Although every penny counts on Canada's return to balanced
budgets, when introducing Budget 2012, Finance Minister Jim
Flaherty announced the elimination of the penny – Canada
will stop making them. The Budget does not increase tax rates, but it does propose a
number of technical tax changes that will result in $3.5 billion in
additional tax revenue over five years. In this newsletter we
have summarized some of the key changes to the Canadian tax rules
proposed in Budget 2012. Partnerships are an important form of business organization that
have tax advantages as flow-through entities. For example,
partnerships can be useful in synthesizing tax consolidation.
However, their flow-through nature can also be used in more
aggressive tax planning, which seems to have perpetually troubled
Canada's tax policy makers. Last year, Budget 2011 proposed significant changes to the
taxation of partnerships and their partners by ending the ability
of corporations to defer income recognition through the use of
partnerships, particularly multi-tiered partnerships.
Clearly, the Department of Finance still has concerns with certain
tax planning techniques involving partnerships since Budget 2012
proposes further changes to the partnership rules. Some corporate acquisitions use partnerships to facilitate an
increase ("bump") in the tax basis of the target
corporation's assets. Budget 2012 proposes to reduce the
bump available in certain situations involving
partnerships. Existing tax rules permit a bump in the adjusted cost base (ACB)
of certain non-depreciable assets of a target corporation where
control of the target is acquired followed by a merger of the
target and the acquirer. These rules are useful where the
purchase price for shares of the target is higher than the
target's aggregate tax basis in its assets. Although the
bump is limited to certain non-depreciable assets of the target, it
is not unusual for a target, at the request of the acquirer, to
transfer depreciable assets to a partnership in advance of the
acquisition so that, at the time of the acquisition, the target
holds non-depreciable partnership interests. The
"bump" rule is often used by tax-exempt purchasers and
non-resident purchasers to extract businesses from a target on a
tax free basis. To prevent this kind of tax planning, Budget 2012 proposes that
the bump on a partnership interest held by the target will be
reduced if the bump is reasonably attributable to the underlying
fair market value of the partnership's depreciable property,
Canadian or foreign resource property, or any other property that
is neither a capital property nor a resource property. For
depreciable and other non-qualifying property, the bump reduction
will depend on whether the fair market value of such properties
exceeds their tax basis. This change will be applicable to
corporate amalgamations that occur, and windings-up that begin, on
or after March 29, 2012, subject to limited grandfathering. Partnerships have also been used to avoid recapture and other
adverse tax consequences on a sale of assets to
non-residents. Budget 2012 proposes to eliminate the use of
partnerships for this purpose by extending the rules in section 100
of the Income Tax Act. Section 100 currently applies where an interest in a partnership
that owns depreciable property and other assets is sold to a
tax-exempt purchaser. In general terms, that section will
cause the capital gain realized by a taxpayer on the sale to be
increased to the extent the gain is reasonably attributable to
depreciable property and certain other assets. Budget 2012 proposes to extend this rule to the sale of a
partnership interest to a non-resident purchaser. An
exception to the new rule will apply if all of the property of the
partnership is used in a business carried on through a permanent
establishment in Canada. In that case the business will
generally continue to be taxable in Canada. The Canadian "thin capitalization rules" limit the
deductibility of interest by a Canadian-resident corporation.
Presently these rules apply where the amount of debt owing to
certain non-residents exceeds a 2-to-1 debt-to-equity ratio.
