Canadian Federal Budget 2016 – Selected Tax Measures
The Minister of Finance (Canada), the Honourable Bill Morneau, presented the Government of Canada's 2016 Federal Budget ("Budget 2016") on March 22, 2016 ("Budget Day"). Budget 2016 contains several significant proposals to amend the Income Tax Act (Canada) (the "ITA") and the Excise Tax Act (the "ETA") while also providing updates on previously announced tax measures and policies.
Significant Budget 2016 proposals include:
- changes to the small business taxation rules including proposals related to the small business tax rate, the multiplication of the small business deduction, and anti-avoidance measures related to the business limit and the taxable capital limit;
- conversion of eligible capital property to a new class of depreciable property;
- new back-to-back loan rules for shareholder loans and back-to-back rules for Part XIII withholding tax payments in respect of royalties;
- cross-border surplus stripping rules; and
- updates on Canada's participation in the Organisation for Economic Co-operation and Development ("OECD") project on Base Erosion and Profit Shifting ("BEPS").
Selected tax measures are detailed below:
Personal Income Tax Measures
Consequential Amendments Following the Introduction of the New Top Marginal Tax Rate
On December 9, 2015, the Canadian Government tabled Bill C-2, which included proposals to reduce the personal income tax rate from 22% to 20.5%, on the personal income tax bracket applicable to income from $44,702 to $89,401, and to introduce a new 33% personal income tax rate on income in excess of $200,000.
Budget 2016 proposes additional consequential amendments to the ITA in light of the new top marginal tax rate:
- a 33% charitable donation tax credit (for donations above $200) for trusts that are subject to the new top rate on all of their taxable income;
- an application of the new top rate on excess employee profit sharing plan contributions;
- an increase of the tax rate from 28% to 33% for personal services business income earned by corporations;
- a reduction of the relevant tax factor in the foreign affiliate rules from 2.2 to 1.9;
- an amendment to the capital gains refund mechanism for mutual fund trusts to reflect the new top rate in the formulas used for computing refundable tax;
- an increase of the Part XII.2 tax rate from 36% to 40% on the distributed income of certain trusts; and
- an amendment to the recovery tax rule for qualified disability trusts to reflect the new top rate.
The above proposals will apply to 2016 and subsequent taxation years. It should be noted that the amendment to the charitable donation tax credit will not apply to donations made in 2015. However, the proposed 33% charitable donations tax credit rate will be made available to donations made by a graduated rate estate with a taxation year straddling 2015 and 2016. For corporations whose taxation years straddle 2015 and 2016, the increased rate of 33% on personal services business income will apply on a pro-rated basis to those days of the taxation year after 2015.
Extension of Mineral Exploration Tax Credit for Flow-Through Share Investors
Budget 2016 proposes to extend eligibility for the 15% mineral exploration tax credit for one year to flow-through share agreements entered into on or before March 31, 2017.
Taxation of Switch Fund Shares - No More Tax Advantage
Canadian mutual funds are structured as trusts or corporations. Since trusts are better vehicles for flowing through all sources of income for tax purposes, they are more common. However, one advantage of a corporate fund over a trust fund is the ability of an investor to switch between securities that represent different underlying funds on a tax-deferred basis by relying on tax rules that apply to share-for-share exchanges. There are no equivalent rules for trust unit exchanges.
Budget 2016 proposes to treat an exchange of shares of a mutual fund corporation (or investment corporation) as having occurred at fair market value with the result that any accrued gain in the share will be realized. Presumably, any accrued loss would also be realized on the switch, subject to the usual loss restriction rules.
If the only difference between the classes (or series) of exchanged shares is in respect of management fees or expenses borne by the class or series, then a tax-deferral is still available.
A multi-fund mutual fund corporation may still have some limited advantages compared to a mutual fund trust. For example, an existing mutual fund corporation is a "public corporation" with the result than any new class of shares that it offers is a qualified investment for RRSPs and other registered plans regardless of the number of investors in the new class. In contrast, unless it is a registered investment, a mutual fund trust requires to maintain at least 150 different unitholders in a class of its units (each of whom holds a specified number and value of units) in order for its units to be qualified investment for such registered plans. As another example, although losses of a mutual fund corporation and mutual fund trust cannot be flowed through to investors, in the case of a multi-fund mutual fund corporation, losses from one "fund" can be applied to reduce income earned from another fund within the corporation.
There is currently no simple mechanism for a switch corporation to convert to a series of trust funds without incurring tax at the investor and fund level. Ideally, tax rules should be introduced to accommodate such conversions for those mutual fund corporations that decide it is best to continue as, or merge with, corresponding trust funds.
