The Department of Finance has clearly been busy while Parliament was prorogued the past two months judging from the number and extent of technical changes proposed in Budget 2010. Given the number of new ideas put forward for public consultation, there will be no rest any time soon for our hard working colleagues at the Department.
Fortunately, while taking steps to reduce the nation’s deficit, they also found time to fix one of the long standing impediments to foreign investment in Canada, and saw fit to give our charity sector the fundamental reform to disbursement quotas they have been requesting. Unfortunately, for employers and their employees, Finance also found the wherewithal to close a nice loophole that previously provided tax advantages when cashing out stock options.
Section 116 Requirements Are Eased
Non-resident investors finally obtain relief
In a welcome move, Budget 2010 proposes that non-residents will no longer need to obtain clearance certificates or pay withholding tax on the sale of shares in a Canadian corporation (and certain other interests), as long as the shares do not derive their value principally from real or immovable property situated in Canada, Canadian resource property, or timber resource property. This change will be particularly beneficial to the high tech sector, which has lobbied for years for this change. It is widely thought that foreign investment in Canada has been impeded by the existing rules, which impose onerous tax and administrative requirements on non-resident investors.
The change proposed by Budget 2010 is important because it takes these investments entirely out of the section 116 compliance regime, provides long-awaited administrative relief for treaty-based foreign investors, and also provides tax relief for non-treaty based foreign investors.
Foreign investors in private Canadian corporations are not taxable on capital gains derived from certain Canadian investments if they reside in a treaty jurisdiction and are entitled to treaty protection. However, despite the entitlement to treaty protection, it was necessary for them to obtain a section 116 clearance certificate from Canada Revenue Agency. A recent case made it clear that the withholding tax mechanism in section 116 is applicable even where treaty protection applies.
Obtaining a section 116 clearance certificate imposes a significant administrative burden on non-resident vendors. The non-resident vendor must obtain a Canadian business number for reporting purposes (which must be subsequently cancelled or the vendor will continue to receive demands for tax returns) and must provide detailed information and background on the vendor and the property. The processing of the clearance certificate by the Canada Revenue Agency can take several months, so it is rare to see a section 116 clearance certificate issued to the vendor prior to the closing of the transaction. Consequently, the purchaser must withhold funds at closing to satisfy its obligations, and escrow arrangements must be entered into pending delivery of the certificate. In some cases, the Canada Revenue Agency may insist on the payment of withholding tax where treaty protection is unclear, thereby necessitating the investor to file a tax return and claim a refund.
Prior amendments were not effective
Previously, Budget 2008 had introduced some measures that purported to relieve the burden of obtaining a section 116 clearance certificate for non-resident vendors of treaty-protected property. However, the effect of the rules was to place a burden on purchasers to determine whether the vendor was entitled to the benefit of a tax treaty and whether the property met the conditions to be treaty protected property. In an arm’s length situation, purchasers are generally not prepared to take the risk of tax liability so they often required a non-resident vendor to obtain and deliver a section 116 certificate. For these reasons, the Budget 2008 changes did not go far enough, and the need to obtain a section 116 clearance certificate remained a practical reality.
For foreign venture capital funds, many of whom are structured as limited partnerships or US limited liability corporations comprising hundreds or even thousands of individual investors, the compliance burden has been a serious bone of contention and has resulted in real restrictions to access to foreign capital for Canadian business. The section 116 compliance burden was often cited by foreign VCs as a sufficient reason to look elsewhere for investment opportunities. The problem was not limited to Canadian technology and life sciences sectors, but efforts to raise funding in these sectors were especially hampered by section 116 requirements. Despite changes to the Canada-US tax treaty, which attempted to accommodate LLC’s, the administrative burden remained significant.
The new changes are far-reaching
The changes announced in Budget 2010 are far-reaching because they eliminate altogether the application of section 116 for shares of private Canadian corporations, partnership interests and interest in trusts - unless the value of the investment is derived principally (more than 50%) from real property, resource property or timber resource property in Canada (or was so derived at any time within the previous 60 months). As a result, Canadian technology and life sciences corporations, as well as other Canadian corporations who meet the value test, will no longer be handicapped by the administrative burden of section 116 that was imposed on foreign VCs and other non-resident investors who reside in treaty jurisdictions.