In 2008, the Advisory Panel on Canada's System of International
Taxation recommended changes to the thin capitalization
rules. Consistent with those recommendations, Budget 2012
proposes to amend the thin capitalization rules by: These changes will prevent foreign corporations from stripping
excess income from their Canadian subsidiaries in the form of
non-deductible interest, to which low or no Canadian withholding
taxes apply. The disallowed interest expense will not merely
attract withholding tax when it is actually paid. Instead,
the accrued, unpaid, disallowed interest will be deemed to have
been paid by the corporation as a dividend at the end of the
taxation year. This forces payment of withholding tax on the
disallowed interest even if the interest is not paid. This
proposal will apply effective March 29, 2012, subject to pro-rating
for taxation years that include that day. In contrast to these tightening rules, Budget 2012 also proposes
relief from certain adverse tax consequences arising from the
application of the thin capitalization rules to internal financing
arrangements. In certain cases, interest earned by the
foreign affiliate of a Canadian corporation may be included in the
income of the Canadian corporation under the foreign accrual
property income (FAPI) rules, even if the deduction for interest
payable by the Canadian corporation is denied under the thin
capitalization rules. In such a case, the deduction will not
be denied to the extent the interest is included in computing the
income of the corporation under the FAPI rules. Existing internal financing arrangements should be reviewed to
mitigate the impact of these proposals. A number of factors
should be taken into account in considering any changes, including
foreign exchange considerations. In some cases, reducing the
debt-to-equity ratio could affect the interest rate that can
reasonably be charged on internal debt. This is because the
interest rates on such loans must be comparable with arm's
length loans and appropriate interest rates may depend on the debt
to equity ratio of the debtor corporation. Foreign Affiliate Dumping Concern has been expressed for a number of years, including by
The Advisory Panel on Canada's System of International
Taxation, about Canadian subsidiaries using borrowed funds to
acquire shares from their foreign parents. The concern has
revolved around the fact that interest paid by the Canadian
subsidiary on such borrowed money is generally deductible in
computing income for tax purposes while, at the same time, certain
dividends received by the Canadian subsidiary on the shares of a
foreign affiliate are exempt from taxation in Canada. The
Department of Finance has expressed its concerns with variations of
these transactions, including, for example: Budget 2012 proposes changes that will deem a dividend to be
paid by a Canadian subsidiary to its foreign parent to the extent
the Canadian subsidiary pays cash or gives any other non-share
consideration for the acquisition of the shares of a foreign
affiliate. The deemed dividend will be subject to Canadian
withholding tax. The Budget further proposes to disregard the
paid-up capital of any shares of the Canadian subsidiary that are
given as consideration. These changes are expected to
generate significant tax revenue. Since these new rules could hinder business transactions, Budget
2012 proposes an exception for transactions that meet a
"business purpose" test. The details of this test
are to be the subject of public consultations, and stakeholders are
invited to provide comments before June 1, 2012. The Budget
proposes that the primary factors to be considered in applying the
business purpose test will be non-tax factors that will be set out
in the legislation. Budget 2012 states that the factors will be
intended to assist in determining whether it is reasonable to
conclude that the foreign affiliate "belongs" to the
Canadian subsidiary more than to any other entity of the foreign
parent's group and lists a number of such
factors. This measure will apply to transactions that occur on or after
March 29, 2012, subject to limited grandfathering. Base Erosion Rules – Canadian
Banks Budget 2012 proposes amendments to alleviate the tax cost to
Canadian banks of using excess liquidity of their foreign
affiliates in their Canadian operations. These amendments
affect the so-called "base erosion" rules in the foreign
accrual property income regime applicable to "upstream
loans". The amendments will be developed to ensure that
certain securities transactions undertaken in the course of a
bank's business of facilitating trades for arm's length
customers are not inappropriately caught by the base erosion rules.
These amendments are to be developed in conjunction with the
financial industry. Canadian transfer pricing rules effectively require cross-border
transactions between non-arm's length entities to be priced at
arm's length prices and conducted on arm's length
terms. Where the actual terms of the transactions do not
reflect arm's length terms and conditions, the tax consequences
will be adjusted based on the prices and terms that would have
prevailed between arm's length parties. This adjustment
to the transfer price between non-arm's length parties is the
primary adjustment. In some situations, secondary adjustments
may be appropriate, but the existing transfer pricing rules do not
expressly contemplate secondary adjustments. Budget 2012 proposes an amendment to confirm that amounts in
respect of secondary adjustments that arise from transfer pricing
