On March 19, 2019, the Minister of Finance introduced Canada’s 2019 federal budget (2019 Budget). The government had already signalled that the primary focus of the 2019 Budget would not be business concerns as those had been largely addressed in the 2018 Fall Economic Statement. Given that 2019 is an election year, that should not be surprising. Nonetheless, the 2019 Budget does contain some significant tax changes, particularly for those in the investment fund and capital markets sectors. The government also proposed significant changes for the Canadian taxation of employee stock options, the details of which are expected to be released later this year.
Here is an overview of the key provisions in the 2019 Budget, which are discussed in further detail below:
- Allocation to Redeeming Unitholders
- Changes to The Derivative Forward Agreement (Character Conversion) Rules
- Scientific Research and Experimental Development Program
- Tax Incentives for Canadian Journalism Organizations
The 2019 Budget indicates the government’s intention to limit the benefits under the current employee stock option regime. Specific details are not included in the 2019 Budget materials, but are promised “before summer 2019”, with any changes applying on a prospective basis only to options granted on or after the date of announcement of specific legislative proposals. Previously issued stock options will be grandfathered. There may be an opportunity to issue new options before the legislation is released and such options would continue to be subject to existing rules.
For decades, holders of most employee stock options have enjoyed favourable treatment, specifically (i) no taxation at the time of grant, and (ii) taxation at capital gains rates (i.e., half the normal tax rate) on the in-the-money value at the time of exercise.
The 2019 Budget proposes a major change to the latter benefit. Specifically, access to capital gains rate taxation will be limited to grants of options of up to an annual C$200,000 cap per employee, based on the market value of the underlying shares. Presumably to pre-empt the inevitable objections of relatively new businesses that rely on stock options as a key component of executive compensation, the new rules will apply only to “large, long- established, mature” businesses (which the 2019 Budget distinguishes from “start-ups and rapidly growing Canadian businesses”). These terms are not defined in the 2019 Budget materials.
This measure may result in affected employers considering alternatives to stock options, such as stock appreciation rights or other equity linked compensation plans for some employees.
The proposal raises several important questions, including the precise way in which “large, long-established, mature” businesses will be defined, and more fundamentally, how the abandonment of the longstanding capital gains-like treatment is appropriate on policy grounds.
The 2019 Budget curiously refers to aligning Canadian law tax treatment of employee stock options with the U.S. rules. Since many features of Canada’s tax system (including notably tax rates) differ fundamentally with those in the U.S., questions regarding the appropriateness of that reference arise.
While the government has pointed to the distributional impact of the “tax expenditure” associated with the current stock option deduction, it is likely that stakeholders in the tax and business communities may have a different outlook on this issue.
The foreign affiliate dumping (FAD) rules were introduced in 2012 with a stated policy objective of shutting down previously existing tax planning opportunities for certain multinational corporations with Canadian subsidiaries. The government was concerned that such multinationals could cause their Canadian subsidiaries to incur debt to make investments in foreign corporations the dividends from which would be exempt from Canadian tax. The rules also prevented such entities from using surplus funds to invest in foreign corporations. The Department of Finance (Finance) was of the view that such structuring was eroding the Canadian tax base.
The FAD rules currently apply where a corporation resident in Canada (a CRIC) that is controlled by a non-resident corporation makes certain investments in foreign affiliates. Where these rules apply, they result in either a reduction of the paid-up capital of the shares of the CRIC or a dividend being deemed to be paid by the CRIC, which dividend would be subject to withholding tax.
Currently, the FAD rules apply only where the CRIC is controlled by a non-resident corporation. The 2019 Budget proposes to extend the application of these rules to circumstances where the CRIC is controlled by: i) a non-resident individual, ii) a non-resident trust, or iii) a group of persons that “do not deal at arm’s length” with one another where the group includes any combination of non-resident corporations, non-resident individuals and non-resident trusts. Because the concept of “not dealing at arm’s length” in Canadian tax law includes not only related persons but also persons who are considered “factually” non-arm’s length, the latter branch of the rule could, in some situations, result in considerable uncertainty as to the scope of the rule.
These proposals may have a significant impact where one or more investment groups or private equity investors acquire significant interests in Canadian target corporations that have foreign subsidiaries. The determination of whether different parties deal with each other at arm’s length on a factual basis is highly dependent on the particular circumstances. This determination can be fraught with uncertainty particularly when one is trying to ascertain whether different parties are acting with separate interests or a common mind.