Further, the change applies to all investors, including those who reside in non-treaty jurisdictions and investors from treaty jurisdictions who are not eligible for treaty protection such as LLC’s. Under existing law, a non-treaty investor was liable for Canadian tax on the gain, was required to pay withholding tax on account of its Canadian tax liability, and was required to file a Canadian tax return reporting the capital gain realized on the sale of its Canadian investment. By excluding private Canadian corporations, partnership interests and interests in trusts altogether from the definition of “taxable Canadian property” (unless the value is principally derived from real property, resource property or timber resource property in Canada at any time in previous 60 months), capital gains on investments in the hands of foreign investors are no longer taxable in Canada even where treaty protection is not available to them.
Purchasers should still exercise caution
In many circumstances, a purchaser will have sufficient knowledge and information about the target corporation, partnership or trust and its operations and assets during the prior 60 months to determine whether the property it is purchasing is “taxable Canadian property”. However, the purchaser is at risk if there is uncertainty or if it is subsequently determined that the purchased property was “taxable Canadian property”. For example, there may have been a point in time during the 60 months prior to a sale when more than 50% of the value of the property was derived from real property in Canada. Therefore, in certain circumstances it may be prudent for purchasers who acquire property from non-residents to obtain protection, by way of indemnities or otherwise, with respect to the target’s asset mix during the preceding 60 months.
Budget Shuts Down “Offensive” Loss Trading in connection with SIFT Conversion
Finance Has its Cake ....
On Halloween day, 2006, legislation was announced to stem the growing trend of top Canadian corporations converting to a more tax-efficient (and perfectly legal) “income trust” model. For income trusts that began trading after that date, the application of the SIFT rules (as they would become known) would apply commencing with their 2007 taxation year. For income trusts and listed limited partnerships already in existence, the new rules would not take effect until the SIFT's 2011 taxation year. In the interim, further new rules were subsequently introduced to facilitate the “de-conversion” of SIFT trusts and partnerships back into corporations on a tax-free basis.
Recently, creative tax planners have made use of these rules governing “de-conversion” transactions to allow SIFT entities to “acquire” corporations with accumulated losses. The transaction typically takes the form of a “reverse takeover” by having the loss company issue its shares to the former SIFT interest-holders in consideration for all of the interests in the SIFT trust, SIFT partnership or real estate investment trust, as the case may be.
.... And Eats it Too ....
The Department of Finance has consistently opposed this kind of “loss trading” between unrelated parties. This is typically accomplished through the existing “acquisition of control” rules. These rules generally provide that where control of a corporation is acquired, tax losses realized by the corporation arising in a pre-acquisition of control period may generally not be used to reduce tax payable in respect of a post-acquisition of control period. A special rule deems there to be an acquisition of control of a corporation (and its subsidiaries) that issues shares in consideration for the shares of another corporation (the target) in a “reverse takeover”. These rules do not extend to a “reverse takeover” of a non-corporate entity (such as a SIFT trust, SIFT partnership or real estate investment trust).
Budget 2010 proposes to enact a similar rule to deem an acquisition of control of a corporation (and therefore deny it the use of its accumulated losses) where that corporation issues shares in consideration for interests in a SIFT trust, a SIFT partnership or real estate investment trust.
.... And to the Taxpayers Go the Crumbs
Mercifully, Budget 2010 does propose to ensure that the losses of a corporation whose shares are distributed on the winding-up of a SIFT trust whose sole beneficiary is a corporation will not be restricted under the “acquisition of control rules”. The Department of Finance seemed satisfied that these were not losses being “traded” between unrelated parties and therefore did not offend their sensibilities.
These rules will apply to transactions undertaken on or after 4:00 pm (EST) on March 4, 2010 (unless the obligation to enter into the transaction was pursuant to a written agreement entered into before that time).
Foreign Tax Credit Generators
Canada's foreign tax credit system is intended to relieve double taxation for Canadian residents who pay tax in both Canada and a foreign country on the same income. Relief is also provided in computing the income of a foreign affiliate that is taxed in the hands of its Canadian shareholder, through various mechanisms that take foreign taxes into account. These include the foreign accrual tax (FAT) mechanism, in the case of foreign accrual property income (FAPI) of a controlled foreign affiliate, and the underlying foreign tax (UFT) mechanism, in the case of certain dividend distributions. The Department of Finance has identified certain arrangements as abusive "foreign tax credit generator schemes" that use foreign special purpose entities to enter into complex series of transactions that generate foreign taxes that may be claimed by a Canadian corporate shareholder as a foreign tax credit, or a FAT or UFT deduction to offset Canadian tax. Budget 2010 proposes measures intended to eliminate the benefit of entering into these arrangements by denying claims for foreign tax credits, FAT or UFT deductions, in circumstances where the Canadian corporate shareholder has a lesser direct or indirect interest in the foreign special purpose entity in the jurisdiction levying the foreign income tax than it does for purposes of the Income Tax Act (Canada) (the “Tax Act”). The intended effect is to put the Canadian corporation in the same tax position as if it had made a simple loan to the foreign entity.