This measure will apply to exchanges that occur after September 2016.
Taxation on Sales of Linked Notes
The ITA and its regulations contain rules that deem interest to accrue on certain types of debt obligations. However, the application of these rules is uncertain in the case of debt instruments or notes where the return is linked to an index or asset whose value is unpredictable. In such circumstances, there is no income inclusion until the year in which the note matures and the return is certain. The return on maturity is taxed as interest income. If an investor disposes of this type of note that is held as capital property before maturity of the note, the position can be taken that any gain realized on the disposition is a capital gain.
Budget 2016 proposes to tax the return realized on a disposition of these types of notes prior to maturity as interest income. If a linked note is held to maturity, there should still be a deferral of taxation until maturity; however, the entire return will be taxed as interest income.
This measure will apply to dispositions that occur after September 2016.
Business Income Tax Measures
Small Business Taxation
Budget 2016 proposes that the small business tax rate remain at 10.5% after 2016. This proposal eliminates the gradual reductions that were proposed in the 2015 Federal Budget ("Budget 2015") for 2017, 2018 and 2019 that would have seen a rate of 9% apply to taxation years after 2018. Budget 2016 also proposes to maintain the current gross-up factor and dividend tax credit ("DTC") rate applicable to non-eligible dividends. This proposal eliminates the gradual reductions in the gross-up factor and DTC that were proposed in Budget 2015 for 2018 and 2019. Specifically, the gross-up factor applicable to non-eligible dividends will be maintained at 17% (as opposed to decreasing to 15% in 2019) and the corresponding DTC rate at 21/29 of the gross-up amount (as opposed to decreasing to 9/13 in 2019). Expressed as a percentage of the grossed-up amount of a non-eligible dividend, the effective rate of the DTC in respect of such a dividend will remain at 10.5% after 2016, placing it in line with the new small business rate.
Multiplication of the Small Business Deduction
The ITA has rules that are designed to prevent the multiplication of access to the small business deduction. Budget 2016 proposes changes to these rules to prevent attempts to multiply the deduction through the use of certain partnership and corporate structures.
With respect to partnerships, the specified partnership income ("SPI") rules in the ITA are intended to eliminate the possibility that the small business deduction could be multiplied amongst a partnership of corporations that are not associated with each other. Despite numerous favourable advance tax rulings being issued by the Canada Revenue Agency (the "CRA"), Budget 2016 is specifically concerned with a structure in which a shareholder of a Canadian-controlled Private Corporation ("CCPC") is a member of a partnership and the partnership pays the CCPC as an independent contractor under a contract for services. As a result, the CCPC claims a full small business deduction in respect of its active business income earned in respect of the partnership because, although the shareholder of the CCPC is a member of the partnership, the CCPC is not.
To address this type of partnership structuring, Budget 2016 proposes to extend the SPI rules to partnership structures in which a CCPC provides, directly or indirectly, services or property to a partnership during a taxation year of the CCPC where, at any time during the year, the CCPC or a shareholder of the CCPC is a member of the partnership or does not deal at arm's length with a member of the partnership.
Generally, for the purpose of the SPI rules:
- a CCPC will be deemed to be a member of a partnership throughout a taxation year if: (i) it is not otherwise a member of the partnership in the taxation year, (ii) it provides services or property to the partnership at any time in the taxation year, (iii) a member of the partnership does not deal at arm's length with the CCPC, or a shareholder of the CCPC, in the taxation year, and (iv) it is not the case that all or substantially all of the CCPC's active business income for the taxation year is from providing services or property to arm's length persons other than the partnership;
- a CCPC that is a member of a partnership (including a deemed member) will have its active business income, from providing services or property to the partnership, deemed to be partnership active business income; and
- the SPI limit of a deemed member of a partnership will initially be nil (as it does not receive any allocation of income from the partnership). However, an actual member of the partnership who does not deal at arm's length with a deemed member of the partnership will be entitled to notionally assign to the deemed member all of or a portion of the actual member's SPI limit in respect of a fiscal period of the partnership that ends in the deemed member's taxation year (and where the actual partner is an individual, the assignable SPI limit of all members of the partnership will be determined as if they were corporations).
This proposal will apply to taxation years that begin on or after Budget Day. However, an actual member of a partnership will be entitled to notionally assign all or a portion of the member's SPI limit in respect of their taxation year that begins before and ends on or after Budget Day.
