Canada: 2016 Federal Budget – Selected Tax Measures

The new royalty rule will apply where the non-resident recipient of the intermediary payment is subject to a higher withholding rate on a payment from Canada than the intermediary.

It appears that this new rule could interfere with legitimate commercial arrangements. For example, suppose a Canadian company pays trademark royalties to an unrelated Dutch company. Canada's tax treaty with the Netherlands provides for a 10 per cent withholding tax rate. If the Dutch licensor, in turn, has an obligation to pay royalties to a company in a non-treaty jurisdiction, such as the Netherlands Antilles, the new rule could conceivably be engaged, effectively denying a negotiated treaty benefit. The rule appears to raise compliance issues for Canadian licensees, who may have no knowledge of the behind-the-scenes affairs of a licensor. While the Canada Revenue Agency (CRA) has produced forms that payees can provide to payors in order to claim the benefits of a tax treaty, unlike in some other jurisdictions, no due diligence defence is available to a payor that relies on the representations in the forms. Perhaps the government will take this into account in drafting the definitive legislation to implement this new rule.

Second, the 2016 Budget also proposes to extend the existing BTB rules relating to interest to circumstances where the arrangements between the intermediary and the other non-resident person are not in the same form as the "first leg" (i.e. the interest or royalty payment out of Canada), but are economically similar to the first leg. This includes situations where the payment out of Canada to the intermediary is interest, and the payment by the intermediary is a royalty (and vice versa), as well as situations where the payment out of Canada is interest or a royalty and a non-resident person holds shares of the intermediary that include certain obligations to pay dividends or that satisfy certain other conditions (e.g. they are redeemable or cancellable).

This character substitution rule will apply only where a sufficient connection is established between the first leg and the intermediary's obligations described above. Where the rule is engaged, the Canadian resident payor will be deemed to have made a payment of the same character as the first leg directly to the other non-resident. Again, as these provisions are not limited to transactions among an affiliated group, the rules could raise compliance issues for Canadian payors as they seek to determine whether to withhold at treaty-reduced rates.

Third, the 2016 Budget proposes measures to apply the BTB rules to arrangements involving multiple intermediaries, again relying on a "sufficient connection" test, the details of which have yet to be revealed. In such cases the Canadian payor will be deemed to have made a payment with the same character as the first leg (i.e. interest or royalty) to the ultimate non-resident recipient in the chain of connected arrangements.

The royalty, character substitution and multiple intermediary BTB measures will apply to royalty and interest payments made after 2016, which provides taxpayers with approximately nine months to reorganize existing structures.

Apart from the BTB rules, the Budget materials include some general comments on treaty abuse. The government notes that under BEPS, there is a treaty abuse minimum standard that requires countries to include in their tax treaties an express statement that their common intention is to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping arrangements, and that Canada is committed to addressing treaty abuse in accordance with the minimum standard. This standard requires countries to adopt in their tax treaties one of two approaches to treaty anti-abuse rules. The first of these is a general anti-abuse rule that uses the criterion of 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 PPT). The second approach is the use of a more mechanical and specific anti-abuse rule that requires satisfaction of a series of tests in order to qualify for treaty benefits (a limitation on benefits (LOB) rule).

Currently, only the Canada-U.S. Treaty has adopted a LOB rule, and several treaties have adopted a limited PPT. Going forward, Canada will consider either approach, depending on the particular circumstances and discussions with Canada's tax treaty partners. Amendments to Canada's tax treaties to include a treaty anti-abuse rule could be achieved through bilateral negotiations, the multilateral instrument, or a combination of the two. The multilateral instrument, which is to be developed in 2016, is a tax treaty that many countries could sign, modifying certain provisions of existing bilateral treaties. The 2016 Budget notes that Canada is actively participating in international work to develop the multilateral instrument, which the government expects will streamline the implementation of treaty-related BEPS recommendations, including treaty abuse.

Interestingly, no reference is made to the 2014 proposal to unilaterally implement a PPT. Given this and the broadening of the BTB measures, it may now be safely inferred that the government has no intention to proceed with such a measure.

