Copyright 2011, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Tax, March 2011
On March 22, the Canadian federal government released its much-anticipated 2011 budget (the Budget). The Budget contained no changes to tax rates but did include promises to keep tax rates down. No changes were proposed to the previously legislated corporate tax reductions, which will generally reduce the combined federal-provincial rate to 25% in most provinces within the next few years. A deficit of C$30-billion is projected for the current fiscal year. A modest surplus is predicted for the 2015-2016 fiscal year.
Early indications are that the Budget may not be passed into law, as the opposition parties in the current minority Parliament have stated that they will not be supporting the Budget. This may lead to a general election, with the potential for some or all of the Budget measures ultimately not being enacted. Experience would suggest, however, that many of the technical changes proposed in the Budget are likely to be enacted with effect as of March 22, 2011, whatever the outcome may be at the political level.
The Budget contains a number of amendments to the Income Tax Act (Canada) (the Act) which will impact corporate and individual taxpayers.
Corporate Tax Measures
(a) Anti-avoidance Provisions
Accrual taxation of partnership income earned by a corporate partner
The most significant corporate tax proposal and the most significant revenue generator in the Budget is a proposal to introduce a new regime for the taxation of partnership income earned by a corporation in respect of taxation years of the corporation ending after March 22, 2011. The new regime is designed to eliminate the potential for deferral of tax on partnership income earned by a corporation where the taxation year of the corporation ends before the fiscal period of the partnership.
Existing tax rules permit a deferral of up to one year where all members of a partnership are corporations. This is achieved by setting the partnership's fiscal year to end shortly after the corporate partner's year-end. Similar deferral was available before 1995 for partnerships with individual members and sole proprietorships, but changes introduced at that time ended deferral in those situations. The Budget proposes to similarly put an end to such deferral even where all members of the partnership are corporations.
The concept of the proposed change is straightforward. Where a corporate partner has a significant (generally exceeding a 10% threshold) partnership interest, the deferral otherwise available to such partner is eliminated. This is done either by means of a requirement for inclusion of "stub period" income (i.e., partnership income accrued in the corporation's tax year after the partnership's fiscal year-end which falls in that year) or alternatively by allowing a partnership of corporations to make a one-time election to change its fiscal year-end. The latter concept would be to match the partnership year-end with that of the corporate partners in order to avoid the complexity of a stub period calculation. Of course, if there are multiple significant corporate partners with different year-ends, the stub period calculation will continue to be necessary. Essentially, these proposed amendments would move the regime under the Act for the taxation of partnership income earned by a corporation from one in which recognition of income and losses are deferred to the end of the partnership's fiscal period to a regime where underlying partnership income will be accrued currently but losses are still deferred.
As in the case of the 1995 change, transitional relief is available where the new rules would result in two years' worth of partnership income being included in a single tax year of a corporate partner. This relief is in the form of a reserve under which none of the "extra income" is taxed in 2011, 15% is taxed in 2012, and the remainder is taxed over the subsequent four years.
Members of the Blakes Tax Group are working with our clients to assess the best strategy to be employed in cases where these new rules will apply.
Details of Proposed Change
As noted above, a corporation which is a member of a partnership will be required to include in income for each taxation year of the corporation, in addition to such corporation's share of the partnership's income for the fiscal period of the partnership which ends during such taxation year, an additional amount in respect of the corporation's share of partnership income for the period beginning immediately after the end of the partnership's fiscal period and ending at the end of the corporation's taxation year (the Stub Period). The corporation's actual share of the partnership income for a fiscal period will continue to be included in income in the taxation year in which the fiscal period ends. However, income for a Stub Period would be deducted from the corporation's share of the partnership's income for the fiscal period which includes such Stub Period.
A corporate partner will have the option of calculating Stub Period income for its taxation year based on a formula which computes the corporate partner's share of the partnership's income for the fiscal periods ending in the year pro-rated for the number of days in the Stub Period, or to designate a lower amount in respect of the Stub Period. For these purposes, dividends received by the partnership are not included in calculating partnership income, and the corporate partner may also elect to apply certain resource expenditures incurred by the partnership to the end of the corporation's taxation year to reduce such Stub Period income.
If a lower amount is designated and the partnership's actual pro-rated income for the Stub Period (determined at the end of the fiscal period of the partnership) exceeds the designated amount, the excess would be included as additional income in the corporate partner's income for the taxation year which includes the end of the relevant fiscal period, plus interest calculated at the rate prescribed for underpayments of tax over the applicable period. The income inclusion would be increased by 50% to the extent that the excess amount is greater than 25% of the lesser of the amount calculated using the formula described above and the actual pro-rated amount.
The Budget proposals provide that a corporation's Stub Period income inclusion in respect of a particular partnership cannot be less than zero. As a result, a corporate member of multiple partnerships would not be permitted to deduct losses realized by one partnership during the Stub Period to offset the Stub Period income inclusion from another partnership.
