalization proposals will apply to partnerships where a Canadian-resident trust is a member and may result in the inclusion of non-deductible interest in the income of the trust. The trust will be able to designate the included income as a payment of trust income to the non-resident beneficiary and deduct the payment from the trust’s income.
In recognition that existing trusts may not have kept appropriate records to be able to compute amounts under these new rules, a trust that exists on March 21, 2013 may elect to determine the amount of its equity for thin capitalization purposes as at that date, in accordance with certain rules.
Non-Resident Corporations and Trusts
Budget 2013 proposes to extend the application of the thin capitalization rules to non-resident corporations and trusts “that carry on business in Canada”. Although references are made to a “Canadian branch”, the rules are not limited to circumstances where there is a permanent establishment in Canada (i.e., an office or fixed place of business or permanent establishment). However, a non-resident corporation or trust that is eligible for a treaty exemption from Canadian tax on its Canadian business profits (because it does not have a permanent establishment in Canada) would generally not be concerned with the denial of an interest deduction. The Supplementary Information to the Tax Measures notes that where a non-resident corporation or trust earns rental income from Canadian properties and elects to be taxed on net income under Part I of the ITA (a so-called “216 election”), the thin capitalization rules will apply in computing the non-resident’s Part I tax.
A loan used in the Canadian operations of a non-resident corporation or trust will be an outstanding debt to a specified non resident for thin capitalization purposes if the lender does not deal at arm’s length with the non-resident corporation or trust. A debt-to-asset ratio of 3:5 will be used, which is intended to parallel the 1.5:1 debt-to-equity ratio for Canadian resident corporations. The application of the thin capitalization rules may increase the liability of a non-resident corporation for branch tax under Part XIV of the ITA.
These thin capitalization rules will apply to partnerships in which a non-resident corporation or trust is a member. An income inclusion for a non-resident partner arising as a consequence of these rules will be deemed to have the same character as income against which the partnership’s interest deduction applied.
Pre-Production Mine Development Expenses
Budget 2013 proposes to amend the definition of Canadian exploration expense (CEE) by removing from the list of expenditures that qualify as CEE, certain expenditures incurred for the purpose of bringing a new Canadian mineral resource mine into production. These expenditures will now be treated as Canadian development expenses (CDE). CEE is fully deductible by taxpayers who are not principal business corporations, and fully deductible to the extent of income by principal business corporations. In contrast, a taxpayer can deduct only 30 per cent of cumulative CDE on a declining balance in a taxation year.
The stated purpose of the Budget 2013 amendment is to bring the treatment of certain expenditures in the mining sector into alignment with the treatment of comparable expenditures in the oil and gas sector. In particular, amendments in Budget 2007 and Budget 2011 phased out accelerated CCA for tangible assets in oil sands projects and changed the deduction rates for intangible expenses for new oil sands mines.
The expenditures covered by the amendment are expenditures incurred for bringing a new mine in mineral resource in Canada into production in reasonable commercial quantities and before the mine comes into production in commercial quantities. These expenditures include clearing, removing overburden, stripping, sinking a mine shaft or constructing an underground entry.
There are grandfathering and phase-in rules. Expenditures incurred in existing projects are grandfathered until after 2017. For new projects, the loss of CEE is phased-in over 4 years until 2018.
Accelerated Capital Cost Allowance for Mining
The ITA currently provides for an accelerated CCA in respect of certain assets acquired for use in new mines and eligible mine expansions. This additional allowance is equal to 100 per cent of the eligible expenditure up to the taxpayer’s income for the year.
Budget 2013 proposes to phase out this additional allowance over the 2017 to 2020 calendar years. Existing projects are grandfathered. The grandfathering will include assets acquired before 2018 under agreements entered into before March 21, 2013 or as part of the development of a new mine or mine expansion commenced before March 21, 2013.
Reserves for Future Services/Reclamation Obligations
A great deal of attention has been paid over the past several years to the tax treatment of environmental reclamation obligations, without many solutions. While accruals for such costs can be very large, they are not generally deductible until actually paid. Compounding the problem, reclamation expenses often become payable after the income-generating activity has ceased, at which point there may be insufficient taxable income to fully use the expenses. In some limited circumstances, tax-deductible contributions can be made to “qualifying environmental trusts”, but such trusts are often not feasible. One solution was for the taxpayer to pay another entity to assume the future reclamation obligation. The taxpayer would deduct the payment on the basis that it was no longer a contingent expense. The entity assuming the obligation included the amount in income but claimed a reserve under paragraph 20(1)(m) with respect to its obligations to provide the reclamation services in the future.
