Even though he was wearing re-soled shoes, the Minister has announced some new and welcome initiatives. While his steps were small, we applaud their direction. It is difficult to see anything sufficiently contentious in this budget to drive Canadians to the polls anytime soon.
Prior to the next budget we would suggest a mail-in campaign to buy the Minister new shoes, so we can better measure his level of commitment to a more practical set of rules. The Minister has a long way to go before he begins to make amends for the universally assailed reduction in the goods and services tax rate, in lieu of the stimulus that could have been achieved by using the foregone revenues to fund harmonization of commodity taxes with some of the provinces and to reduce corporate and personal rates generally. It is however a welcome relief, and a small step in the right direction, that Budget 2008 shows no signs of the complexity and curious policy choices that underlie recent proposals in the areas of interest deductibility regarding foreign investments, foreign investment entities and non-resident trusts.
It is encouraging to see the removal of some procedural constraints on dispositions of “taxable Canadian property” by non-residents. The removal of painful procedural rules that neither raised revenue nor promoted compliance can only be positive. The extension of time limits for registered education savings plans can also be seen as the removal of administrative restrictions that unnecessarily interfered with the purpose of the tax incentive. The same underlying philosophy is reflected in the liberalization (pun intended) of some grandfathering rules with respect to the excess corporate holding regime for private foundations.
The most interesting change in Budget 2008 is the introduction of Tax-Free Savings Accounts. While contributions will not be deductible, all withdrawals, including accumulated earnings, will be tax-free. Everyone over 17 will accumulate $5,000 per year of contribution room. At all turns the new rules emphasize simplicity over theoretical purity. The Minister can now suggest that he has addressed his party’s election promise to provide relief regarding the taxation of capital gains. At the same time, it may be difficult for those in other parties to argue that these rules discriminate against those at the low end of social-economic scale. These changes could be viewed as an incentive for low-income individuals to save as much as they can on a completely tax-free basis. It should be noted that funds received from such plans will not be taken into account in determining eligibility for means-tested benefits or credits whether under the Income Tax Act (Canada) (the “Tax Act”) or other federal government programs. Let’s see how well this theme plays on Main Street in Whitby.
The principal tax changes in Budget 2008 are:
- The introduction of the “Tax-Free Savings Account” for Canadian residents 18 years of age and older
- Changes to the “taxable Canadian property” compliance regime
- Enhancements to the scientific research and experimental development program
- Changes to the provincial tax component of the specified investment flow-through tax system
- Extension of the accelerated capital cost allowance for manufacturing and processing and further alignment of the capital cost allowance rates with the useful life of assets
- Future adjustments to the eligible dividend rules
- GST/HST measures
Introduction of the Tax-Free Savings Account
As part of his election mandate, Stephen Harper promised changes to the tax system that would allow Canadians to defer taxation on capital gains provided that the proceeds from the sale of investments were re-invested. Conspicuously absent from the government’s first two budgets, the promised savings vehicle has now been delivered in the form of the proposed “Tax-free Savings Account” (“TFSA”). Depending on one’s point of view, the proposal may be viewed as a cheap substitute for the original promise or a clever and elegant way of delivering the economic benefits of the original promise while avoiding the complexity that a capital gains deferral would have necessarily involved.
Under the proposal, any natural person resident in Canada 18 years of age and older will be entitled to establish a TFSA with the same types of institutions that currently administer RRSPs. Unlike an RRSP, contributions to the TFSA will not be deductible but all income (including capital gains) earned in the TFSA and all withdrawals will be exempt from tax and will not be taken into account in determining means-tested benefits or credits delivered through the income tax system.
Individuals will be entitled to make annual contributions to a TFSA up to certain contribution limits. Generally, each individual 18 years of age or older will acquire $5,000 of contribution room each year (indexed to inflation and rounded to the nearest $500). Unused contributions may be carried forward indefinitely and amounts withdrawn may be re-contributed at any time. Excess contributions are subject to a penalty tax of 1 per cent per month.