Surplus Stripping

The Income Tax Act (ITA) contains an "anti-surplus-stripping" rule that generally prevents a non-resident shareholder from entering into a transaction to extract free of tax (or "strip") a Canadian corporation's retained earnings (or "surplus") in excess of the paid-up capital (PUC) of its shares. It generally applies where a non-resident (seller) transfers shares of a Canadian corporation (target) to another related Canadian corporation (buyer). The rule deems buyer to have paid a dividend to seller equal to the excess of the cash or other non-share consideration over the PUC of the target shares. To the extent the consideration given by buyer consists of buyer shares, the PUC of these shares is limited to the PUC of the transferred target shares. PUC is the amount that can be returned to shareholders free of tax. It is a key component of "equity" under the thin capitalization rules and it supports a foreign-controlled Canadian corporation's ability to make investments in its non-Canadian subsidiaries under the foreign affiliate dumping rules.

This rule contains an exception (the control exception) that applies where buyer controls seller. Such a situation would arise, for example, where a Canadian purchaser corporation acquires a non-resident target corporation that happens to own Canadian subsidiaries. The exception facilitates the unwind of the resulting "sandwich" structure, enabling the buyer to rationalize its structure without running afoul of the surplus stripping rule.

It is well known that the control exception has been used in many settings to facilitate debt push-downs and otherwise to step up PUC. The government has scrutinized some of these arrangements, and at least two cases have been appealed to the Tax Court of Canada. Evidently, the government has now decided that, going forward, the control exception should be narrowed significantly, thereby shutting down many previously existing opportunities.

The 2016 Budget proposes to amend the control exception, stating that it seeks to address situations where non-resident corporations with Canadian subsidiaries have "misused this exception by reorganizing the group into a sandwich structure with a view to qualifying for the exception as part of series of transactions designed to artificially increase the PUC of the shares of such Canadian subsidiaries." The government acknowledges that such transactions are already being challenged under the existing provisions of the ITA, but asserts that the new measure is intended to promote certainty and to "clarify" the intended scope of the existing exception.

As amended, the control exception will not apply where, either immediately before the disposition, or at any time in the "series of transactions", any shares in buyer are owned by a non-resident person that does not deal at arm's length with the top tier Canadian corporation, regardless of whether the transaction in question is a new acquisition by the Canadian purchaser corporation or a reorganization of an existing corporate structure. As the concept of a "series of transactions" is very broad, this change could have unintended effects on ordinary commercial transactions involving an acquisition by a Canadian corporation of a foreign corporation with Canadian subsidiaries. The measure also includes a potentially punitive rule that applies where the non-resident vendor does not receive any consideration (such as on a wind-up or an in-kind dividend). In that circumstance the non-resident vendor is deemed to receive non-share consideration equal to the fair market of the subject Canadian shares (except to the extent of any increase in the fair market value of the Canadian purchaser corporation's shares).

This measure will apply in respect of dispositions occurring on, or after, March 22, 2016.

Shareholder Loans and Canadian Subsidiary Guarantees

Currently, where a person (other than a Canadian corporation) that is a shareholder of a Canadian corporation or is not dealing at arm's length with such a shareholder becomes indebted to the Canadian corporation, subject to certain exceptions the amount of the indebtedness is included in the debtor's income on the basis that such debt is, in substance, equivalent to a distribution of the corporation's profits. Where the debtor is a non-resident, this amount is deemed to be a dividend subject to withholding tax.

In contrast to some other jurisdictions, Canada does not generally treat the provision of guarantees (secured or otherwise) by a Canadian member of a corporate group to its non-resident parent as a deemed distribution.

The 2016 Budget introduces a targeted BTB measure similar in form to the other BTB rules, which applies to circumstances where a shareholder of a Canadian corporation owes an amount to an intermediary, and the intermediary either (i) owes an amount to the Canadian corporation and, generally, that receivable supports the debt owing to the intermediary, or (ii) the intermediary has a "specified right" granted by the Canadian corporation (such as certain secured guarantees). "Specified right" is to have the same meaning as in the existing BTB loan rules. 