The stated reason for these proposals is to “better achieve the policy objectives of the foreign affiliate dumping rules”. It is unclear that the expansion of the FAD rules beyond control by foreign corporations aligns with the original stated policy objective noted above. Before enacting this proposal, it is suggested that Finance should carefully consider whether this particular formulation strikes the right balance between policy objectives and the general objective of certainty, predictability and fairness, having regard to the uncertainty noted above.
These changes to the FAD rules are effective for transactions or events that occur on or after March 19, 2019 (Budget Day).
Generally, when a person borrows a share, he or she is obligated to make payments to the lender as compensation for any dividends paid on the share until such time as the borrower returns the share or an identical share. The Act contains rules that characterize such dividend compensation payments for withholding tax purposes. Where the transaction qualifies as a “securities lending arrangement” as defined in the Act, and the borrowed security is a share, payments made as compensation for dividends on the borrowed share are deemed either to be interest or dividends depending on how the transaction is collateralized. Where the Canadian resident securities borrower has provided cash or qualifying government debt in an amount equal to at least 95 per cent of the value of the borrowed shares, such dividend compensation payments are deemed to be dividends for withholding tax purposes. Otherwise, such payments are deemed to be interest for withholding tax purposes.
Since interest other than “participating debt interest” paid by a Canadian resident to an arm’s length non-resident is generally exempt from withholding tax under the Income Tax Act (Canada) (the Act), the existing rules create an incentive for parties entering into cross-border securities loans not to meet the collateralization requirements described above. Thus, subject to avoidance considerations, a non-resident could lend its dividend paying Canadian shares to a Canadian resident securities borrower under a securities lending arrangement that did not meet the collateralization requirements described above and could receive dividend compensation payments that were not subject to withholding tax. If the non-resident had not loaned the shares, the dividends that such non-resident would have received would have been subject to withholding tax.
The 2019 Budget proposes to eliminate the ability to avoid withholding tax in the manner described above where the borrowed shares are those of a Canadian issuer. Dividend compensation payments made to a non-resident securities lender under a securities lending arrangement will be deemed to be Canadian source dividends for withholding tax purposes regardless of how the transaction is collateralized. Related rules will ensure that such treatment will apply for treaty purposes.
The 2019 Budget also introduces rules that are intended to ensure that withholding tax on dividend compensation payments on Canadian shares made to a non-resident securities lender cannot be avoided by “tainting” the stock loan so that it does not qualify as a “securities lending arrangement” as defined in the Act. This is done by extending the concept of a “specified securities lending arrangement” to the withholding tax rules governing securities lending arrangements. This term had been introduced in Canada’s 2018 federal budget and is now applicable in the context of withholding tax. This is intended to ensure that the rules governing the withholding tax treatment of payments under a securities lending arrangement cannot be avoided by not meeting all of the technical requirements set out in the definition of a “securities lending arrangement”.
These changes will apply to compensation payments that are made on or after Budget Day. Where, however, a securities loan was in place before Budget Day, only compensation payments made after September 2019 will be subject to these new rules.
Finally, the 2019 Budget includes a proposal intended to end a longstanding trap in the rules governing the withholding tax treatment of payments under securities lending arrangements. Under the existing rules, where the borrowed share is a foreign share rather than a Canadian share and the transaction is collateralized as described above, dividend compensation payments are deemed to be Canadian source dividends subject to withholding tax. The 2019 Budget includes changes that are generally intended to address this issue such that dividend compensation payments relating to shares of a non-resident corporation would generally not be deemed to be Canadian source dividends subject to withholding tax where the transaction is “fully collateralized”. This change will apply to dividend compensation payments made on or after Budget Day.
Order of Application of the Transfer Pricing Rules
Canada, like most jurisdictions, has transfer pricing rules based on the internationally accepted “arm’s length principle”. These rules can permit the Canada Revenue Agency (CRA) to adjust the quantum or nature of amounts relevant to computing tax liability where the terms or conditions of related-party transactions do not reflect what “arm’s length” parties would have agreed to in similar circumstances. In many cases, other provisions of the Act are also applicable to the same facts or transactions. The 2019 Budget asserts that where both the transfer pricing rules and another provision of the Act may apply, uncertainty has arisen as to the priority of application.