primary adjustments will be deemed to be dividends subject to
Canadian withholding tax. This measure will increase the
overall tax liability in connection with a transfer pricing
adjustment. Primary adjustments typically occur when the Canadian
corporation either overstates expenses or understates income on
transactions with a non-arm's length, non-resident entity in a
lower tax jurisdiction, for example, by overpaying for goods or
services received or undercharging for goods and services
supplied. The primary adjustment is to use arm's length
prices which will often result in an increase in the taxable income
of the Canadian corporation. Despite a primary adjustment to the Canadian resident, the
non-arm's length non-resident entity may derive a benefit from
the transaction since it will either be paying less for the goods
or services it receives from the Canadian corporation or receiving
relatively greater consideration for the goods or services it
provides to the Canadian corporation. In the past, CRA has relied on other provisions in the
Income Tax Act to levy a secondary adjustment on the
corresponding benefit to the non-arm's length non-resident
entity. However, there is no explicit provision in the
existing transfer pricing rules to allow deemed dividend
treatment. Under the proposed amendment, a Canadian corporation subject to
a primary adjustment will be deemed to have paid a dividend to each
non-arm's length non-resident participant in the offending
transaction in proportion to the amount of the primary adjustment
that relates to the non-resident. This deemed dividend will
be subject to Canadian withholding tax. The Canadian
corporation will have the responsibility to collect and remit this
withholding tax. Budget 2012 contains important changes to Canada's
scientific research and experimental development
("SR&ED") rules, and introduces new measures to
support innovation and research and development. These
changes are modeled on the recommendations of an expert panel
tasked with reviewing federal support for research and
development. The panel submitted a report in October 2011
called Innovation Canada: A Call to Action (the "Jenkins
Report"). While Budget 2012 proposes reductions to the SR&ED tax
credit and new restrictions on deductions, relative to the changes
recommended in the Jenkins Report, the proposed changes to the
SR&ED rules in the Budget are incremental, rather than
revolutionary. In contrast, the Jenkins Report called for
significantly larger reductions and more fundamental changes to the
SR&ED rules. Under the current SR&ED rules, there are two investment tax
credit rates for qualified expenditures. The general rate is
20% and there is an enhanced rate of 35% for eligible
Canadian-controlled private corporations (CCPCs). CCPCs may
claim the enhanced 35% investment tax credit on up to $3 million of
qualified SR&ED expenditures annually. The general 20% investment tax credit rate applicable to
SR&ED qualified expenditures at the end of a taxation year will
be reduced to 15%, for taxation years that end after 2013.
The enhanced 35% rate for eligible CCPCs will remain unchanged on
up to $3 million of qualified SR&ED expenditures annually. Itemized overhead expenditures directly attributable to the
conduct of SR&ED are currently eligible for the SR&ED tax
incentives. Instead of itemizing such overhead expenditures,
taxpayers have the option of using a simplified proxy method for
calculating these expenditures. Under this proxy method, a taxpayer
can generally include 65% of the total eligible portion of salaries
and wages of the taxpayer's employees directly engaged in the
conduct of SR&ED in Canada in the taxpayer's SR&ED
qualified expenditure pool for a taxation year. The Budget proposes to reduce the prescribed rate that applies
to the simplified proxy SR&ED overhead expenditures from 65% to
60% for 2013 and to 55% after 2013. Under the Budget changes, capital expenditures in respect of
SR&ED will no longer be eligible for SR&ED deductions and
investment tax credits. Therefore, it is likely that
considerably more capital expenditures will be capitalized and
amortized over the life of the property. This measure will apply to property acquired on or after January
1, 2014, and to amounts paid or payable in respect of the use of,
or the right to use, property during any period that is after
2013. Where a taxpayer contracts to have SR&ED performed by a
non-arm's length contractor, the total qualified expenditures
on which either the contractor or the taxpayer can claim SR&ED
investment tax credits are currently restricted to the amount of
the qualified SR&ED expenditures incurred by the contractor in
fulfillment of the contract. In the case of arm's length SR&ED contract payments,
however, the taxpayer is currently entitled to SR&ED investment
tax credits in respect of the entire amount of the contract
payment, while the amount of the contract payment is netted against
the qualifying SR&ED expenditures of the contractor. The expenditure base for investment tax credits will exclude the
profit element of arm's length SR&ED contracts. This will
be achieved by limiting the expenditure base, such that only 80% of
the contract costs will be eligible for SR&ED investment tax
credits. This measure will apply to expenditures incurred on or
after January 1, 2013. In addition, the amount of an arm's length contract payment
eligible for SR&ED tax credits for the taxpayer will also
exclude any amount paid in respect of a capital expenditure
incurred by the contractor in fulfilling the contract.