The focus of this measure appears to be on using an otherwise unconnected third-party intermediary to circumvent the shareholder loan rules, just as it was when the BTB loan rules were first introduced in the 2014 Budget. However, the specified right component of the test could potentially impact the provision by Canadian subsidiaries of secured guarantees to non-resident members of the corporate group (except its subsidiaries). Presumably the intended effect of these rules is not to interfere with legitimate commercial lending arrangements. However, based on experience with the current BTB loan provisions, the application of this new rule to certain atypical secured guarantee arrangements may need to be considered. As a result, Canadian tax advice should be sought where Canadian members of a corporate group provide secured guarantees of indebtedness to other group members.​

The shareholder loan BTB measure will apply to arrangements as of March 22, 2016. For arrangements in place as of such date, the indebtedness will be deemed to have become owing on such date.

Other BEPS Measures

The 2016 Budget reiterates that Canada has been actively engaged in the multilateral efforts of the G20 and the OECD to address BEPS. BEPS refers generally to the perceived shifting by multinational enterprises (MNEs) of income from high-tax jurisdictions to low-tax jurisdictions. The Action Plan on BEPS was first released in July 2013, and was followed up with a series of final reports in October 2015. Canada and the other G20 members endorsed the package of recommendations developed under the BEPS project, and the 2016 Budget includes the following measures:

Country-by-Country Reporting

Item 13 of the OECD Action Plan on BEPS, entitled "Transfer Pricing Documentation and Country-by-Country Reporting", contemplates multilateral or bilateral agreements between participating states providing for the collection and exchange by their respective tax authorities of standardized transfer pricing documentation and country-by-country (CbC) reporting for MNEs. Such CbC reporting would include information concerning revenue, profit, tax paid, stated capital, accumulated earnings, number of employees, tangible assets and the main activities of each of its subsidiaries. The stated purpose of the requirement to produce CbC reports and of the exchanges by countries of these reports is risk assessment, i.e. to enable the affected countries to assess perceived high-level transfer pricing risks and other BEPS-related risks.

The 2016 Budget proposes to implement CbC reporting, applicable to MNEs with total annual consolidated group revenue of €750-million or more. Where such an MNE has an ultimate parent entity that is resident in Canada (or, in certain cases, a Canadian resident subsidiary), it will be required to file a CbC report with CRA within one year of the end of the fiscal year to which the report relates. The 2016 Budget indicates that, before any exchange with another jurisdiction, CRA will formalize an exchange arrangement with the other jurisdiction and will ensure that it has appropriate safeguards in place to protect the confidentiality of the reports.

The 2016 Budget contemplates that CbC reporting will be required for taxation years that begin after 2015; most taxpayers that will be subject to these rules will be required to file their first CbC reports in Canada at the end of 2017. First exchanges between jurisdictions of CbC reports are expected to occur by June 2018. There were no draft legislative proposals included in the 2016 Budget, but these are expected to be released for comment in the coming months.

Revised Transfer Pricing Guidance

The 2016 Budget reiterates the principle that transfer prices for intra-group transactions within an MNE should meet the international arm's length standard, which principle is enshrined in domestic law in section 247 of the ITA and in Article IX of most of Canada's bilateral tax treaties. In Canada, the OECD Transfer Pricing Guidelines are endorsed in CRA's published administrative guidance on applying the arm's length principle. The Supreme Court of Canada has made clear that the OECD Transfer Pricing Guidelines are not law in Canada, but may provide relevant guidance in this regard (like other extrinsic interpretive aids).

The BEPS final reports include proposed revisions to the OECD Transfer Pricing Guidelines. The 2016 Budget describes these proposed revisions as clarifications, and states that they support CRA's current interpretation and application of the arm's length principle. The proposed revisions are thus being applied currently by CRA because they are consistent with CRA's current practices. Two exceptions to this position are the yet-to-be-finalized BEPS guidance on "low value-adding services" and "risk-free" as opposed to "risk-adjusted" returns for "cash box" entities.