The 2019 Budget proposes to amend the Act to stipulate that transfer pricing adjustments (if applicable) shall be made before any other provision of the Act is applied. The likely outcome of this change is larger and more frequent transfer pricing adjustments, resulting in the CRA levying larger transfer pricing penalties. The 2019 Budget hints at this motivation but does not elaborate on the policy justification for this proposed change. There is also the possibility of more frequent assessment of withholding tax under the “secondary adjustment” rules that can apply to deem a dividend to have been paid when transfer pricing income adjustments are made.
The 2019 Budget provides that current exceptions to the transfer pricing rules that pertain to situations in which a Canadian resident corporation has an amount owing from, or extend a guarantee in respect of an amount owing by, a controlled foreign affiliate will continue to apply. However, the Notice of Ways and Means Motion accompanying the 2019 Budget proposes to repeal a provision that makes certain other rules in the Act inapplicable where the transfer pricing rules apply. The relevant rules generally limit deductions to reasonable amounts, deem certain related party transactions to occur at fair market value, and permit the CRA to reallocate amounts as between the cost of property, service fees and payments for restrictive covenants in certain circumstances. Presumably Finance believes this provision is no longer necessary given the new ordering rule. However, it is concerning if the effect of this repeal would be to permit the application of these rules where a transfer pricing adjustment has already been made. That outcome would be hard to justify from a policy perspective.
Applicable Reassessment Period
The 2019 Budget proposes to specifically incorporate the broad definition of “transaction” used in the transfer pricing rules for the purposes of the rule in subparagraph 152(4)(b)(iii) of the Act which extends the usual reassessment period for transactions involving a taxpayer and a non-resident with whom the taxpayer does not deal at arm’s length. This proposal is clearly intended to allow the CRA more opportunity to extend the limitation period for making audit adjustments, but it is unclear what difficulties the CRA was having absent this change. It is important to note that the extended limitation period in subparagraph 152(4)(b)(iii) is not limited to transfer pricing. Any adjustment is permitted that arises as a consequence of “transactions” involving a non-arm’s length non-resident. The proposed change will therefore have application well beyond the transfer pricing context.
This measure will apply to taxation years for which the normal reassessment period ends on or after Budget Day.
INVESTMENT FUND RELATED TAX MEASURES
Allocation to Redeeming Unitholders
Mutual fund trusts are subject to income tax on income (including taxable capital gains) at the highest rate applicable to individuals. However, mutual fund trusts are generally permitted to deduct the amount of income and taxable capital gains that have been distributed to their unitholders and included in the income of the unitholders. Typically, mutual fund trusts distribute all of their income and capital gains each year so that they are not subject to income tax.
When a holder of a unit of a mutual fund trust redeems that unit, the mutual fund trust may often be required to dispose of property in order to fund the resulting redemption price. If the mutual fund trust realizes a capital gain on that disposition, there is a potential for double tax. This is because the redeeming unitholder could realize a capital gain on the disposition of the redeemed unit and the mutual fund trust would realize a capital gain on the disposition of property required to fund the redemption, which gain would be distributed to the remaining unitholders, who would pay tax on the taxable portion of that capital gain.
To alleviate this potential for double tax, mutual fund trusts are entitled to utilize the so-called capital gains refund mechanism that provides a refund in respect of tax on net realized capital gains based on a formula that depends, in part, on the amount of redemptions of the fund’s units. In practice, this formula often does not work appropriately. Accordingly, rather than rely on the capital gains refund mechanism, many mutual fund trusts allocate capital gains to redeeming unitholders. Capital gains so allocated by the mutual fund trust to a redeeming unitholder reduce the proceeds of disposition of the redeemed units to the unitholder such that a redeeming unitholder typically pays the same amount of tax regardless of whether the mutual fund trust allocates capital gains to him/her on the redemption.
The 2019 Budget materials state that Finance is concerned that where the amount of a capital gain allocated to a redeeming unitholder exceeds the amount of the capital gain that would otherwise have been realized by the unitholder on a redemption of his/her units, the excess portion results in an inappropriate deferral of capital gains for remaining unitholders rather than a reduction of double tax. Finance’s concern appears to be that the tax indifference of the redeeming unitholder has been taken advantage of to push out a larger capital gain than reasonably relates to the redeeming unitholder’s investment. If the capital gain results from the disposition of property by the mutual fund trust in order to fund the redemption, it is unclear how the deferral would be necessarily inappropriate, since in the absence of the redemption, the mutual fund trust would not have disposed of the property and would not have realized a capital gain. An argument could also be made that it is fair for the redeeming unitholder to be allocated his/her portion of any capital gains previously realized by the mutual fund trust in the year of redemption, so that such portion is not inappropriately borne by the remaining unitholders.