Other features of the proposal are as follows:
- a TFSA will generally be allowed to hold the same investments that may be held by RRSPs with certain exceptions for investments in entities with which the account holder does not deal at arm’s length or of which the account holder is a “specified shareholder” as defined in the Tax Act
- not surprisingly, interest on money borrowed to invest in a TFSA will not be deductible
- spousal attribution rules will not apply to amounts earned in a TFSA so an individual will be able to make a contribution to his or her TFSA using funds acquired from his or her spouse or common law partner
- a TFSA will lose its exempt status on the death of the account holder but the account or its assets may be transferred to the account holder’s spouse or common law partner on death without affecting the survivor’s contribution room
- the tax-free status of the account continues if the account holder becomes a non-resident of Canada but no contributions are permitted and no contribution room accrues while an account holder is non-resident
Anytime that the government provides taxpayers with a tax-free vehicle it opens the door for creative and at times abusive tax planning and this proposal will be no different. Planning will focus on accumulating as much capital and income in one’s TFSA as quickly as possible. The restrictions on investments that may be held in a TFSA should prevent many abuses but the question will be whether these restrictions are sufficient.
The proposal takes effect after 2008.
Compliance for Non-Residents Disposing of Taxable Canadian Property
Budget 2008 proposes a number of significant changes to the current compliance regime applicable in respect of non-residents who dispose of certain property (referred to as “taxable Canadian property”) the income or gain from the disposition of which may be taxable in Canada. Most significantly, taxable Canadian property of a nonresident includes unlisted shares of Canadian corporations.
Currently, to ensure that any Canadian tax liability of the non-resident who disposes of such property is collected, section 116 of the Tax Act generally requires the non-resident seller to notify the Canada Revenue Agency (“CRA”) of such disposition and, most importantly, makes the purchaser liable to pay an amount to the CRA on account of the non-resident seller’s possible Canadian tax liability unless the purchaser obtains a clearance certificate from the CRA, the property is “excluded property” (including, generally, listed shares, units of a mutual fund trust, and certain types of indebtedness), or after reasonable inquiry the purchaser had no reason to believe that the seller was a non-resident of Canada. A purchaser that is faced with potential liability under section 116 will normally withhold a portion of the purchase price otherwise payable to the non-resident seller, pending receipt of the appropriate clearance certificate. To obtain a clearance certificate from the CRA, the nonresident seller is generally required to remit the appropriate amount to the CRA, post adequate security for any potential tax liability, or satisfy the CRA that no tax will be owing.
In the case of a non-resident who is resident in a country with which Canada has a tax treaty, most (albeit not all) of Canada’s tax treaties would typically exempt a resident of that country from Canadian taxation on capital gains except for gains on Canadian real and resource properties and shares of companies that derive more than half of their value from such properties. However, any exemption from Canadian taxation afforded by an applicable tax treaty is not currently taken into account under the existing section 116 regime. Therefore, for example, a nonresident who disposes of unlisted shares of a Canadian corporation is likely to face the prospect of a significant portion of the proceeds being withheld (and potentially remitted to the CRA) even if any gain realized on the disposition of those shares is exempt from Canadian taxation under the terms of an applicable tax treaty. The prospect of this withholding is often a significant concern for non-resident investors in Canadian enterprises, and the section 116 compliance regime has been subject to considerable criticism in recent years as the length of the time period for the review of transactions and the issuance of a clearance certificate by the CRA has increased as a result of a severe administrative backlog in the process.
Effective for dispositions that take place in 2009 and subsequent years, Budget 2008 proposes three significant changes in an attempt to “streamline and simplify” the compliance process that arises in this context.
First, the category of “excluded property” will be expanded to exempt from the section 116 compliance process the disposition of a property by a non-resident that is, at the time of its disposition, a “treaty-exempt property” of the non-resident. A property will be considered a “treaty-exempt property” of a non-resident at the time of its disposition if the income or gain from the disposition of that property by the non-resident would be exempt from tax in Canada because of a tax treaty at that time and, in the case of a disposition between related persons, the purchaser sends a notice to the CRA, on or before the day that is 30 days after the acquisition of the property by the purchaser, setting out certain basic information about the non-resident seller and the transaction.