While it is premature to offer substantive comment on the intended application of the proposed October 2015 revisions to the OECD Transfer Pricing Guidelines, it should be noted that there are likely to be legal issues that will need to be considered and addressed. For example, there may be legal impediments to the application of the revised guidance in audits of transactions that were completed before October 2015 or in the application of the provisions of a bilateral treaty concluded before any revision of the OECD Transfer Pricing Guidelines. The resolution of such issues may depend in part on whether the revisions are properly characterized as clarifications of prior rules or guidance or whether they go further. Another issue expected to be raised will be the resolution of conflicts between the proposed revisions and Canadian domestic law, including the legal principle that legal relationships are to be respected absent specific statutory authority to the contrary.

Spontaneous Exchange of Tax Rulings

The BEPS project developed a framework for the spontaneous exchange of certain tax rulings that could give rise to BEPS concerns in the absence of such exchange. The 2016 Budget confirms that the government intends to implement the BEPS minimum standard for the spontaneous exchange of certain tax rulings, and that CRA will commence exchanging tax rulings in 2016 with other jurisdictions that have committed to the minimum standard. CRA announced, contemporaneously with the introduction of the 2016 Budget, that its Income Tax Rulings Directorate will be updating its published guidance (Information Circular IC 70-6) to outline the types of rulings potentially subject to this exchange, the process CRA will follow in performing the exchange and the additional information that it will require in respect of requests for rulings within the scope of the exchange initiative. Presumably CRA's processes will also need to have regard for its legislated privacy and confidentiality obligations to Canadian taxpayers.

Common Reporting Standard

The 2015 Budget had announced that Canada intended to implement another project initiated by the OECD, the development of a common reporting standard (CRS) for the automatic exchange of information among participating countries. While CRS may have its origins in the U.S. Foreign Account Tax Compliance Act (FATCA) rules, it is in many respects different from FATCA; one key difference is that CRS does not impose withholding obligations as a consequence of compliance failures or non-participation.

CRS will require CRA to collect information from Canadian financial institutions concerning financial accounts maintained by them for residents of participating countries, and to provide such information to the tax authorities of those participating countries. The goal stated in the 2015 Budget was to implement CRS as of July 1, 2017, with the first exchange of information occurring in 2018. The 2016 Budget reiterates the government's intention to proceed with CRS, but did not provide further details. 

DOMESTIC BUSINESS MEASURES

Secondary Market Sales of Structured or "Linked" Notes

Structured or "linked" notes have become a popular investment product in Canada. Such notes, which offer a return linked to the performance of an underlying reference asset such as an equity index, are generally "prescribed debt obligations", with the result that they are subject to deemed interest accrual rules. Under these rules, any positive return paid on such notes at maturity is normally treated as interest.

CRA's historic administrative policy with respect to linked notes has generally been not to require any accrual of interest on such a note until such time as the amount payable at maturity, or any minimum amount payable at maturity, becomes calculable or "locked-in". Based in part on this policy, Canadian taxpayers generally take the position that any gain arising on a disposition of such a note in the secondary market prior to the time on which the amount payable at maturity is calculable is eligible for capital gains treatment (meaning only one half of such gain is included in income).

The 2016 Budget proposes to override capital gains treatment on secondary market dispositions of linked notes by deeming a portion of the price for which such a note is purchased on the secondary market to be interest (ordinary income), thereby doubling the investor's effective tax rate. This rule would apply regardless of whether a gain on the reference asset itself, if acquired directly by the taxpayer instead of a structured note, would have been on income or capital account.

The amount deemed to be interest is generally calculated as the amount by which the secondary market sale price of a note exceeds the remaining principal amount of the note (taking into account any partial principal repayments made before the sale in the case of notes such as return of capital (or RoC) notes, which provide for partial repayments of principal over the life of the notes). For notes denominated in a foreign currency, exchange rate fluctuations are ignored for purposes of this calculation. There is also an exception for any portion of that excess that is reasonably attributable to any increase in value of fixed rate interest payments under the notes due to a decrease in market interest rates.