Foreign Investment Entities and Non-Resident Trusts
A decade of uncertainty ....
The saga, which began in 1999 with proposals to fundamentally change the taxation of non-resident trusts (NRTs) and foreign investment entities (FIEs), continues in Budget 2010. The proposals, in their various forms, and subject to retroactive application, have given rise to a decade of uncertainty for taxpayers. For 10 years taxpayers have had to arrange their affairs to comply with highly technical draft legislation that was in a state of flux and had many unintended consequences.
The complexity of the previous outstanding proposals was daunting, even for experienced tax professionals, and their scope was overly broad, not in keeping with the underlying policy. We have seen detailed draft legislation released and revised and re-introduced, followed by further proposals for change. Budget 2010 is the latest iteration in the process. Clearly, this is a difficult area to achieve a reasonable balance between protecting the fisc and allowing taxpayers to make appropriate arrangements.
In what was a dramatic development for tax professionals, submissions on the NRT rules were made by representatives of institutional investors to the Senate Banking Committee after the rules had been passed in the Commons. The Chair of the Committee stated that the Bill containing the FIE and NRT rules would not pass the Senate without amendments to the NRT rules. Since that time, the FIE and NRT rules have been under review by the Department of Finance.
.... and the uncertainty continues
Budget 2010 proposes significant modifications to the rules, but there is no draft legislation that can be reviewed at this time. The public is being asked to submit comments before May 4, 2010, following which draft legislation will be developed and then eventually released. As a result, the climate of uncertainty continues since, once again, the non-resident trust rules are to be generally retroactive to 2007.
Foreign Investment Entities
The previous FIE proposals were complex ....
Under the previous proposals, income would be imputed to taxpayers holding a “participating interest” in a “foreign investment entity”. The draft legislation defining these concepts was extensive, complex, difficult to comprehend in all its detail, and raised serious compliance issues. Nevertheless, because of the proposed retroactive effect of the FIE rules, some taxpayers made an effort to voluntarily comply with the previous draft legislation. Other taxpayers made fundamental changes to their offshore structures in an attempt to avoid adverse consequences under the proposed rules.
.... and have now been withdrawn
To the relief of some, and the chagrin of others who attempted to comply with the old proposals, Budget 2010 proposes to completely replace the previous outstanding proposals for foreign investment entities and will revert to the existing provisions in the Tax Act, with only limited changes. Abandoning the outstanding proposals for foreign investment entities is an implicit acknowledgment that those rules were unworkable.
Taxpayers who attempted to comply with the previous draft legislation in prior years are in the interesting position of having paid tax according to rules that may never become law. They will be given the option to be reassessed for those years. Other taxpayers who made irrevocable changes to their investment structures may not have the ability to take remedial action. These are just some of the difficulties which arise when governments propose retroactive tax legislation.
.... so the existing rules will be tightened
Under current law, special rules apply where a taxpayer has an interest in an “offshore investment fund property” that derives its value primarily from portfolio investments. The rules are relatively simple, although not always easy to apply. Under these rules, if one of the main reasons for the taxpayer holding an interest in the offshore investment fund property is to significantly reduce the taxes that would have applied to the portfolio income, income will be imputed to the taxpayer at a prescribed rate. Budget 2010 will increase the imputed income so it will instead be computed at a rate equal to the three-month average Treasury Bill rate plus 2%.
Under current law, beneficiaries of a non-discretionary non-resident trust may be required to include in their income a portion of the foreign accrual property income of the trust. These rules will be broadened to apply to any Canadian resident beneficiary who, together with non-arm’s length persons, holds 10% or more of any class of interest in the non-resident trust. This will prevent obvious attempts to circumvent the rules. The rules will also apply to any Canadian resident who has contributed “restricted property” to the non-resident trust. The concept of “restricted property” will be defined in more detail when the draft legislation is released. These changes have relatively limited application since they will not apply to non-resident trusts which are deemed resident in Canada under the new NRT rules discussed below.
Unlike the previously proposed FIE rules, and unlike the NRT rules, these changes are merely incremental, slightly expanding the existing rules for the taxation of non-resident holdings.