Second, the “reasonable inquiry” defence available under section 116 to purchasers of taxable Canadian property from non-residents will be expanded. As indicated above, currently the defence is only available if the purchaser, after reasonable inquiry, had no reason to believe that the seller was not resident in Canada. Budget 2008 proposes to expand this defence so that the purchaser would also be absolved from liability under section 116 if (i) the purchaser concludes after reasonable inquiry that the non-resident seller is, under a tax treaty that Canada has with a particular country, resident in that country; (ii) the property is a property any income or gain from the disposition of which by the non-resident would be exempt from Canadian tax because of a tax treaty if the nonresident were, because of the tax treaty referred to in (i), resident in the particular country; and (iii) the purchaser sends a notice to the CRA, on or before the date that is 30 days after the acquisition of the property by the purchaser, setting out certain basic information about the non-resident seller and the transaction. It should be noted that the reasonable inquiry defence only extends to a conclusion reached by a purchaser with respect to the status of the non-resident seller as a resident of a country with which Canada has a tax treaty and does not appear to extend to a conclusion reached by a purchaser with respect to whether the terms of such tax treaty would operate to exempt any income or gain realized by a resident of that country from Canadian taxation. Accordingly, it may well be the case in many instances that a purchaser may simply be unwilling to take any risk that arises with respect to the interpretation or application of a particular relieving provision in a tax treaty that is ostensibly applicable and would, as a result, seek to withhold from the purchase price in order to protect itself. Therefore, as a practical matter, the most significant impact of the proposed changes to the section 116 compliance process may only be to related party transfers. Whether this was intended or not is unclear.
Finally, a related change proposed by Budget 2008 is to exempt certain non-residents from filing a Canadian income tax return in respect of a disposition of taxable Canadian property. Currently, a non-resident is required to file a Canadian income tax return for any taxation year in which the non-resident (or a partnership of which the non-resident is a member) disposes of taxable Canadian property. This requirement is typically viewed by nonresident investors as an onerous feature of the Canadian tax compliance landscape, particularly in circumstances where no Canadian income tax would be payable because of, for example, the application of a tax treaty. Budget 2008 proposes to ease this burden by exempting non-residents from filing Canadian income tax returns for any taxation year in which the non-resident satisfies all of the following criteria: (i) no mainstream Canadian tax is payable by the non-resident for the taxation year (including, it would seem, tax on the disposition of the taxable Canadian property); (ii) the non-resident is not currently liable to pay any amount under the Tax Act in respect of any previous taxation year (other than, generally, in respect of certain stipulated amounts for which the CRA has been provided with adequate security); and (iii) each taxable Canadian property disposed of by the non-resident in the year is either “excluded property” (which as described above, will now include “treaty-exempt property”) or a property in respect of the disposition of which the CRA has issued to the non-resident a clearance certificate under section 116 of the Tax Act.
Enhancements to the SR&ED Program
Budget 2008 proposes certain improvements to the scientific research and experimental development (“SR&ED”) tax incentive program for qualifying Canadian-controlled private corporations (“CCPCs”). The Tax Act currently provides qualifying CCPCs with an enhanced SR&ED investment tax credit (“ITC”) of 35 percent on their first $2 million of qualified expenditures (qualifying CCPCs are those with taxable income (on an associated group basis) for the preceding taxation year of not more than the federal small business income threshold (i.e., $400,000 in 2008)).
For qualifying CCPCs with taxable income over the small business income threshold, the $2 million expenditure limit is reduced by $10 for every $1 of taxable income over the threshold. The $2 million expenditure limit is also phased out for qualifying CCPCs having taxable capital (for Large Corporations Tax purposes) of between $10 and $15 million in the prior year. The expenditure limit is reduced by $4 for every $10 by which taxable capital exceeds $10 million. The ability to claim the 35 per cent investment tax credit rate and related 100 per cent refund is, therefore, eliminated once taxable capital exceeds $15 million or once taxable income reaches a maximum of $600,000 for 2007 and subsequent years.
Budget 2008 proposes to enhance the SR&ED tax incentive program by increasing the expenditure limit from $2 million to $3 million. The upper limit for the taxable capital phase-out range will be increased from $15 million to $50 million and the upper limit of the taxable income phase-out range will also be increased from $600,000 to $700,000.