This measure will apply to dispositions of structured notes beginning on October 1, 2016. No grandfathering is proposed for structured notes issued before March 22, 2016.

Valuation of Derivatives

The recent Tax Court of Canada decision in Kruger Incorporated v. R. (Kruger) held that certain derivatives held by a taxpayer as trading assets in a business of trading in such derivatives could qualify as inventory for tax purposes and, as such, could be written down to the lower of cost or market (LCM) under the inventory valuation rules in the ITA. The 2016 Budget materials indicate that a broad application of LCM valuation to derivatives could lead to significant tax base concerns.

The 2016 Budget proposes to effectively override the Kruger decision by excluding derivatives (including swaps, forward purchase or sale agreements, forward rate agreements, option agreements and similar agreements) from the inventory valuation rules in the ITA, while otherwise maintaining the status of such property as inventory. A more general rule is also proposed to ensure that the LCM method is not used to generate deductions in computing profit from a derivatives business under general principles.

This measure will apply to derivatives entered into on or after March 22, 2016. It should be noted that neither of the proposed measures purports to impact taxpayers who account for derivatives by reporting both gains and losses on a mark-to-market basis.

Attack on Switch Funds

A number of mutual funds are marketed as "switch funds". These funds are structured in corporate form, and permit holders to "switch" among different investment strategies on a tax-free basis by means of a share conversion. This would, for example, enable an investor who wants to reduce exposure to, say, foreign equities in favour of Canadian equities to do so on a tax-free basis.

Somewhat surprisingly, the government has now decided that this ability to switch on a tax-free basis should be denied. The 2016 Budget proposes a new legislative measure under which a share conversion in a mutual fund will generally be a taxable event. A narrow exception is provided for conversions where the shares received in exchange differ only in respect of management fees or expenses to be borne by investors and otherwise derive their value from the same portfolio or fund within the mutual fund corporation.

The new measure will apply starting October 1, 2016, with no grandfathering for investments made before March 22, 2016. It appears likely that the investment industry will make submissions to the government with respect to both the appropriateness of the measure and the absence of grandfathering. The government estimates that this measure will generate approximately C$75-million of new revenue annually starting in 2017.

Labour-Sponsored Venture Capital Corporations (LSVCCs)

The previous government had initiated the gradual phase-out of the tax credits formerly available to investors in LSVCCs. The incoming government's election platform included a promise to reinstate those credits in full, and that promise appears to have been fulfilled. The 2016 Budget proposes to restore the federal credit in respect of provincially registered LSVCCs and otherwise halts and in some cases reverses the phase-out of the federal LSVCC program.

Debt Parking to Avoid Foreign Exchange Gains

Since income for tax purposes must generally be computed in Canadian dollars, taxpayers who have issued foreign currency-denominated debt may realize a capital gain or loss as a result of foreign exchange fluctuations between the time the debt is issued and the time it is settled. However, under the debt forgiveness rules, such foreign exchange gains or losses are disregarded in computing any "forgiven amount". In principle, debtors could seek to avoid such gains by arranging for a non-arm's length non-resident to purchase the debt at face value from the holder of the debt, and leave the debt outstanding indefinitely so as not to trigger a gain. While the debt would be considered settled under the existing "debt parking" rules, these rules would not capture the foreign exchange component. The 2016 Budget proposes the introduction of measures designed to prevent debtors from avoiding foreign exchange gains through such "debt parking" arrangements. With some exceptions, this proposal will apply to a foreign currency debt that meets the conditions to become a parked obligation on or after March 22, 2016.

Eligible Capital Property

The 2014 Budget announced a public consultation on a proposal to repeal the current tax regime dealing with goodwill, trademarks and certain other intangibles (known as "eligible capital property" or ECP) and replace it with a new class of depreciable property. The primary goal was a simplification of the tax rules relating to these types of property.