The previous NRT proposals had unintended consequences
The previous proposals for the taxation of non-resident trusts constituted a significant expansion of current law. One consequence of those proposals was the inadvertent imposition of Canadian tax in a broad range of circumstances where there was no obvious policy reason, and where the result could be to impede legitimate commercial transactions.
For example, the previous NRT proposals would deem a non-resident discretionary trust to be resident in Canada if it had a Canadian contributor, regardless of whether there was a Canadian resident beneficiary. Further, all Canadian resident contributors and resident beneficiaries of the trust would be jointly liable for all tax payable by a trust that was deemed to be resident in Canada. As a result, a relatively minor contribution to a non-resident trust could render the contributor fully liable for all Canadian tax payable by the trust. Some of the more egregious problems are now addressed by the new proposals in Budget 2010, but the changes in the new proposals are so extensive that further consultation is required.
One unfortunate consequence of the previous proposals was that a Canadian tax-exempt entity was not excluded from the NRT rules. As a result, if a tax-exempt entity invested in a foreign trust, the trust could be deemed resident in Canada and the tax-exempt entity could thereby become jointly liable for the trust’s income tax liability despite its tax-exempt status in Canada. There was no apparent policy reason to penalize a tax-exempt entity for a legitimate investment in a foreign trust.
Budget 2010 proposes the introduction of an exemption for all entities which are tax exempt under section 149 of the Tax Act. To prevent abuse, an anti-avoidance rule will apply where a tax-exempt entity is used as a conduit to allow a resident of Canada to make an indirect contribution to a foreign trust. Because there is currently no draft legislation, it is not clear how the determination will be made that a resident of Canada is making indirect contributions through a tax-exempt entity.
Another significant problem under the previous proposals was the uncertainty they created for legitimate investments in foreign funds which happened to be structured as trusts. A Canadian resident who invested in a foreign commercial trust could find itself potentially liable for Canadian tax imposed on the foreign trust under the previous NRT rules in unexpected circumstances. Where the Canadian investor itself is a trust, liability for that tax could cascade down to its investors. As a result, sophisticated investors became wary of investing in foreign commercial trusts and began to ask for assurances from Canadian funds that they would not invest in foreign commercial trusts. The uncertainty created by the prior NRT proposals was a serious impediment to legitimate investments.
These problems arose even though the previous NRT rules included an exemption for a commercial trust that qualified as an “exempt foreign trust”. The purpose of the exemption was to exclude a legitimately commercial foreign trust from the rules which would deem it to be resident in Canada and hence liable for Canadian tax. Unfortunately, the requirements for the previous exemption as set out in paragraph (h) of the definition of “exempt foreign trust” were convoluted and required investors to have access to extensive information, potentially including information regarding the other investors in the foreign trust, their residence, the amount of their respective investments, the nature and extent of certain “restricted property” held by the trust, and many other details.
It was generally impractical for taxpayers to determine with any reasonable degree of certainty whether a foreign trust satisfied the various requirements for this exemption. Further, the status as an exempt foreign trust had to be maintained on an ongoing basis for the exemption to apply. Consequently, actions by the foreign trust or other investors could result in a change in the status of that trust after an investment had already been made in circumstances beyond the control of the investor. The consequences of being wrong about a trust qualifying as a foreign exempt trust, namely joint liability for the resulting Canadian tax liability of the foreign trust, was often considered an unacceptable risk. These challenges deterred investment in foreign commercial trusts.
Budget 2010 proposes to change the requirements for foreign exempt trusts in an attempt to make it easier to determine whether a foreign commercial trust will qualify. It will do this by eliminating the test based on whether the trust holds “restricted property”. Further, it is proposed that a commercial trust will not be subject to the NRT rules if it meets all of the following conditions:
- each beneficiary is entitled to both the income and capital of the trust
- any transfer of an interest in the trust is a disposition
- interests in the trust cannot cease to exist except where the beneficiary is entitled to receive fair market value
- the amount of distributions to beneficiaries is not discretionary
- interests in the trust are listed or other dispersal tests are satisfied
- the terms of the trust cannot be varied without certain levels of approval
- the trust cannot be a personal trust
It is apparent from this list of requirements that even under this “simplified” test, investors will have to conduct a significant amount of due diligence on a foreign commercial trust before being in a position to make any determination whether the trust is an exempt foreign trust.