The 2019 Budget proposes to address this perceived issue by introducing a rule that will limit the amount that is deductible by a mutual fund trust in respect of an allocation of a capital gain to a redeeming unitholder to the extent that the allocated capital gain would have exceeded the capital gain that the unitholder would have realized on the disposition of his or her units. In order to make this determination, the mutual fund trust will be required to know the cost amount of the unitholder’s units, which may not be possible, particularly where the units of the mutual fund trust are traded on an exchange. Mutual fund trusts that are not permitted to allocate the desired amount of a capital gain to a redeeming unitholder will be forced to rely on the capital gains refund mechanism or to distribute the remaining capital gain to the other unitholders.
Some mutual fund trusts also allocate income (other than taxable capital gains) to redeeming unitholders. This permits mutual fund trusts to ensure that unitholders do not avoid taxation on their portion of the income of the mutual fund trust by redeeming their units. The 2019 Budget materials state that Finance is concerned that some mutual fund trusts have been using the allocation of income to redeeming unitholders to convert returns that would otherwise be on income account to capital gains. Finance asserts that this planning is possible where a redeeming unitholder holds units of the mutual fund trust on income account, but other unitholders hold their units on capital account.
The 2019 Budget proposes to effectively deny the ability of mutual fund trusts to allocate income to redeeming unitholders. This may lead to difficulties in certain circumstances where, for example, a large unitholder redeems its units requiring the fund to dispose of investments which would result in a significant amount of income being realized that would need to be distributed to the remaining unitholders. Some mutual fund trusts may be required to make a special distribution (in cash or in units that are automatically consolidated) to all unitholders in order to ensure that the trust is not subject to tax on the income that was realized in order to fund the redemption.
These measures will apply to the taxation years of mutual fund trusts that begin on or after Budget Day. This will allow for funds to have the rest of the year to prepare for these changes provided that they do not have an early taxation year-end as a result of a fund merger or loss restriction event. It is expected that these measures will affect a significant number of mutual fund trusts.
Changes to the Derivative Forward Agreement (Character Conversion) Rules
The 2019 Budget includes a change to the definition of a derivative forward agreement (DFA) that would eliminate a perceived loophole in the definition that Finance asserts could be used by taxpayers to convert certain income into capital gains.
The DFA rules are intended to curb character conversion transactions that enable amounts that would otherwise be fully included in income to be taxed as capital gains. Such results have typically been achieved using forward sales or purchases, as well as by using other derivative contracts, often by mutual funds that have made the “Canadian securities” election.
The 2019 Budget materials state that the perceived abuse relates to an exception from the DFA rules applicable in circumstances where the economic return from a purchase or sale transaction depends on the actual performance of the property being purchased or sold. Finance asserts that this exception was intended to ensure that commercial transactions, such as merger and acquisition transactions, are not caught by the DFA rules. The 2019 Budget materials include the following example of a transaction that Finance believes was developed to inappropriately rely on this exception:
- A mutual fund trust (Investor Fund) enters into a forward purchase agreement to acquire units of a second mutual fund trust (Reference Fund) from a counterparty for a purchase price equal to the value of such Reference Fund units at the time the agreement is entered into
- The Reference Fund holds an investment portfolio that yields a significant amount of ordinary income
- When the forward purchase agreement is settled, the Investor Fund acquires the Reference Fund units from the counterparty for the purchase price under the forward purchase agreement
- The Investor Fund sells or redeems the Reference Fund units, realizing a capital gain by virtue of making the election to have gains and losses on Canadian securities, including Reference Fund units, treated as capital gains and losses.
The 2019 Budget proposes adding a new requirement to the availability of the exception from the DFA rules described above. This exception will not be available if it can reasonably be considered that one of the main purposes of the series of transactions that involves an agreement to purchase the relevant security is to achieve character conversion of an amount that would otherwise be income into a capital gain and the counterparty to the transaction is either a financial institution or a “tax-indifferent investor” (generally, a tax-exempt or a non-resident).
This proposal will apply to dispositions made on or after Budget Day. However, limited grandfathering is available for dispositions made in 2019 pursuant to agreements entered into prior to Budget Day or agreements entered into after Budget Day but that are substantially similar to a prior agreement, provided in each case the notional amount of the property underlying the agreement does not exceed specified growth limits.