In order for expenditures to be deductible, qualifying SR&ED activities must generally be carried on in Canada. Budget 2008 proposes to further extend the SR&ED ITC by recognizing certain salary or wages incurred by a taxpayer in respect of SR&ED activities carried on outside Canada. The activities must be directly undertaken by the taxpayer and must be done solely in support of SR&ED carried on by the taxpayer in Canada. Permissible salary or wages incurred by a taxpayer in a taxation year will be limited to 10 per cent of the total salary and wages directly attributable to SR&ED carried on in Canada by the taxpayer during the year.
These proposed changes will generally be applicable for taxation years that end on or after February 26, 2008.
SIFTS: Changes to the Provincial Tax Component
Proposals to tax certain publicly traded trusts and partnerships referred to as specified investment flow through entities or SIFTs first announced on Halloween night, 2006 were enacted into law in 2007. These rules, commonly known as the SIFT rules, impose tax on certain income of SIFT trusts and partnerships in a manner similar to the tax imposed on corporations and treat certain distributions from such entities as dividends from a corporation.
In particular, distributions of the non-portfolio earnings of a SIFT trust or partnership are taxed in the SIFT at a rate that contains both a federal and provincial component. The federal component is the prevailing federal tax rate reduced by the prevailing general rate reduction and the 10 per cent provincial abatement. For 2008 this rate is 19.5 per cent. As currently defined, the provincial component is a constant 13 per cent which was the average provincial corporate tax rate at the time that the SIFT rules were introduced. Under the current rules, the provincial component has no relationship to the provinces in which the income of the SIFT is actually earned.
Budget 2008 proposes to amend the provincial tax component so that it is equal to the blended corporate tax rates of the provinces in which the SIFT has permanent establishments. The blended rate will be determined by applying an allocation factor to each of the applicable provincial tax rates prevailing in the relevant year. The allocation factor for each province will be equal to one-half of the aggregate of (i) the proportion that the SIFT’s wages and salaries in the province are of its total salaries and wages in Canada and (ii) the proportion that the SIFT’s gross revenues in the province are of its total gross revenues in Canada. To the extent that distributions are not allocated to any province, a 10 per cent rate will apply and to the extent that distributions are allocated to Quebec, a nil rate will apply to take into account that province’s own SIFT tax.
As an example, suppose that for its 2009 taxation year, a SIFT has permanent establishments in Ontario and Quebec and three-quarters of its salary and wages are paid in Ontario (with the balance paid in Quebec) and onehalf of its gross revenue is earned in Ontario (and the balance in Quebec). The resulting allocation factor for Ontario will be 62.5 per cent and the allocation factor for Quebec will be 37.5 per cent. Accordingly, for 2009, the SIFT’s provincial tax component will be 8.75 per cent (i.e. .625 times 14 per cent plus .325 times nil) rather than 13 per cent as under the current rules.
Extension of Accelerated CCA for M&P Assets
Budget 2008 contains certain measures that revise the existing capital cost allowance (“CCA”) rules contained in the Income Tax Regulations.
The most significant change to the CCA regime proposed by Budget 2008 involves the extension of the accelerated CCA rate applicable to certain manufacturing and processing equipment that was first introduced as part of Budget 2007. In general terms, machinery and equipment used in connection with manufacturing and processing activities is subject to a CCA rate of 30 per cent per year, calculated on a declining balance basis. This rate of CCA is reduced by the “half-year rule” for the taxation year in which the equipment is first available for use.
As noted above, Budget 2007 included a proposal to provide an accelerated CCA regime to certain eligible types of manufacturing and processing equipment (“Eligible Equipment”) acquired on or after March 19, 2007 and before 2009. In general, this proposal would enable taxpayers to claim CCA on Eligible Equipment at an annual rate of 50 per cent, calculated on a straight-line basis (again, subject to the half-year rule).
