Canada: Budget Briefing 2013 - Other Income Tax Measures

Synthetic Disposition Arrangements

Appreciation on many properties, including capital properties, is recognized for tax purposes on a realization basis upon disposition of the property.  If a taxpayer chooses to enter into arrangements to hedge its risk of loss or opportunity for gain in respect of the appreciated property without disposing of the property, generally speaking, no immediate disposition of the property results and the recognition for tax purposes of the appreciation on the property will continue to be deferred until disposition.

Budget 2013 proposes to change this treatment where a taxpayer enters into an arrangement that has the effect of eliminating all or substantially all the taxpayer’s risk of loss and opportunity for gain or profit in respect of the property (a synthetic disposition arrangement) for a period of more than one year.  Budget 2013 proposes to deem such arrangements to result in a disposition and reacquisition of the property at fair market value.

Similar treatment applies where the arrangement is entered into by a person or partnership with whom the taxpayer does not deal at arm’s length and such arrangement can reasonably be considered to have been entered into, in whole or in part, with the purpose of obtaining the effect outlined above.  Tax deferred conversions of property and leases of tangible property are not subject to this 2013 Budget proposal.

Such proposal would apply to so-called “monetization” transactions, but a deemed gain could arise as a result of the application of this proposal even if the taxpayer has not obtained funds, whether by loan or otherwise, against the hedged appreciated property.

Under parallel proposals, if a taxpayer has entered into a synthetic disposition arrangement for a period of more than 30 days, the taxpayer will be deemed to have disposed of and to have reacquired the property, interrupting the statutory one-year holding period applicable to dividend stop-loss rules and limitations on foreign tax credits.

These proposals apply to agreements and arrangements entered into or extended on or after Budget Day.

Character Conversion Transactions

Budget 2013 includes proposals that would affect the characterization of gains and losses in respect of capital property sold or received under certain forward sale agreements, deeming such gains and losses to arise on income, rather than capital, account.

The proposals apply to an agreement (a derivative forward agreement) for the sale or purchase of capital property, where the term of the agreement is greater than 180 days (or shorter where the agreement is part of a series of agreements having a collective term greater than 180 days) and the sale price of the capital property sold, or value of the capital property received, under the agreement is determined by reference to a measure other than the value of the capital property, capital gains in respect of the capital property, or income or certain other distributions in respect of the capital property.

Forward contracts of this type have long been employed by investment funds to obtain investment returns that are otherwise difficult to achieve.  For example, in the late 1990’s, the CRA issued numerous advance tax rulings permitting Canadian mutual funds to use similar forward agreements to mimic the return on foreign investments that, if held directly, could give rise to penalty taxes under the now-repealed “foreign property” regime.

Under the proposals in Budget 2013, the amount of any capital gain or loss in respect of a derivative forward agreement that is recharacterized on income account would be added to or subtracted from the cost of the affected capital property.  In this way, the gain or loss would not be treated as both a deemed income gain or loss and an actual capital gain or loss.

These proposals apply to agreements entered into or extended on or after Budget Day.

Leveraged Life Insurance Arrangements

Budget 2013 will eliminate what the Government refers to as “multiple and unintended tax benefits” arising from two life insurance arrangements involving the use of borrowed funds.  The two arrangements targeted by the Government are referred to as the “leveraged insured annuity” and the “10/8 arrangement”.

Although specific rules have been proposed to deny the “multiple and unintended tax benefits”, the Government warns that it will be monitoring developments and, if structures or transactions emerge that undermine the effectiveness of the proposals, it may take further action with possible retroactive application.

Leveraged Insured Annuities

Generally, a “leveraged insured annuity” involves the use by a taxpayer of borrowed funds to pay a single premium to acquire an annuity under which annuity payments will be made for the lifetime of the annuitant.  The taxpayer may then buy a life insurance policy that has an insurance amount on the life of the annuitant (the life insured) equal to the single premium paid to acquire the annuity and pay annual premiums on that policy.  To secure the borrowing, the taxpayer may assign both the annuity and the life insurance policy to the lender.  If the arrangement remains in place until the death of the annuitant, the life insurance proceeds may be applied to repay the borrowed funds.

From an income tax perspective, if the annuity is one to which section 12.2 of the ITA applies, an amount in respect of such an annuity is required to be included in the taxpayer’s income annually.  Interest paid by the taxpayer on the borrowed funds is deductible under the ITA to the extent of such income.  A portion of the premiums paid on the life insurance policy may also be deductible under the ITA as a cost of borrowing.  Provided that the life insurance policy qualifies as an “exempt policy” for the purposes of the ITA, there is no income from the life insurance policy while it remains in force and, on the death of the annuitant, the death benefit proceeds of the life insurance policy are received free of any income taxes and may be applied to repay the borrowed funds.  In effect, the taxpayer may receive a portion of the annuity payments free of any income tax while the annuitant is alive and, thereafter, repay the borrowed funds from the tax free death benefit proceeds of the life insurance policy.

Where such an arrangement is entered into by a private corporation with the shareholder as the annuitant, there may be a reduction in the fair market value of the shares for tax purposes immediately before the death of the shareholder (with a consequent reduction in the capital gain deemed to have been realized on death).  Moreover, any death benefit proceeds in excess of the tax cost of the policy will be added to the corporation’s capital dividend account and may be distributed tax free to a shareholder as a capital dividend.

Budget 2013 describes these tax consequences as being unintended and introduces rules that will apply to such arrangements to deny the perceived tax benefits.