If the new test is also a point in time test, as it appears to be, the investor will be at risk if circumstances change. Indeed, the Budget proposals specifically contemplate a situation where a trust initially meets all the conditions as an exempt foreign trust, but is subsequently varied in a way that causes it to lose its exempt status. In that case the trust will be deemed resident and subject to Canadian on all of the trust’s income that has been accumulated (together with an interest amount) since it first had a resident beneficiary or resident contributor. This retroactive consequence to a change in status is thought to be necessary to prevent abuse, but it is a clear signal that investors will need to exercise caution if these proposals become law.
Relief for certain loans
Budget 2010 proposes some additional relief for specific situations. For example, Canadian financial institutions that make loans to a foreign trust will not be considered a resident contributor to the trust and therefore will not trigger deemed residence of the trust in Canada, as long as the loan is made in the ordinary course of the financial institution’s business.
New regime for taxing contributors
To address the fundamental unfairness of each resident contributor being fully liable for all of the trust’s tax liability regardless of the amount they may have contributed, a new regime is proposed. Instead of a contributor being jointly liable for the trust’s tax, a portion of the income of the trust will be allocated to resident contributors, and contributors will be taxed in Canada on the amount attributed to them. Resident beneficiaries will remain jointly liable with the trust for its tax to the same extent they were under the prior proposals.
This new regime requires contributions by Canadian residents to be tracked so the trust’s income can be attributed to the resident contributors in proportion to their relative contributions to the trust. The new proposals will no doubt cause trustees significant work keeping accurate accounts, tracking contributions from residents, and segregating contributions by residents from contributions by non-residents. In addition, income which accumulates on the resident contributions and non-resident contributions will have to be tracked and kept separate. When income is distributed, special rules will apply to allocate that income between the resident portion and the non-resident portion. One consequence of tracking these amounts will be that distributions to non-resident beneficiaries out of the resident portion of the trust will be subject to Part XIII withholding tax. Trustees will have to ensure they keep proper accounts so they are in a position to determine when to withhold and remit tax under the new regime. Many other detailed rules are contemplated for the new regime which will certainly increase the complexity of maintaining foreign trusts which are governed by these rules. The very complexity of the rules coupled with the ongoing uncertainty and never ending stream of changes is proving to be a reasonably effective deterrent. Many are beginning to wonder how long the process can continue.
In general, the NRT rules are still to be effective retroactively to 2007. However, since the proposed regime for attributing income to resident contributors is completely new, this aspect of the Budget proposals will only apply to taxation years that end after March 4, 2010. Even so, with taxation years already in progress, there is an element of retroactivity in these proposals.
In case the new NRT proposals do become law, trustees of foreign trusts potentially affected by the rules should start considering whether to keep the necessary accounts and may wish to begin segregating assets now rather than face compliance problems later.
Trustees and others who will be affected by these proposals should also take the opportunity to submit comments for consideration by the Department of Finance. Comments will be accepted until May 4, 2010.
Employee Stock Options
Stock Option Cash Outs
One of the surprises in the Budget 2010 was a change to the stock option rules. When an employee exercises an option and acquires shares, provided that certain conditions in paragraph 110(1)(d) or (d.1) of the Tax Act are met, the benefit that is equal to the difference between the exercise price and the fair market value of the shares, is included in the employee's income. The employee is entitled to deduct one-half of the benefit realized at the time of exercise (the “stock option deduction”). The employer is denied a deduction in computing its income in respect of the benefit to the employee. The rationale underlying the denial of the employer deduction is that on the issuance of shares by the employer there is no cash outlay and, therefore, the employer is not “out of pocket”.
Some stock option plans have attached stock appreciation rights (“SARs”) to options that allow an employee to elect to surrender a stock option, in lieu of exercising it, and receive a cash payment equal to the difference between the exercise price and the fair market value of the underlying shares. Prior to the Budget 2010 announcements, if all of the conditions for the stock option deduction were met at the time of the surrender, the employee was entitled to deduct one-half of the cash payment received in computing income. The employer was entitled to deduct the cash payment as an employment expense.