With respect to corporations, Budget 2016 is concerned that the tax planning described above could utilize a corporation, in place of the partnership, to effectively multiply the small business deduction. Such multiplication could occur in circumstances where a CCPC earns active business income from providing services or property, directly or indirectly, to a private corporation during the CCPC's taxation year when, in the taxation year, the CCPC, one of its shareholders, or a person who does not deal at arm's length with such a shareholder has a direct or indirect interest in the private corporation. To address this type of structuring, Budget 2016 proposes to amend the ITA to deem a CCPC's active business income to be ineligible for the small business deduction in such circumstances. This ineligibility for the small business deduction will not apply to a CCPC if all or substantially all of its active business income for the taxation year is earned from providing services or property to arm's length persons other than the private corporation.
Under Budget 2016 proposals, a private corporation that is a CCPC will be entitled to assign all or a portion of its unused business limit to one or more CCPCs that are ineligible for the small business deduction under this proposal. The amount of active business income earned by a CCPC from providing services or property to the private corporation that will be eligible for the small business deduction (subject to the CCPC's own business limit) will be the least of:
- the CCPC's income from providing services or property to the private corporation;
- the unused business limit of the private corporation; and
- the amount determined by the Minister of National Revenue to be reasonable in the circumstances.
This proposal will apply to taxation years that begin on or after Budget Day. However, a private corporation will be entitled to assign all or a portion of its unused business limit in respect of its taxation year that begins before and ends on or after Budget Day.
Avoidance of the Business Limit and the Taxable Capital Limit
In general, associated corporations must share the $500,000 small business limit and the $15 million taxable capital limit available to CCPCs. There are a number of technical rules in the ITA that apply for the purpose of determining if two or more corporations are associated with each other. In particular, Budget 2016 is concerned with the application of subsection 256(2) of the ITA which deems two corporations, who would not otherwise be associated, to be associated if each of the corporations is associated with the same third corporation. Subsection 256(2) will not apply if the third corporation is not a CCPC or, if it is a CCPC, and it elects not to be associated with the other two corporations for the purposes of determining entitlement to the small business deduction. The effect of this exception is that the third corporation cannot claim the small business deduction (if it is a CCPC), but the other two corporations may each claim a $500,000 small business deduction subject to their own taxable capital limit.
The election under subsection 256(2) does not affect the associated corporation status for the purposes of other rules in the ITA. For example, subsection 129(6) deems investment income to be active income eligible for the small business deduction if the income is derived from the active income of an associated corporation. As such, two corporations may not be associated for purposes of claiming the maximum small business deduction while retaining the ability to treat investment income that one receives from the other as active business income. Specifically, where the third corporation is not a CCPC, or is a CCPC that files an election, the other two corporations may claim the small business deduction on investment income that traces to the active business income of the third corporation, even though the third corporation could not have claimed the deduction. In essence, the two corporations are using subsection 256(2) to multiply the small business deduction. Additionally, where the other two corporations directly earn active business income, their small business deductions are determined without regard to the taxable capital of the third corporation to which they are each associated.
Budget 2016 proposes to amend the ITA such that income derived from an associated corporation's active business income will be ineligible for the small business deduction, and be taxed at the general corporate income tax rate, where the exception in subsection 256(2) applies. In addition, where this exception applies, the third corporation will be considered to be associated with the other two corporations for purposes of the $15 million taxable capital threshold. These proposals are effective for taxation years beginning on or after Budget Day.
Consultation on Active versus Investment Business
Budget 2015 announced a review of the circumstances in which income from a business, the principal purpose of which was to earn income from property, should qualify as active business income and therefore be eligible for the small business deduction. The consultation period ended on August 31, 2015 and, following an examination of the submissions, no modifications to these rules are included in Budget 2016.
Life Insurance Policies
Distributions of Life Insurance Proceeds
Life insurance proceeds received as the result of the death of an individual insured under a life insurance policy are generally not subject to income tax. Furthermore, only the portion of the life insurance proceeds that exceed the policyholder's adjusted cost base of the policy may generally be added to the capital dividend account of a corporation or the adjusted cost base of the partnership.
Budget 2016 notes that some taxpayers have structured their affairs to artificially increase a corporation's capital dividend account balance, or the adjusted cost base of a partner's partnership interest, to allow taxpayers to avoid income tax on dividends payable by a private corporation or gains from the disposition of a partnership interest.
Budget 2016 proposes to amend the ITA to ensure that the current rules apply as intended. Specifically, the proposed measures will limit the amount that can be added to the capital dividend account of the corporation or the adjusted cost base of the partnership interest, as the case may be, regardless of whether the corporation or partnership that receives the policy benefit is a policyholder of the policy. The measure will also introduce new information-reporting requirements where a corporation or a partnership is not a policyholder but is entitled to a policy benefit.