Budget 2013 stops this type of planning by denying a reserve taken under paragraph 20(1)(m) where the reserve is in respect of a reclamation obligation. The Supplementary Information gives an example of a waste disposal facility that charges customers a fee to cover the cost of the future reclamation of the landfill. After this amendment, such fees will no longer qualify for the reserve and will thus be taxable in the year of receipt. Limited grandfathering is available in respect of amounts received that were previously authorized by a government or regulatory authority.
Lifetime Capital Gains Exemption and Tax Rate on Non-Eligible Dividends
Effective 2014, Budget 2013 proposes to increase the LCGE by $50,000 to $800,000 and to index the amount of the LCGE to inflation in future years. Even individuals who previously used their existing LCGE will be able to use the additional LCGE. The measure will cost the Government $110 million over five years.
Coinciding with the increase in the LCGE, Budget 2013 proposes to decrease the gross-up and dividend tax credit in respect of non-eligible taxable dividends paid after 2013. The result is an increase in the effective top federal tax rate on an individual’s dividend income of 1.64 per cent to 21.22 per cent. The measure is expected to generate an additional $2.34 billion for the Government over five years, representing the single largest proposed tax change. While stated to increase tax integration, this measure will likely also off-set the benefit of the increased LCGE to private business owners that meet the requirements of a QSBC, as it will increase the tax those individuals pay on dividends paid out of the corporation’s “low rate income pool.”
Labour Sponsored Venture Capital Corporations Tax Credit
Labour-Sponsored Venture Capital Corporations (LSVCCs) are professionally managed funds that raise capital from individual Canadians. LSVCCs have been a significant source of venture capital for small and medium-sized Canadian companies, but federal tax credits for the investors represent a significant cost for the Government.
Budget 2013 proposes to phase out the federal LSVCC tax credit. For taxation years that end before 2015, the credit will remain at 15 per cent for investments of up to $5,000 per year. The credit will be reduced to 10 per cent for the 2015 taxation year; 5 per cent for the 2016 taxation year; and will be eliminated after 2016. There will be no new federal LSVCC registrations and provincially registered LSVCCs will not be prescribed for purposes of the federal tax credit unless the application was submitted before March 21, 2013.
Restricted Farm Losses
Budget 2013 proposes that effective for taxation years that end on or after March 21, 2013, the restricted farm loss rules will apply to taxpayers whose chief source of income is neither farming nor a combination of farming and another subordinate source of income. This measure effectively reverses the recent decision of the Supreme Court of Canada in the Craig case. In Craig, the taxpayer's primary source of income was his law practice, and he also had a substantial farming business that was a subordinate source of income. Under the pre-Budget 2013 rules, the restriction applied if the taxpayer's chief source of income was neither farming nor a combination of farming and another source of income (regardless whether the farming business or the other business was dominant). The Court found that the taxpayer’s chief source of income was such a combination (even though his horse racing/farming business was subordinate to his law practice) and, therefore, he was permitted to deduct the losses of his horse racing/farming business from the income of his law practice without restrictions. Under the Budget 2013 amendment, farming must be the taxpayer's chief source of income. The concept of a chief source of income from a combination of activities has essentially been rendered meaningless, as farming is now required to be dominant in any such combination.
While the restricted farm loss rules will now apply more broadly, Budget 2013 does increase the maximum amount that may be deducted in the year from non-farming income from $8,500 ($2,500, plus half of next $12,500) to $17,500 ($2,500, plus half of next $30,000). Unused farm losses may be carried back three years and forward 20 years and deducted against farming income.
Of course, Budget 2013 is not exclusively about integrity and tightening and does include a few “goodies.”
Extension of the Mineral Exploration Tax Credit for Flow-Through Share Investors
Budget 2013 proposes to extend the flow-through mining tax credit that has been in place for a number of years. Annual extensions of this 15 per cent federal tax credit have been a feature of federal budgets since 2007.
The credit is available to purchasers of flow-through shares under flow-through share agreements entered into on or before March 31, 2014. It is available only in respect of a certain subset of Canadian exploration expenses relating to specified kinds of surface or “grassroots” exploration.