The Budget 2010 proposals deny the one-half deduction to the employee on the exercise of the SAR, unless the employer makes an election to forgo the deduction for the cash payment. The expressed policy rationale for this change is to “preserve symmetry” in tax treatment between stock based benefits. The Notice of Ways and Means Motion proposed amendments are made to paragraphs 110(1)(d) and (d.1) and are applicable for “transactions” occurring after 4:00 pm EST on March 4, 2010. The change is made by adding, as new conditions of eligibility for the stock option deduction that the employee acquire shares, unless: (a) the employer elects in prescribed form in respect of all stock options issued or to be issued under the stock option agreement with that employee that neither the employer (nor any person non-arm's length with the employer) will deduct any amount in respect of the payment, to or for the benefit of the employee, for the employee's disposition of the options, and that election is filed with the Canada Revenue Agency1; (b) the employee is provided with evidence in writing of such election; and (c) the employee files that evidence with his or her tax return for the year in which the stock option deduction is claimed. Existing stock option plans and agreements will not have to be amended and the election of the employer will not have to be made as long as employees in all cases exercise options and acquire shares. If the plan/agreement provides for SARS, the election has not been made by the employer, and the employee exercises a SAR, the employee will be denied the stock option deduction. Removing an existing enforceable SAR right may create other difficulties. Consequently, if there are existing SARs in a stock option plan or agreement, the employer will have to either (a) make the prescribed election not to take any deduction; or (b) inform employees that the stock option deduction is not available if they exercise the SAR.
SARs have provided a relatively simple method of allowing an employee to benefit from stock options without having to come up with the funds to pay the exercise price. In some cases, finding the funds to pay the exercise price poses a significant financial burden on the employee. SARs have not been as common as might be expected, because they can create cash flow problems, particularly for private company employers. Given that employers will not be able to deduct the cash payment, unless they are prepared to deny the employees the benefit of the stock option deduction, the SAR mechanism will become even less popular. SARS may still be adopted in a take-over situation where it is desirable to cash out option holders even though the payment is not deductible.
Non-Arm's Length Dispositions
Section 7 of the Tax Act is a complete regime that governs the treatment of stock options, including what happens on a disposition of those options. Budget 2010 introduces a provision that confirms that these rules govern the disposition of rights under a stock option agreement to a non-arm's length person. The Supplementary Information indicates that this change “clarifies” that non-arm's length dispositions results in an employment benefit at the time of disposition.
Elimination of Tax Deferral for Public Company Shares
Subsections 7(8) to (16) of the Tax Act were introduced in Budget 2000. These complex rules provide a deferral of the payment of tax on the benefit that arises on the exercise of options and acquisition of the public company shares, provided that the stock option deduction is available and certain other conditions are satisfied. The Ways and Means Motion in Budget 2010 repeals these provisions for shares acquired on the exercise of options after 4:00 pm EST on March 4, 2010.
There is a possible interpretation that withholding of income tax is not required on the benefits realized on the exercise of stock options and acquisition of shares. The Canada Revenue Agency has provided administrative relief when withholding from the stock option benefit would create hardship (for example, where the options are exercised near the end of the year and withholding from other remuneration would leave the employee with little or no cash remuneration). The Ways and Means Motion proposals provide that an amount must be withheld and remitted by an employer in respect of an employment benefit arising on the issuance of shares (other than on the exercise of options granted by a Canadian controlled private corporation). Although included in the provisions dealing with the repeal of the deferral for public company shares, these provisions appear to confirm the more general withholding and remittance obligation with respect to stock option benefits.
There is a relief from the withholding and remittance obligations in respect of options granted before 2011 if the stock option agreement was entered into in writing before 4:00 pm EST on March 4, 2010 and the agreement included a condition that restricted the employee from disposing of the securities for a period of time (i.e., restricted shares).
Special Relief for Tax Deferral Elections
As a consequence of the economic downturn, the value of publicly traded shares acquired by employees who elected to defer tax may have gone down in value after the shares were acquired and may, in some cases, be worth less than the cost of the shares to the employee (the exercise price). As a general rule, the employee is taxed on one-half of the benefit equal to the difference between the exercise price and the trading price of those shares at the time they were acquired, regardless of the value at the time of sale. If there is a loss on the sale of the shares, the loss is a capital loss that cannot be applied to reduce the taxable benefit included in income. Budget 2010 proposes amendments that provide relief for employees in this situation. If an employee exercised an option and acquired publicly traded shares and elected to defer the tax, and the employee disposes of those shares before 2015 for proceeds of disposition that are less than the benefit included in income, the employee will be permitted to elect to instead pay a special tax that is equal to the proceeds of disposition.
Repeal of Charitable Expenditure Rules
Registered charities must spend 80% of their previous years’ receipted donations and 3.5% of a two-year rolling average value of their investment property on their charitable activities or on transfers to registered charities and other qualified donees. The disbursement quota rules have been in place since the mid-1970s. They were originally intended to achieve two policy objectives: the 80% rule was intended to regulate fundraising and other administrative costs by restricting them to 20% of receipted donations; the 3.5% rule was intended to prevent registered charities from accumulating donations, capital and income for an indeterminate length of time, never spending appropriate resources on charitable works.