SR&ED contractors will be required to inform the taxpayers of
these amounts. The exclusion with respect to capital expenditures
will reduce the amount of the contract payment before the 80%
eligibility ratio is applied. Consistent with recommendations in the Jenkins Report, Budget
2012 proposes expenditures of approximately $1.1 billion over 5
years for direct research and development support, and $500 million
for initiatives related to developing venture capital activities in
Canada. These expenditures are largely funded by the proposed
reductions in SR&ED tax credits, which are expected to save the
government approximately $1.3 billion. The Government of Canada will provide $400 million to support
the creation of venture capital funds and to spur private sector
investments in early-stage risk capital. A further $100
million will be given to the Business Development Bank of Canada to
support its venture capital activities. Budget 2012 sets aside an additional $110 million per year
starting in 2012–13 for the National Research
Council's Industrial Research Assistance Program which supports
research and development activities by small and medium-sized
businesses. The National Research Council will also help small and
medium-sized businesses make effective use of federal innovation
programs by creating a concierge service to provide information and
assistance. Mineral Exploration Tax Credit for Flow-Through Share
Investors To support Canada's resource sector, Budget 2012 extends the
eligibility for the mineral exploration tax credit for one more
year, to flow-through share agreements entered into on or before
March 31, 2013. Further, under the existing
"look-back" rule, funds raised in one calendar year under
a flow-through offering can be spent on eligible exploration up to
the end of the following calendar year. Therefore, funds raised
under flow-through share agreements entered into during the first
three months of 2013 can support eligible exploration until the end
of 2014. Eligible Dividends Individual taxpayers in receipt of an eligible dividend are
entitled to an enhanced dividend tax credit which reduces the
effective rate of tax on such dividends. However, the rules
for designating eligible dividends are very strict. Budget
2012 proposes to alleviate some of the strictness in the
application of these rules. Under current rules, a corporation paying an eligible dividend
must notify each shareholder in writing, at the time the eligible
dividend is paid, that the dividend is designated as an eligible
dividend. It is not possible, under the current rules, for a
corporation to file a late eligible dividend designation. As
well, the designation can only apply to the full amount of the
dividend. If only part of a dividend would qualify, the
corporation is required to declare multiple dividends in order to
designate the appropriate portion. Budget 2012 proposes that the Minister of National Revenue will
have a discretion to accept a late designation of an eligible
dividend if the late filed designation is filed within three years
following the date the designation should have been made. The
Minister must be of the opinion that accepting the late filed
designation is just and equitable in the circumstances, including
to affected shareholders. The Budget also proposes that a designation may be made in
respect of a portion of a dividend, instead of the whole dividend,
as currently required. The new rules will improve tax fairness in situations where a
corporation could have designated a dividend as an eligible
dividend, but did not. The changes will also simplify the mechanics
of declaring, paying and designating eligible dividends. The most significant Canadian income tax incentive for promoting
the use and expansion of clean energy generation equipment is the
financial benefit of accelerated capital cost allowance.
Qualifying equipment may be depreciated for income tax purposes at
a 50 per cent per year on a declining balance basis. Budget
2012 continues the trend of past Budgets by expanding the scope of
qualifying equipment to now include: In addition, it is proposed that plant residue (for example,
straw, corn cobs, leaves and similar organic waste produced by the
agricultural sector) will be added to the list of eligible waste
fuels that can be used in waste-fuelled thermal energy equipment or
a cogeneration system. To deal with the increased risk of pollutants associated with
waste fuels, Budget 2012 proposes that equipment using eligible
waste fuels must comply with federal, provincial or local
environmental laws and regulations at the time it first becomes
available for use. These measures will apply to property acquired on or after March
29, 2012 that have not been used, or acquired for use, before that
date. Retirement Compensation Arrangements For a number of years, the Government has been concerned that a
number of arrangements have been developed to take advantage of the
retirement compensation arrangement (RCA) rules, giving rise to
unintended income tax benefits. An RCA is an employer-sponsored funded retirement savings plan
that is typically used to fund retirement benefits for
higher-income employees in excess of the maximum pension benefits
permitted by registered pension plans contribution limits. Under
current rules, employer contributions to an RCA are deductible to
the employer, but subject to tax in the RCA trust, at the rate of
50%. This 50% tax is refunded on a proportionate basis when the
employee draws down funds from the plan in retirement. Income and
capital gains in the RCA trust are similarly subject to a 50%
refundable tax. There is a special rule that permits a refund of
the 50% tax even where the RCA investments have lost some or all of
their value. Some arrangements exploit the fact that the 50% tax is
refundable even where the investments have lost all of their
value. Other arrangements use insurance products that to give
rise to deductible expenses inside the RCA and benefits outside the
RCA. Non-arm's length investments by the RCA are a common
characteristic of most of these arrangements. Budget 2012 proposes to address the perceived abuses by
subjecting RCAs to new prohibited investment and advantage rules
similar to the rules that already exist for tax-free savings
accounts, registered retirement savings plans and registered
retirement income funds. These rules will generally limit the
ability of RCAs to engage in non-arm's length transactions by
imposing a 50% tax on the RCA on the value of its prohibited
investments. An employee entitled to benefits under the RCA
who also has a significant interest in the employer will be jointly
and severally liable for this tax. Budget 2012 proposes a new restriction on tax refunds where the
RCA investments have lost value. "RCA strips" are also addressed by the Budget.