Budget 2008 now proposes to extend this measure for an additional three years. This extension will include a one year extension of the 50 per cent straight-line CCA rate (i.e. for Eligible Equipment acquired in 2009) and the introduction of a new declining balance CCA regime for Eligible Equipment acquired in 2010 and 2011. Eligible Equipment acquired in 2010 will generally be subject to a 50 per cent declining balance CCA rate for the first taxation year ending after the assets are acquired and a 40 per cent declining balance CCA rate for the next taxation year. Thereafter, the general 30 per cent declining balance CCA rate will apply. Eligible Equipment acquired in 2011 will generally be subject to a 40 per cent declining balance CCA rate for the first taxation year ending after the assets are acquired and the general 30 per cent declining balance CCA rate thereafter. In each such case, the amount of CCA claimed by a taxpayer will continue to be subject to the half-year rule.
Budget 2008 also contains proposals to extend the scope of assets that are eligible for Class 43.2. This special class of CCA is available for certain clean energy generation equipment (such as wind turbines and certain solar equipment). The expanded list of assets eligible for Class 43.2 will generally apply to assets acquired on or after February 26, 2008.
Finally, as part of an on-going review of CCA rates, Budget 2008 contains proposals to revise the CCA rates for certain railway locomotives and carbon dioxide pipelines and related equipment so that they more closely reflect the useful life of the related assets. These measures will generally apply to relevant assets acquired on or after February 26, 2008.
Future Adjustments to the Eligible Dividend Rules
One of the general policy objectives underlying the Tax Act is to tax income earned directly by an individual at the same effective rate as the same income earned by a corporation and then distributed to an individual shareholder as a dividend. The objective, known as integration, is partially achieved through the application of the “gross-up and credit” rules in subsection 82(1) and section 121 of the Tax Act, which have the effect of providing the dividend recipient with a credit for the income taxes paid by the payer corporation.
Prior to 2006, individuals (other than certain trusts) were required to include in their income 125 per cent of the amount of taxable dividends they received during the taxation year from taxable Canadian corporations. Such individuals were then entitled to claim as a dividend tax credit (“DTC”) an amount equal to 2/3 of the amount of the gross-up (i.e. 25 per cent of the taxable dividend received). This gross-up and credit formula provided less than perfect integration for income earned by public corporations and income earned by private corporations not subject to the small business deduction.
Since 2006, in addition to the above rules, an enhanced gross-up and tax credit has been in place for eligible dividends received by individuals from taxable Canadian corporations. While the gross-up and credit mechanics are essentially the same as those described above, in the case of eligible dividends, individuals are required to include in their income an amount equal to 145 per cent of the eligible dividend received while the amount of the related DTC is equal to 11/18 of the amount of the gross-up (i.e. 45 per cent of the eligible dividend received). Taxable dividends that are not eligible dividends continue to be subject to the original gross-up and credit rules described above.
The purpose of the enhanced gross-up and credit system is to better achieve integration in cases where taxable dividends are attributable to income of the payer corporation that was subject to full corporate tax rates. In general terms, such a taxable dividend can be designated by the payer corporation as an eligible dividend.
In order to reflect the planned reductions in the general corporate tax rates over the 2010 through 2012 taxation years, Budget 2008 proposes to adjust both the amount of the gross-up for eligible dividends and the amount of the related DTC. The specific adjustments that are being proposed are set out below:
Certain Other Income Tax Measures
Budget 2008 also proposes the following additional income tax measures:
- relief from the excess corporate holdings rules for certain investments in private corporations that were held by charitable private foundations on March 18, 2007
- expansion of these excess corporate holdings rules to cover certain holdings within trusts
- treating exchangeable shares and partnership units as listed securities for the purpose of donating such shares to charities
- expansion of the contribution periods and duration of registered education savings plans
Budget 2008 signals the government’s commitment to replacing the remaining provincial retail sales taxes with value-added taxes harmonized with the goods and services tax (“GST”) and helping the provinces to facilitate the transition.
Budget 2008 also proposes to improve the application of the GST/harmonized sales tax (“HST”) to a range of health care services, prescription drugs and medical devices to reflect the evolving nature of the health sector.
Other GST/HST measures relate to wind- or solar-powered equipment and rental property rebates.