The division of the disbursement quota into these two components, however, distorted gifting decisions of donors and spending decisions of charities in multiple ways:
- it forced donors to impose artificial time-restrictive conditions on their donations;
- it forced charities to establish artificial disbursement plans that were one year, five year or more than ten years in length;
- it tended to preclude charities engaging in total return investing; and
- the 80%-rule required charities to identify “administrative” as opposed to “charitable” expenditures, even though there was no definition of “administrative” in the Tax Act.
Budget 2010 responds to the many criticisms of the disbursement quota regime offered by representatives of the sector and the charity bar. Under Budget 2010 proposals, the 80%-rule is abolished altogether. This is, in large measure, the fundamental reform the charity sector was asking for. Henceforth, registered charities will not be required to disburse 80% of their previous years’ receipted donations, but still must disburse 3.5% of a two-year rolling average of their investment property.
The new simplified rule applies to all registered charities. However, there is an exemption for registered charities that are designated as charitable organizations and whose investment property is less than $100,000. These smaller charities will not have a disbursement quota at all.
As a consequence of the change, certain anti-avoidance rules are improved. Charities are prohibited, on pain of revocation and/or penalty taxes, from cycling donations from one charity to another with the intention of avoiding expenditures on charitable activities.
Potpourri of Changes Affecting Business
Clean Energy Generation is Good
Specified clean energy generation and conservation equipment is generally eligible for the accelerated 50% “fast write-off” CCA rate. Budget 2010 proposes to expand the class of assets that qualify for this rate by broadening the range of qualifying heat recovery equipment to include specified thermal energy distribution equipment that is part of a district energy system relying primarily on specified renewable energy technologies. This change will apply to eligible assets acquired after March 3, 2010 that have not been previously used or acquired for use.
Budget 2010 also proposes to expand the list of corporations that are permitted to renounce certain start-up costs (Canadian renewable and conservation expenses) to investors using flow-through shares. This list will include corporations whose principal business is producing fuel, generating energy or distributing energy using specified clean energy generation equipment. This change will apply to taxation years ending after 2004.
Mineral Exploration Tax Credit Extended
Consistent with the last several federal budgets, Budget 2010 proposes to extend the mineral exploration tax credit for another year. The Canadian resource sector should be pleased with this announcement.
Currently scheduled to expire at the end of March 2010, flow-through agreements entered into on or before March 31, 2011 will continue to qualify for the mineral exploration tax credit. Flow-through shares allow corporations to renounce their Canadian exploration expenses to investors, such that individuals who invest in flow-through shares may deduct the expenses in calculating their own income. The mineral exploration tax credit is an added tax benefit equal to 15% of mineral exploration expenses renounced to investors.
Specified leasing property rules
The restrictions contained in the specified leasing property rules will be extended to otherwise exempt property in circumstances where the lessee of the exempt property is a tax-exempt entity or a non-resident who cannot make use of the capital cost allowance for Canadian tax purposes.
The specified leasing property rules effectively recharacterize an equipment lease as a loan thereby depriving the lessor of deductions for capital cost allowance as owner of the equipment. The rules do not apply to exempt property which includes general purpose office furniture; general purpose computer equipment; residential use furniture, appliances, telecommunications equipment, furnaces, hot water heaters and similar properties; certain motor vehicles; truck transportation equipment; and component parts of buildings. Such exempt property will no longer be eligible for exemption if leased to a tax-exempt entity or non-resident unless the total value of the leased property is less than $1,000,000. The $1,000,000 exception will be the subject of a special anti-avoidance rule if it may reasonably be considered that one of the main purposes of dividing property among separate leases is to obtain the benefit of the $1,000,000 threshold.
The new restrictions will apply to leases entered into after March 4, 2010.
Reporting tax avoidance transactions
To assist Canada Revenue Agency in identifying aggressive tax planning, public consultation will be held on proposals to be released shortly which will require reporting of certain “reportable transactions”. A reportable transaction will be an “avoidance transaction”, as currently defined in the Tax Act, that bears at least two of the following three so-called hallmarks of tax abuse:
- a promoter or tax advisor is entitled to fees that are contingent on the taxpayer obtaining a tax benefit, attributable to the amount of the tax benefit, or attributable to the number of taxpayers who participate in the transaction;
- a promoter or tax advisor requires “confidential protection” about the transaction;
- the taxpayer obtains “contractual protection” in respect of the transaction.