This measure will apply to policy benefits received as a result of a death that occurs on or after Budget Day.
Transfers of Life Insurance Policies
The proceeds of disposition on the disposition of a life insurance policy by a policyholder to an arm's length person is the fair market value of the consideration received. However, where a policyholder disposes of a life insurance policy to a non-arm's length person, a special rule applies to deem the policyholder's proceeds of the dispositions to be the amount of the policy's cash surrender value. Where this special rule applies, any consideration given for the interest that exceeds the cash surrender value is not taxed.
Budget 2016 proposes to include the fair market value of any consideration given for a life insurance policy in the policyholder's proceeds of disposition and in the acquiring person's cost. Any resulting increase to the paid-up capital ("PUC") of the shares of an acquiring corporation or adjusted cost base of a partnership interest on such dispositions will be limited to the amount of such deemed proceeds of disposition.
This measure will apply to dispositions that occur on or after Budget Day.
Debt Parking to Avoid Foreign Exchange Gains
A Canadian debtor must realize a foreign exchange gain or loss on the repayment of a debt denominated in a foreign currency, where there has been a fluctuation in the value of the foreign currency relative to the Canadian dollar. To avoid realizing a foreign exchange gain on the repayment of a foreign currency debt, some Canadian debtors have entered into "debt parking" transactions. Typically, in such transactions, instead of directly repaying the debt to the creditor, the debtor arranges for a non-arm's length party to acquire the debt from the creditor for a purchase price equal to the principal amount. The intended result is that the creditor receives the full principal amount, but the debt remains in existence, thereby allowing the debtor to avoid having to recognize the foreign exchange gain.
Certain debt parking rules in the ITA prevent the use of debt parking techniques to avoid the application of the debt forgiveness rules. Budget 2016 proposes to introduce similar rules, so that any accrued foreign exchange gains on a foreign currency debt are realized by the debtor if the debt is parked to a non-arm's length party and thereby becomes a "parked obligation". Specifically, the debtor will be deemed to have realized the gain that it otherwise would have realized, had it repaid the principal amount of the debt to the creditor.
Exceptions will be provided so that a foreign currency debt will not become a parked obligation in the context of certain bona fide commercial transactions. Related rules will also provide relief to financially distressed debtors.
These measures are to apply to a foreign currency debt that becomes a parked obligation on or after Budget Day.
Valuation for Derivatives
Budget 2016 contains proposals aimed at preserving Canada's fiscal tax base in response to concerns raised by recent case law on the application of inventory valuation methods applied to derivatives held on account of income. The Tax Court of Canada recently held in Kruger Incorporated v. The Queen, 2015 TCC 119, that derivatives held on account of income which are not considered mark-to-market property, or property that is used in an adventure or concern of the nature of trade, could be considered inventory that may be valued at the lower of cost and fair market value.
Budget 2016 proposes to deem swap agreements, forward purchase or sale agreements, forward rate agreements, futures agreements and option agreements, to not be inventory of a taxpayer for purposes of the inventory valuation rule while ensuring that such agreements retain their status as inventory for other purposes. A related rule is also proposed which provides that taxpayers, when computing profit from a business or property, may not use the lower of cost and fair market value methodology.
This measure will apply to derivatives entered into on or after Budget Day.
Transitioning Eligible Capital Property to the Capital Cost Allowance Regime
The Canadian Government announced in the 2014 Federal Budget ("Budget 2014") that it would start public consultations on changing the eligible capital property ("ECP") regime into a capital cost allowance regime. In Budget 2015, the Government noted that it was continuing to receive submissions on this proposal and was considering all representations in developing the new rules (including transitional rules).
Budget 2016 follows up on the consultation process introduced in Budget 2014 regarding the conversion of the tax treatment of ECP to a new capital cost allowance class for depreciable property (Class 14.1) and to propose transitional rules to transfer existing cumulative eligible capital pools to the new capital cost allowance class. The application of Goods and Services Tax/Harmonized Sales Tax ("GST/HST") to ECP will not be affected.
Current rules for the tax treatment of ECP mandate that 75% of an eligible capital expenditure is added to a cumulative eligible capital ("CEC") account on a pooled basis which is deductible annually at a 7% declining balance depreciation rate. Similarly, 75% of an eligible capital receipt is used to reduce the balance of a business's CEC pool, leading to a recapture of any CEC previously deducted and ultimately, where there is a receipt in excess of the amount of the CEC pool, an income inclusion of the amount of the excess at the rate of 50% (to generally equate to a capital gain).