That consultation is now complete and the 2016 Budget proposes to repeal the ECP regime and replace ECP with a new class of depreciable property. The full amount of such capital expenditures will be added to the new class, and will be depreciable at five per cent per year. Unlike the ECP regime, the "half-year rule" will apply, thereby reducing the deduction available in the year of acquisition. On the other hand, upon sale, any proceeds received above original cost will be treated as a capital gain, enabling taxpayers to use capital losses to offset those gains (the use of capital losses in this manner is not permitted for ECP gains).

The new regime takes effect January 1, 2017, and there are transitional rules that are intended to ensure appropriate treatment of existing ECP balances.

Canadian-Controlled Private Corporations (CCPCs)

The 2016 Budget contains a number of measures impacting CCPCs. There will be no further reductions to the current small business tax rate of 10.5 per cent (the small business deduction (SBD)), which generally applies on the first C$500,000 of annual active business income. This reverses the Conservative government's previously-announced plan to reduce the rate to nine per cent by 2019. The 2016 Budget also contains anti-abuse measures intended to prevent certain planning to multiply access to the SBD. 

GST/HST MEASURES

There were no major GST/HST changes relevant to the business community in the 2016 Budget, but there are several GST/HST-related amendments that are intended to clarify or correct known issues with the application of certain GST/HST rules. For example, under the current legislation, a person may be considered a "de minimis financial institution" where its income from interest earned on investments, or fees or other charges associated with the lending of money or the granting of credit during the previous year, exceeded C$1-million. As a result of this treatment, persons who earn significant interest income through bank deposits are subject to restrictive rules that were generally intended to apply only to active participants in the financial services industry. The 2016 Budget proposes amendments to correct this problem.

The 2016 Budget also includes amendments to correct known issues with the GST/HST self-assessment obligations in connection with reinsurance premiums. The Department of Finance had already issued a letter to the insurance industry clarifying its policy intent, and CRA had issued GST/HST Notice No. 287 to announce its intention to follow the Department of Finance's policy intentions. The 2016 Budget incorporates amendments that are intended to address these issues, though it remains to be seen whether these amendments have any broader impact.

The 2016 Budget also adds stringency to the definition of "closely related" parties, which is relevant for the availability of certain GST/HST elections. The current test requires that the parent corporation or partnership own 90 per cent or more of the value and number of the shares of the subsidiary corporation that have full voting rights under all circumstances. However, due to the complexity of share capital structures, it has been suggested that a parent corporation or partnership could be considered to be closely related to a subsidiary corporation even if it lacks nearly complete voting control over the subsidiary corporation. Under the proposed amendments, a corporation or partnership must hold and control 90 per cent or more of the votes in respect of every corporate matter of the subsidiary corporation (with limited exceptions) in order to be considered closely related.

Finally, the 2016 Budget demonstrates that the Department of Finance has listened to the GST/HST community by including a new zero-rating provision for exported call centre services. Under the current legislation, there was some uncertainty whether a Canadian company that supplies call centre services to a non-resident, to respond to customer issues and complaints, may be required to charge GST/HST to the non-resident on the services. The 2016 Budget proposes to zero-rate certain exported supplies of call centre services providing certain conditions are met (i.e., at the time the supply is made it can reasonably be expected that the technical or customer support is to be rendered primarily to individuals who are outside Canada at the time the support is rendered). This measure may not meet the needs of all non-resident businesses with Canadian call centres, but it is helpful to have clear rules in this regard.

OUTSTANDING MEASURES

The government announced that it intends to proceed with a number of previously announced tax measures, "as modified, to take into account consultations and deliberations since their announcement".
These include:

• The "synthetic equity arrangement" rules, which can deny the dividends-received deduction on hedged shares where there is a tax-indifferent counter-party;
• The domestic capital gains anti-avoidance rule in section 55; and
• New certification rules for non-resident employers.

The government also affirmed its commitment to enact technical amendments "to improve the certainty of the tax system", suggesting that a bill incorporating technical amendments may be introduced in 2016, either as part of, or in addition to, the usual budget implementation bills.

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.