OTHER SELECTED PROPOSALS
Scientific Research and Experimental Development Program
The Scientific Research and Experimental Development (SR&ED) program permits a full deduction of qualifying expenditures in the year incurred and an investment tax credit in respect of such expenditures. Canadian controlled private corporations (CCPCs) are eligible to receive a fully refundable tax credit at a rate of 35 per cent on up to C$3-million of qualifying SR&ED expenditures annually. This expenditure limit is reduced where taxable income for the previous year is between C$500,000 and C$800,000. The expenditure limit is also reduced where taxable capital employed in Canada is between C$10-million and C$50-million.
Under the current calculation, SR&ED credits can be disproportionately reduced by a relatively small increase in the amount of income for CCPCs with income between C$500,000 and C$800,000. In response to this concern, the 2019 Budget proposes to repeal the use of taxable income as a factor in determining a CCPC’s annual expenditure limit for purposes of the SR&ED credit. As a result, provided that a CCPC has less than C$10-million of taxable capital employed in Canada, the CCPC will have access to maximum refundable SR&ED credit regardless of income. This should provide welcome predictability to the phase-out of the SR&ED credit, particularly to small and medium CCPCs.
This measure will apply to taxation years that end on or after Budget Day.
Tax Incentives for Canadian Journalism Organizations
The 2018 Fall Economic Statement announced that the 2019 Budget would provide further detail on certain tax measures intended to support Canadian journalism. As expected, the 2019 Budget proposes to:
- Add “registered journalism organizations” as a new category of tax-exempt qualified donee
- Provide a 25 per cent refundable labour tax credit to qualifying journalism organizations on salary or wages paid to eligible newsroom employees (subject to a cap of C$55,000 per eligible employee per year and reduction for any other government assistance received in respect of such salary and wages)
- Provide a temporary, non-refundable 15 per cent tax credit to individuals for subscriptions to eligible Canadian digital news subscriptions (subject to a cap of C$500 in costs paid for such subscriptions per year).
The new category of qualified donee will generally be available to non-profit journalism organizations that meet certain eligibility requirements and have applied for registration with the CRA as a “registered journalism organization”. As qualified donees, eligible non-profit journalism organizations would be able to issue official donation receipts and be eligible to receive funding from registered charities; however, unlike registered charities, journalism organizations will be required to provide the name of each person that donates more than C$5,000 in a year to the organization.
In addition to other specific requirements, qualified Canadian journalism organization (QCJO) status is a necessary requirement for each of the preceding three measures. The 2019 Budget materials include certain criteria that organizations will be required to meet to qualify as a QCJO and note that an independent panel will be appointed to further develop the criteria. Among other requirements, in order to qualify as a QCJO, the 2019 Budget proposes that an organization will need to operate in Canada (and be incorporated in and resident in Canada if a corporation) and its controlling members or board of directors will need to meet certain Canadian citizenship requirements.
The measure adding registered journalism organizations as a new category of qualified donees will apply as of January 1, 2020.
The refundable labour tax credit will apply to salary or wages earned in respect of a period on or after January 1, 2019.
The personal income tax credit for digital subscriptions will be available in respect of eligible amounts paid after 2019 and before 2025.
SALES AND EXCISE TAX MEASURES
The 2019 Budget extends GST/HST relief to certain biologicals, medical devices and health care services. Of particular note, the 2019 Budget relieves GST/HST on supplies and imports of human ova and imports of human in vitro embryos (human sperm has been zero-rated since 1993).
Cannabis Excise Duties
The 2019 Budget amends the excise duty framework for cannabis products by imposing a flat excise duty on cannabis extracts (including cannabis oils), edible cannabis and cannabis topicals, based on total tetrahydrocannabinol (THC) content. Previously, cannabis oils could be taxed based on the quantity of cannabis materials used to produce the oils which led to compliance difficulties for licensed producers, and this change is intended to alleviate those difficulties. The combined federal-provincial-territorial excise duty rate is C$0.01 per milligram of THC contained in a final product. Similar to the existing regime for dried cannabis, the THC-based duty will be imposed on cannabis licensees at the time of packaging and becomes payable when it is delivered to a non-cannabis licensee (e.g., a provincial wholesaler, retailer or individual consumer). The proposed changes will come into effect on May 1, 2019, subject to transitional rules.