Budget 2016 proposes that ECP expenditures that would otherwise be added to CEC will be added to new Class 14.1 at a 100% inclusion rate and will have a 5% annual depreciation rate (subject to transitional rules in some circumstances). Other existing CCA rules relating to recapture, capital gains and depreciation will apply to this new CCA Class.
The current ECP rules deal with intangible property that does not relate to specific properties of a business (such as goodwill) therefore special rules are required to deal with such categories of property under a CCA regime. New rules will be implemented to ensure that every business has goodwill associated with it regardless of whether any actual expenditure to acquire goodwill has been made. Expenditures of such a nature not relating to specific property will be added to the balance of the new CCA Class as an increase to the capital cost of goodwill and a receipt not specifically relating to a property will reduce the capital cost of goodwill and the new CCA balance by the lesser of the capital cost of the goodwill and the amount of the receipt. To the extent a receipt exceeds the capital cost of goodwill, a capital gain will result, along with recapture of previously deducted CCA.
Under the new rules, businesses must account for the new CCA Class by transferring then existing CEC pool balances to Class 14.1 and the depreciation rate applicable to expenditures incurred before January 1, 2017 will be 7% (until 2027). For receipts received after January 1, 2017 which related to property acquired before that time the Class 14.1 Pool will be reduced at a 75% rate.
Budget 2016 also attempts to reduce the complexity of the ECP regime transition by allowing the deduction as CCA, in respect of expenditures incurred before 2017, of the greater of $500 per year and the amount otherwise deductible for that year (provided that the additional balance will be provided only to 2027) and to allow a separate business deduction for incorporation expenses, whereby the first $3,000 of such expenses will be treated as a current expense rather than being added to Class 14.1. As a result, it is expected most newly incorporated businesses may deduct the full amount of incorporation expenses in their initial year of existence.
This measure, including the transitional rules, will apply as of January 1, 2017.
International Tax Measures
Implementation of the Base Erosion and Profit Sharing Recommendations
The OECD BEPS project is intended to address concerns related to tax planning by multinationals ("MNEs") which rely on bilateral tax treaties and their interaction with domestic tax rules to minimize taxes for the overall enterprise. Canada, along with other G20 members, endorsed the final package of reports and recommendations from the BEPS project which was released on October 5, 2015.
Practitioners and MNEs based in Canada, or with operations in Canada, have been waiting for the Canadian Government to comment on the specific proposals that it intends to implement, as it was generally recognized that Canada already met the standards of some of the BEPS recommendations and other recommendations were not relevant to the Canadian context.
Budget 2016 proposes to move forward with a number of initiatives to address BEPS including:
- new legislation to strengthen transfer pricing documentation by introducing country-by-country reporting;
- applying the revised international guidance on transfer pricing by multinational enterprises which affects the interpretation of the arm's length principle;
- participating in the international efforts to develop a multilateral instrument to streamline the implementation of treaty-related BEPS recommendations; and
- undertaking the spontaneous exchange of tax rulings with other tax administrations.
Transfer Pricing Documentation - Country-by-Country Reporting
The tax rules in Canada and many other countries generally require that MNEs set "transfer prices" in cross-border transactions between affiliated entities in different countries based on the arm's length standard. These rules also require MNEs to prepare transfer pricing documentation to report such intra-group cross-border transactions and the methodologies used to set such prices.
The OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations provide guidance on the application of the arm's length principle and include recommendations to incorporate new standards for transfer pricing documentation. Such recommendations also include a minimum standard for country-by-country reporting.
Under the guidelines, the country-by-country report received by one jurisdiction will be automatically exchanged with other jurisdictions in which the MNE operates in cases where the other jurisdiction has also implemented country-by-country reporting.
Budget 2016 proposes to implement this reporting requirement such that it applies only to MNEs with a total annual consolidated revenue of €750 million or more. Where an MNE has its ultimate parent resident in Canada, it will be required to file a country-by-country report with the CRA within one year of the end of the fiscal year to which the report relates. The proposals have measures to deal with the circumstance where a Canadian subsidiary's ultimate parent does not reside in a jurisdiction which has automatic reporting with Canada. In such cases, a "surrogate" subsidiary that is resident in a country with country-by-country reporting automatic exchange agreements may file reports on behalf of the MNE as a whole.
This country-by-country reporting requirement will apply in respect of payments that begin after 2015. First exchanges between jurisdictions of country-by-country reports are expected to occur by June 2018.