If discovered, the failure to have reported a reportable transaction will not necessarily result in denial of the tax benefit, however, the taxpayer will be required to provide all required information and pay a penalty in order to advance its claim for the tax benefit.
This proposal is similar to the proposal recently announced in Quebec to address aggressive tax planning, and is consistent with efforts by tax authorities in other countries to require taxpayers to identify transactions of interest.
Subject to consultations, the proposals are expected to apply to avoidance transactions entered into after 2010 or to series of transactions completed after 2010 (which could include series of transactions already undertaken).
Taxation of Corporate Groups
Unlike many other jurisdictions, the Canadian tax system does not provide for consolidated tax reporting by a corporate group. Loss utilization within a corporate group is often acceptable even under our general anti-avoidance rule, but the mechanisms to utilize losses can be cumbersome and can result in exposing profitable operations to creditors from underperforming businesses.
Budget 2010 announced that the Government will explore new rules for the taxation of corporate groups – including a formal system of loss transfers or consolidated reporting – and that stakeholder views will be sought prior to the introduction of any changes.
Budget 2010 proposes to continue the Government of Canada’s initiative to encourage the exercise of direct taxation powers by Aboriginal governments on reserves. There are currently 32 sales tax arrangements under which bands and self-governing Aboriginal groups levy sales taxes within their reserves or settlement lands. There are currently 12 such arrangements in respect of personal income tax with self-governing Aboriginal groups under which personal income taxes imposed on all residents within the settlement lands. The Government reiterates its interest in discussing and putting into effect direct taxation arrangements with interested Aboriginal governments.
Narrowing of Scope of GST/HST Exempt “Financial Services”
Budget 2010 included draft GST/HST legislation consistent with the proposals to amend the Excise Tax Act as announced by the Minister of Finance by press release on December 14, 2009.
Investment Management Services
The first part of the draft legislation reverses the 2009 decision of the Federal Court of Appeal in Her Majesty the Queen v. The Canadian Medical Protective Association, where the Court of Appeal had found that investment management services provided to CMPA were exempt from GST/HST as a service of “arranging for” a “financial service” that included the “transfer of ownership ... of a financial instrument” such as equities and debt.
Consistent with the Minister's earlier announcement, the draft legislation excludes from the definition of “financial service” the concept of an “asset management service”, which is more commonly known as investment management services. The scope of the exclusion will cover a service rendered in respect of the assets or liabilities of another person of managing or administering the assets or liabilities; providing research, analysis, advice or reports in respect of the assets or liabilities; determining which assets or liabilities are to be acquired or disposed of; or acting to realize performance targets or other objectives in respect of the assets or liabilities. The level of discretionary authority the investment advisor is not a factor.
The second part of this draft legislation reverses a trend in recent case law expanding the scope of GST/HST-exempt “arranging for” services provided to credit card issuers and lenders.
The draft legislation will exclude from the definition of GST/HST-exempt “financial service” a service preparatory to, or provided in conjunction with, the provision of “arranging for” a “financial service” that is: a service of collecting, collating or providing information; a market research, product design, document preparation, document processing, customer assistance, promotional or advertising service or a similar service.
It also will exclude from the definition of GST/HST-exempt “financial service” the service of managing credit in respect of credit cards, charge cards, credit accounts, charge accounts, loan accounts or accounts in respect of any advance, that is provided to a person granting, or potentially granting, credit in respect of those cards or accounts. This is to include services of checking, evaluating or authorizing credit; making decisions on behalf of the person in relation to a grant, or an application for a grant, of credit; creating or maintaining records for the person in relation to a grant, or an application for a grant, of credit or in relation to the cards or accounts; or monitoring another person's payment record or dealing with payments made, or to be made, by the other person.
In general, these changes should reduce the number of suppliers of GST/HST-exempt services in Canada, which seems to be one of the objectives of the amendments.
As previously announced, the GST/HST taxable treatment of these newly taxable “asset management services” and credit services will apply to all such services paid or invoiced after December 14, 2009, and to any such services previously paid or invoiced where the supplier charged GST/HST.
Other GST/HST Amendments
Budget 2010 further included legislation that will confirm that certain purely cosmetic procedures, as well as goods and services related to such procedures, are not considered to be basic health care and, as a consequence, are subject to GST/HST. Budget 2010 also included legislation changing the GST/HST treatment for the direct selling industry