Flow-through funds raised in 2014 by mining exploration companies on or before March 31, 2014 can be expended on eligible expenditures prior to the end of 2015, and under the look-back rule, can be renounced to purchasers for deduction and credit in 2014.
The measure is intended as an additional stimulus to surface exploration in Canada. Similar tax measures are in place in Ontario, British Columbia, Manitoba and Saskatchewan.
Accelerated Capital Cost Allowance
Budget 2013 continues its focus on goods manufactured or processed in Canada and encourages investments in low-emission or no-emission energy generation equipment by providing favorable CCA treatment for certain assets.
Manufacturing and Processing Machinery and Equipment
Subject to the half year rule, the accelerated 50 per cent straight-line CCA rate has been extended for two years for machinery and equipment that is used primarily in Canada for the manufacturing or processing of goods for sale or lease. This measure will apply to eligible machinery or equipment acquired after March 18, 2007 and before 2016.
Clean Energy Generation Equipment
Budget 2013 broadens the scope of clean energy generation and conservation equipment, which currently enjoys an accelerated 50 per cent declining-balance CCA rate. Eligibility requirements will be expanded for biogas production equipment to include a larger pool of organic waste, such as pulp and paper waste and waste water, beverage industry waste and wastewater and separated organics from municipal waste. Additionally, restrictions will be removed such that all types of cleaning and upgrading equipment used to treat eligible gases from waste will qualify for the favorable CCA treatment. These measures will apply to eligible equipment acquired on or after March 21, 2013.
GST/HST Relief for Employers with Pension Plans
Budget 2013 simplifies GST/HST compliance for employers with registered pension plans, though it will take some eight additional pages of not so simple amendments to the ETA. Currently, an employer must both collect GST/HST on a taxable supply made to a pension plan and self-assess for GST/HST when the employer acquires, consumes or uses inputs of property or services for activities relating to the pension plan. Employers can make a tax adjustment to avoid any double taxation.
One simplification measure allows the employer to jointly elect with the pension entity to not collect tax on actual supplies made to the entity if the employer already self-assesses on deemed taxable supplies to the entity. The second measure provides a de minimis threshold below which an employer is not required to self-assess for GST/HST. The relief from self-assessment extends to either deemed taxable supplies by the employer to the pension plan, or to inputs of property or services consumed or used by the employer relating to the pension plan that are not used to make supplies to the pension plan. The threshold requires the employer’s GST (or corresponding federal portion of the HST) on such deemed taxable supplies or on such inputs to be less than $5,000 per year and less than 10 per cent of such GST/HST paid by all pension entities of the pension plan.
GST/HST Integrity Measures
Budget 2013 includes several integrity measures.
The first provides the Minister with the right to withhold GST/HST refunds until a business provides certain business identification information. It is hoped that the Minister will use this authority in the promised “fair and judicious manner.”
The second measure eliminates a recent structure by which hospitals, as well as municipalities, universities and colleges, school authorities and non-profit organizations, have provided paid parking largely or entirely for free, and thus exempt from GST/HST, to an associated charity, which then resupplies the paid parking at full cost to the public under another GST/HST exemption.
The third measure reverses a 2001 Federal Court of Appeal decision, which held that medical evaluation reports provided to insurance companies were GST/HST exempt. GST/HST will now apply to medical examinations, diagnostic services and medical reports that are not for the purpose of protecting, maintaining or restoring the health of a person or for palliative care. As a result, such services will be taxable when provided by medical experts in determining liability in court proceedings.
Budget 2013 includes two minor tax relieving provisions. The first expands the scope of the existing exemption from GST/HST for publicly funded or subsidized homemaker services for individuals who need assistance due to age, infirmity or disability. The existing exemption for cleaning, laundering, meal preparation and child care is expanded to include the personal care services of bathing, feeding, and assistance with dressing and taking medication. The second is the elimination of customs duties on baby clothes and sports equipment, though not bicycles.
Deferral of General Preferential Tariff Removal
The Government previously announced its intention to remove the General Preferential Tariff (GPT) treatment for imports of products from 72 countries. The GPT was first implemented in 1974, and provides duty free or preferential market access to most imported goods from developing countries, including large economies such as China, Brazil, Israel and Thailand. Originally, the GPT was set to expire on June 30, 2014. Budget 2013 contemplates a deferral of the changes only apply to goods imported into Canada on or after January 1, 2015.