Adopting BEPS Transfer Pricing Guidance
Budget 2016 confirmed that the CRA is already applying the revised interpretation of the arm's length principle in the Transfer Pricing Guidelines and will continue to do so.
Budget 2016 notes that the CRA will not be adjusting its administrative practices with respect to "low value-adding services" and for certain matters related to minimally functional entities (or "cash boxes"). BEPS project participants are still engaged in follow-up work in these areas. The Canadian Government will decide on a course of action with respect to these measures after the outstanding work is complete.
Bilateral and Multilateral Approaches to Addressing Tax Treaty Abuse
The BEPS project proposes two minimum standard approaches to address perceived tax treaty abuse. The first is the use of a general anti-abuse rule that applies depending on whether one of the principal purposes of an arrangement or transaction was to obtain treaty benefits in a way that is not in accordance with the object and purpose of the relevant treaty provisions (a "principal purpose test"). The second is the use of a specific anti-abuse rule that requires the satisfaction of a series of tests in order to qualify for treaty benefits (a "limitation on benefits rule").
Budget 2016 states that the Canadian Government intends to address treaty abuse in accordance with the minimum standard. Canada's tax treaty with the United States has adopted the limitation on benefits approach. Canada has several treaties that have a limited principal purpose test. In future treaty negotiations, Canada will consider applying either minimum standard approach depending on the particular circumstances and in discussion with the treaty partner. Canada will also be open to joining a multilateral instrument that many countries sign modifying certain provisions of the existing bilateral treaties.
From a practical perspective, given the time that it would take to amend the current bilateral tax treaty network to include either a principal purpose test or a limitation on benefits rule to those treaties without such provisions, a multilateral instrument approach will be necessary if the minimum standard is to be implemented within a reasonable time frame.
Spontaneous Exchange of Tax Rulings
The BEPS project developed a framework for the spontaneous exchange of certain tax rulings. These included six categories of rulings: (i) rulings related to preferential regimes, (ii) cross-border unilateral advance pricing arrangements; (iii) rulings giving a downward adjustment to profits; (iv) permanent establishment rulings; (v) conduit rulings; and (vi) any other type of ruling agreed to in the future.
Budget 2016 proposes to implement the BEPS minimum standard for spontaneous exchange of certain tax rulings. The exchange of information will comply with the rules established in Canada's tax treaties, tax information exchange agreements and the multilateral Convention on Mutual Administrative Assistance in Tax Matters. Any exchanged information will be protected in the same manner as taxpayer information in accordance with the current exchange of information regime to protect the confidentiality of the taxpayer information.
The CRA will commence exchanging tax rulings in 2016 with other jurisdictions that have committed to the minimum standard.
Cross-Border Paid-up Capital Increases
The PUC of shares of a Canadian corporation generally represents the capital that has been contributed to the corporation by its shareholders and consequently can be returned to its non-resident shareholders free of Canadian withholding tax. Section 212.1 of the ITA is intended to prevent the artificial increase of cross border PUC through non-arm's length transactions. An exception to this rule in subsection 212.1(4) applies in the case of certain structures generally involving the 'sandwiching' of a non-resident subsidiary between two Canadian corporations.
Budget 2016 suggests that this exception is being inappropriately relied upon by corporate groups who create a sandwich structure as part of a series of transactions designed to artificially increase the PUC of the shares of the Canadian subsidiary. Budget 2016 therefore proposes to amend the requirements concerning the application of this section, to ensure that it applies as intended.
This measure is to be applicable to transactions that occur on or after Budget Day.
Extension of the Back-to-Back Rules
Certain "back-to-back loan" rules apply in the ITA, where a third party intermediary is interposed between a Canadian borrower and a foreign lender in order to avoid or reduce the tax consequences that would have applied if the loan had been made directly between the two parties. The rules will generally deem the loan to be directly between the Canadian borrower and the foreign lender for purposes of both the "thin capitalization rules" and the withholding tax provisions in the ITA.
Budget 2016 proposes to extend these back-to-back loan rules in the following areas:
- extending the existing back-to-back loan rules in Part XIII of the ITA to extend their application to rents, royalties and similar payments;
- adding character substitution rules to the back-to-back rules in Part XIII of the ITA;
- adding back-to-back loan rules to the existing shareholder loan rules in the ITA; and
- clarifying the application of the back-to-back loan rules to multiple intermediary structures.
Back-to-Back Rules for Rents, Royalties and Similar Payments
Budget 2016 proposes to extend the existing back-to-back loan rules in Part XIII of the ITA to royalty payments. This would apply, for example, where a Canadian resident payor of royalties and a non-resident recipient interpose an entity, located in a favourable tax treaty country, in order to reduce or eliminate the Canadian withholding tax which would otherwise apply to the royalty payments. Where applicable, the proposed rules apply the Part XIII withholding tax which would have applied had the Canadian resident payor made the royalty payments directly to the ultimate non-resident recipient.