The new rules will apply to an “LIA policy”, which will be a life insurance policy (other than an annuity) where (i) a person becomes obligated on or after Budget Day to repay an amount to another person or partnership (the “lender”) at a time determined by reference to the death of a particular individual whose life is insured under the life insurance policy, and (ii) the lender is assigned an interest in the life insurance policy and in an annuity contract that provides for payments at least until the death of the particular individual whose life is insured under the life insurance policy.

For taxation years that end on or after Budget Day, where a life insurance policy is an LIA policy and any amounts are borrowed on or after Budget Day from the lender:

• the policy will not be an “exempt policy” for the purposes of the ITA and the income accrual rules will apply to the LIA policy,

• deductions for borrowing costs will be denied in respect of premiums paid under the LIA policy,

• for purposes of certain deemed disposition rules that apply on the death of the taxpayer, the fair market value of any property deemed to have been disposed of as a consequence of the death of the annuitant under an annuity contract in respect of the LIA policy will be determined as though the fair market value of the annuity contract were equal to the total premium paid under the contract on or before death,

• no portion of the life insurance proceeds will be added to the capital dividend account of a private corporation, and

• the insurer will be required to file an information return in respect of the LIA policy for a calendar year if the insurer was notified by, or on behalf of, the policyholder that the life insurance policy is a LIA policy or if it is reasonable to conclude that the insurer knew, or ought to have known, before the end of the calendar year that the policy is a LIA policy.

10/8 Arrangements

The second arrangement targeted by the Government also involves the use of borrowed funds and a life insurance policy.

It is not uncommon for a taxpayer who has paid premiums under a life insurance policy to borrow an amount from the insurer by way of a policy loan under the terms of the life insurance policy or from any lender as a loan secured by the life insurance policy as collateral.  The borrowed funds are then used by the taxpayer to invest in other income producing property or a business.  By itself, that does not appear to trouble the Government.

However, in some arrangements, the interest rate credited under the life insurance policy may be determined, under the terms of the life insurance policy, by reference to the interest rate paid on the borrowed funds.  The “10/8 arrangement” derives its name from the interest rates commonly used under such arrangements: a 10% interest rate on the borrowed funds and an 8% interest credit under the policy.

Under a 10/8 arrangement, the 10% interest paid by the taxpayer on the borrowed funds is deductible under the ITA to the extent the borrowed funds are used for an income producing purpose.  A portion of the premiums paid on the life insurance policy may also be deductible under the ITA as a cost of borrowing.  Provided that the life insurance policy qualifies as an “exempt policy” for the purposes of the ITA, there is no income from the life insurance policy while it remains in force and, on the death of the life insured, the death benefit proceeds are received free of any income taxes and may be applied to repay the borrowed funds.  Consequently, the taxpayer may deduct the 10% interest paid on the borrowed funds against any income produced by the use of those funds, receive the 8% credits under the life insurance policy on death of the life insured as part of the death benefit proceeds free of any income tax and, thereafter, repay the borrowed funds from the tax free death benefit proceeds of the life insurance policy.

Where such an arrangement is entered into by a private corporation, any death benefit proceeds in excess of the tax cost of the policy will be added to the corporation’s capital dividend account and may be distributed tax free to a shareholder as a capital dividend.

It appears that the Government believes that, but for the tax benefits of such an arrangement, the payment of premiums and the borrowing of funds would not have been undertaken.  Although the Government is challenging 10/8 arrangements under existing provisions of the ITA, Budget 2013 proposes new rules to prevent the use of such arrangements in the future.

The new rules will apply for taxation years ending on or after Budget Day to 10/8 arrangements and will deny interest deductions, premium deductions and additions to the capital dividend account arising for periods after 2013.  The Government will also encourage taxpayers to terminate existing 10/8 arrangements before 2014 by providing relief from certain income tax consequences that would otherwise arise on a withdrawal from a life insurance policy that is part of such an arrangement if the withdrawal is made, after Budget Day and before January 1, 2014, to repay funds borrowed under the 10/8 arrangement.

Reassessment and Collection Proposals

Reportable Transactions

Budget 2013 proposes to give the CRA additional time to reassess a taxpayer that has participated in a tax shelter or a “reportable transaction”, in each case where the required filing of an information return was not made on time.   To combat what the Government describes as reduced time for the CRA to obtain the information necessary for a proper audit when the required information return is filed late, the CRA will be able to reassess a taxpayer in these situations beyond the normal statutory reassessment period, provided such reassessment is made within three years after the date on which the required information return is filed.  An effect of the 2013 Budget proposal is to extend the reassessment period for a GAAR reassessment based upon an abuse of the ITA in respect of a “reportable transaction” which is not timely reported to CRA.

This proposal applies to reassessments of taxation years that end on or after Budget Day.

Tax Collection for Disputed Tax Shelters

Budget 2013 proposes to give the CRA the power to collect 50% of disputed tax, interest and penalties resulting from the disallowance of a charitable donation deduction or tax credit in respect of a tax shelter.  Although the CRA is generally prohibited from taking collection action where a taxpayer that is not a large corporation has objected to a reassessment, the Government has expressed concern that prolonged tax shelter litigation could delay final collection of the taxes.  As a result, this proposal allows the CRA to collect 50% of the disputed amount in these circumstances.  Budget 2013 does not make any changes with respect to the collection provisions that apply to large corporations or amounts in dispute other than those related to charitable donation tax shelters.

This proposal will apply in respect of amounts assessed for the 2013 and subsequent taxation years.

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