These are defined to include a promissory note issued by a
non-arm's length debtor to an RCA in circumstances where the
debtor fails to make commercially reasonable payments of
principal or interest. Transitional rules will address advantage
arrangements already in place. The Government has been concerned that employee profit sharing
plans (EPSPs) have been used by business owners to direct profits
to the members of their families in order to reduce or defer the
payment of income tax on profits. EPSPs are trusts that facilitate the sharing of profits with
employees. An employer's contribution to an EPSP is deductible
in the year it is made. An EPSP is required to make
allocations of all employer contributions, as well as income
and capital gains from trust property, to beneficiaries each
year and the beneficiaries are required to include such
allocation in income. Budget 2012 proposes special tax payable by "specified
employees" on "excess EPSP amounts. Employees who
have a significant equity interest in the employer or who do not
deal at arm's length with the employer will be affected to the
extent contributions exceed 20% of the employee's salary for
the year. Certain taxpayers are allowed to simplify their GST/HST
accounting by not having to track GST/HST paid on inputs, using the
Quick Method or Special Quick Method. Instead, these
taxpayers are entitled to keep a percentage of the GST/HST
collected on taxable sales. The Budget proposes to double the
thresholds for small businesses that can use the Quick Method
of accounting for GST/HST, as well as for public service bodies
including charities and non-profit organizations that can use the
Special Quick Method. Group Sickness or Accident Insurance Plans Currently, employees who receive wage-loss replacement benefits
under a group sickness or accident insurance plan to which an
employer has contributed may be taxed on receipt of those
benefits. An employee is taxed if the benefits are payable on
a periodic basis, but is not taxed on the benefits if: Budget 2012 introduces changes that will include the amount of
an employer's contributions to a group sickness or accident
insurance plan in an employee's income for the year in which
the contributions are made to the extent that the contributions are
not in respect of a wage-loss replacement benefit payable on a
periodic basis. The tax treatment of private health services plans and certain
other plans are not affected by these changes. This measure will apply to employer contributions made on or
after March 29, 2012 to the extent that the contributions relate to
coverage after 2012, except that such contributions made on or
after March 29, 2012 and before 2013 will be included in the
employee's income for 2013. Currently, only donations to foreign charities that are
registered as qualified donees with the Government of Canada are
eligible for the charitable donation tax credit. Budget 2012 contains new rules for registering certain foreign
charitable organizations as qualified donees. The proposed
rules will not apply until at least January 1, 2013. Under the proposed rules, a foreign charitable organization will
be entitled to apply for qualified donee status if it has received
a gift from the Government of Canada, or if it pursues
activities: The Minister of National Revenue will have the discretion to
grant qualified donee status to a foreign charitable organization
that meets the criteria. Information regarding foreign
charitable organizations that are registered as qualified donees
will be made public, and qualified donee status will be granted for
24 months. Foreign charitable organizations that are currently qualified
donees under the existing rules will continue to be qualified
donees until the expiration of the period of their current
status. Individual donors or Canadian registered charities that
currently make gifts to qualified donees registered under existing
rules should take note of the proposed changes, and ensure that the
recipient foreign charities continue to qualify as qualified
donees. The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
Contents
Federal Budget 2012
Partnerships
Bump Planning
Sales to non-residents
Thin Capitalization
Transfer Pricing-Secondary Adjustments
Scientific Research and Experimental Development
Reduced SR&ED Investment Tax Credit Rate
Reduction in Proxy Rate for SR&ED Overhead
Expenditures
Exclusion of SR&ED Capital Expenditures
Removal of Profit Element from Arm's Length SR&ED
Contract Payments
Added Support for Innovation and Business Research and
Development
Clean Energy Generation Equipment
Employee Profit Sharing Plans
Expansion of Streamlined GST/HST Accounting
Registering Charitable Foreign Organizations as Qualified
Donees
CONTRIBUTOR
Canada: Canadian Tax @ Gowlings: March 29, 2012
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