For purposes of the proposed rules, two arrangements are considered to form a back-to-back arrangement if they are sufficiently connected, meaning that generally the amount that the intermediary is obliged to pay is established, in whole or in part, by reference to (i) the amount of the royalty payment obligation of the Canadian resident party, or by (ii) the fair market value or revenue, profit or other similar criteria in respect of the right to use the property in Canada. There can also be a sufficient connection where it can reasonably be concluded that the Canadian leg of the payment was entered into or permitted to remain in effect because the intermediary leg was, or anticipated to be, entered into.
This measure will apply to royalty payments made after 2016.
Character Substitution Rules
Budget 2016 proposes to extend the application of the back-to-back rules to prevent their avoidance by substituting "economically similar arrangements" between the intermediary and a non-resident person. The proposed character substitution rules may apply where a sufficient connection is established between the arrangement under which an interest or royalty payment is made by a Canadian payor and the intermediary's obligations to another non-resident person in respect of an interest or royalty payment (where it is different from the Canadian payment), or where the non-resident person holds shares of the intermediary that has certain obligations to pay dividends or that satisfies certain other conditions (the examples given being where the shares are redeemable or cancellable).
The presence of such a connection will be determined by applying tests similar to those used for back-to-back loans and back-to-back royalty arrangements. Where a sufficient connection is established, an additional payment of the same character will be deemed to have been paid directly by the Canadian resident payor to the ultimate non-resident recipient.
This measure will apply to interest and royalty payments made after 2016.
Back-to-Back Shareholder Loan Rules
The shareholder loan rules in the ITA generally apply where a Canadian corporation makes a loan to a shareholder, and the loan remains outstanding for more than a year after the end of the year in which the loan was made. In this case, the outstanding debt, or an amount determined by reference to the prescribed rate on the amount of the debt, is required to be included in the shareholder's income, meaning that where the shareholder is a non-resident, this inclusion is deemed to be a dividend subject to Part XIII withholding tax.
Budget 2016 proposes to extend the back-to-back rules to apply to the shareholder loan rules, where an intermediary party is interposed between the Canadian corporation and the shareholder. Where applicable, the Canadian corporation will be deemed to have made the loan directly to the shareholder, rather than to the intermediary, such that the shareholder benefit provisions will apply in respect to the loan.
These rules will apply to back-to-back shareholder loan arrangements in place as of Budget Day.
Multiple Intermediary Structures
Budget 2016 proposes to clarify the back-to-back loan rules in their application to structures that involve more than one intermediary. Where a back-to-back arrangement involving multiple intermediaries exists, an additional payment (of the same character as that paid by the Canadian resident to the first intermediary) will be deemed to have been paid directly by the Canadian to the ultimate non-resident recipient.
This measure will apply to payments of interest or royalties made after 2016 and to shareholder loans outstanding as of January 1, 2017.
Sales and Excise Tax Measures
Budget 2016 contains a number of proposed GST/HST changes, some of which are targeted at certain industries and others that will apply more generally.
Charity and Health Industry Amendments
Budget 2016 proposes to modernize the zero-rating provisions by adding a number of new medical and assistive devices to the list of zero-rated devices, including insulin pens and insulin pen needles.
Budget 2016 also proposes to clarify that cosmetic procedures, which are generally subject to GST/HST, remain subject to GST/HST even when supplied by registered charities. Further, with respect to charities, Budget 2016 proposes to enact changes that will bring the GST/HST rules into line with the ITA rules for "split-receipting" where property or services are provided by a charity in return for a donation. The proposed GST/HST amendments will potentially provide a more favourable GST/HST result than is currently the case, by legislating that where a split receipt can be issued for income tax purposes, only the amount of the donation that relates to the property or services being supplied by the charity will be subject to GST/HST. This change only applies to supplies of property or services by the charity that are not already exempt from GST/HST.
Financial Institution Amendments
Budget 2016 proposes to make two significant changes to the legislation that will impact on certain financial institutions. The first amendments is aimed at limiting the application of the de minimis financial institution rules, such that certain entities that are presently deemed to be financial institutions will no longer be so deemed.
The de minimis financial institution rules generally deem an entity to be a financial institution if it earns more than $1 million from financial sources such as interest, fees or charges relating to loans or the granting of credit. Under the proposed rules, persons earning more than $1 million of interest from certain bank deposits or GICs will no longer be deemed to be a financial institution.
Further, Budget 2016 proposes a series of new rules with respect to cross-border reinsurance transactions. Presently, financial institutions are required to self-assess GST/HST on their acquisition of property or services outside of Canada that relate to their Canadian activities, including certain expenses incurred by branches located outside of Canada. Although these general rules will not change, Budget 2016 seeks to clarify that two specific elements of cross-border reinsurance services will not form part of the tax base upon which the GST/HST must be self-assessed – ceding commissions and the margin for risk transfer.
In addition, Budget 2016 proposes to allow financial institutions to make a special request for reassessment for years in which tax, interest or penalty was paid in respect of these two elements of the GST/HST self-assessment for reinsurance services, for years in which this proposed amendment relates (i.e. in respect of any specified year ending after November 16, 2005).
New restrictions on exported call centre services and Closely-related party elections
Budget 2016 also proposes to add some restrictions for taxpayers that operate call centres in Canada for the benefit of non-residents, as well as to corporate groups of Canadian corporations and partnerships that intend to elect such that property and services can flow amongst the members of the corporate group without the application of GST/HST.
Specifically, entities that operate call centres inside of Canada and that supply technical or customer support services to non-residents, will no longer be able to rely on the zero-rating provisions to ensure that their non-resident clients are not required to pay GST/HST unless certain specific conditions are satisfied. In addition to ensuring that their non-resident clients are not registered for GST/HST purposes, the call centre suppliers will need to determine whether it is reasonable to expect that their services will be rendered primarily to people located outside of Canada at the time the services are rendered.
The corporate groups in Canada that have or intend to make elections pursuant to section 150 or section 156 of the ETA with respect to supplies of property or services made amongst a closely related group of companies and/or partnerships will have to satisfy a more stringent test than presently implemented. This purpose of the new test is to ensure that the parent corporation possesses true voting control over all of its subsidiary's corporate matters.
Real Property Industry Amendments
Budget 2016 proposes to relax the reporting requirements for real property developers and builders that make or made supplies of houses to which the "grandparenting" rules have applied since GST/HST harmonization occurred in 2010. Not only will ongoing sales of such homes have more limited reporting requirements (for houses sold for more than $450,000), but a special election will be available to allow such builders to correct past reporting errors and avoid the penalties associated with such errors in respect of houses sold for more than $450,000. However, it is important to note that this election is only proposed to be available until the end of 2016, and so builders that intend to make such elections will need to act promptly.
Previously Announced Tax Measures
The newly elected Canadian Government had raised several items prior to Budget Day which were not addressed in Budget 2016 as some had anticipated. For example, announcements were made last fall relating to limiting the tax benefits of stock options and statements were also made concerning the phasing out of the Canadian exploration expenses for successful oil and gas exploration. There is no indication in Budget 2016 as to how the Canadian Government intends to proceed with these initiatives.
Budget 2015 had included a proposal to provide, beginning in 2017, an income tax exemption in respect of capital gains on certain dispositions of private corporation shares or real estate, where cash proceeds from the disposition are donated to a registered charity or other qualified donee within 30 days. Budget 2016 confirms that the Canadian Government does not intend to proceed with this measure.
Budget 2016 confirms the Canadian Government's intention to proceed with previously announced tax and related measures including:
- the common reporting system established by the OECD for the automatic exchange of financial account information between tax authorities;
- the legislative proposals (draft released for comment on January 15, 2016) related to: (i) clarifying the types of investment funds excluded from the loss restriction event rules that would otherwise limit a trust's use of certain tax attributes (including losses); (ii) income tax rules for recognizing charitable donations made by an individual's former graduated rate estate; and (iii) ensuring that income arising in certain trusts on the death of the trust's primary beneficiary is taxed in the trust and not in the hands of that beneficiary (subject to a joint election for certain testamentary trusts).
Budget 2016 also confirms the Canadian Government's intention to proceed with tax and related measures originally proposed in previous budgets or during the last Parliament. These measures include:
- "synthetic equity arrangements" under the dividend rental arrangement rules;
- the repeated failure to report income penalty;
- information sharing within the CRA for the collection of non-tax debts;
- the conversion of capital gains into tax-deductible inter-corporate dividends in section 55 of the ITA;
- alternative arguments in support of a tax assessment;
- the offshore reinsurance of Canadian risks; and
- the exception to the withholding tax requirements for payments by qualifying non-resident employers to qualifying non-resident employers.
We invite you to read the Budget 2015 commentary for further details on some of these previously released tax measures.