Election to change fiscal period
The Budget proposes to permit a partnership to make a one-time election to change its fiscal period provided the following conditions are satisfied:
(i) the last day of the new fiscal period must be after March 22, 2011 and no later than the last day of the first taxation year ending after March 22, 2011 of a corporate partner that has been a partner continuously since March 22, 2011;
(ii) at least one of the corporate partners of the partnership would, in the absence of the election, be required to include an amount in income in respect of a Stub Period for its first taxation year ending after March 22, 2011; and
(iii) all members of the partnership are corporations other than professional corporations.
Such election would need to be made in writing and filed by the earliest of all filing-due dates for each partner's income tax return for its taxation year in which the new fiscal period ends. If such an election results in the partner having two partnership fiscal periods ending in the taxation year, then the income for the second period will be eligible for the transitional relief described below.
This election may permit the corporate members of a partnership to avoid including Stub Period income under the new regime to the extent such members have the same taxation year-end, but would be of more limited assistance where a partnership has corporate partners with different taxation year-ends.
Corporations which would be required to include Stub Period income in respect of a partnership under the proposed rules for their first taxation year ending after March 22, 2011 may be eligible to claim a reserve equal to the amount of such income for taxation years ending in 2011. Income eligible for transitional relief must be computed using the maximum available permissive deductions. Thus, the ability to maximize transitional relief will be limited. The effect of this reserve will generally be to spread the immediate income inclusion resulting from the Budget proposals over the 2012 through 2016 calendar years. This should at least delay the effect of the loss of deferral until 2012 in most cases, thereby mitigating exposure for interest on deficient tax instalments.
The transitional reserve described above, however, will be available to a corporation only to the extent that the corporation has current-year income. As a result, a corporate partner which is otherwise in a loss position would be required to apply those losses to reduce the transitional reserve otherwise available and would only be entitled to claim a reserve on any remaining transitional reserve. While the deferral strategy will typically have been employed in situations in which the business of a partnership is profitable, there will no doubt be situations in which these rules apply to partnerships whose corporate members have a current-year loss.
Multi-Tiered Partnership Structures
For multi-tiered partnership structures, the Budget proposes to require that all partnerships within such a structure have the same fiscal period. Similar accrual and transitional rules to the rules described above are proposed with respect to Stub Period income earned by a corporate partner through such multi-tiered partnership structures.
Stop-loss rules applicable to share redemptions
The Act includes certain "stop-loss rules" that limit the loss a corporation will realize on the disposition or redemption of a share on which a corporation has received, or is deemed to have received, tax free dividends. These stop-loss rules generally do not apply in respect of a share if the share is held for more than 365 days and the shareholder (and non-arm's length persons) owns 5% or less of the class of shares on which the dividends were received (or were deemed to be received).
If this exception applies in a situation where the adjusted cost base of the redeemed share exceeds its paid-up capital, the redemption may give rise to a loss. This could result in a "double deduction", which the government now seeks to stop.
The Budget proposes to prevent this result by extending the stop-loss rules to any deemed dividend received on the redemption of a share held by a corporation, other than dividends deemed to be received on the redemption of a share of a private corporation held by another private corporation that is not a financial institution. This extension to the stop-loss rules will apply to redemptions that occur on or after March 22, 2011.
(b) Capital Cost Allowance Measures
The Budget proposes that the temporary accelerated depreciation or "capital cost allowance" (CCA) rate of 50% per year for equipment acquired by a taxpayer primarily for use in Canada for the manufacturing or processing of goods for sale or lease, which had been set to expire after 2011, will be extended for two years, and will apply to eligible machinery and equipment acquired before 2014. Manufacturing and processing equipment acquired after 2013 will be eligible for CCA at a rate of 30% unless the accelerated rate is further extended.
The Budget also proposes to expand the types of clean energy generation equipment which will be eligible for accelerated CCA at an annual rate of 50%. In addition to the types of equipment currently eligible for the accelerated rate, the Budget proposes to extend the 50% CCA rate to equipment acquired after March 22, 2011 which is used by a taxpayer, or the lessee of a taxpayer, to generate electricity using waste heat.
(c) Intangible costs incurred in respect of oil sands projects
The Budget also proposes changes to the treatment of certain
intangible costs arising in respect of oil sands projects. This
builds on proposals originally announced in 2007 to align deduction
rates in the oil sands sector with rates applicable to conventional
oil and gas projects. Specifically, the Budget proposes that the
cost of oil sands leases and other oil sands property, currently
deductible at a rate of 30% per year as Canadian development
expense (CDE), will be treated instead as Canadian oil and gas
property expense (COGPE), which is deductible at the lower rate of
10% per year. This change would be effective for acquisitions made
on or after March 22, 2011.
In addition, certain pre-production development costs for oil sands mines, which are currently (in some cases) fully deductible in the year incurred as Canadian exploration expense (CEE), will be treated as CDE (deductible at a rate of 30% per year as described above).
The new CDE treatment for pre-production development costs will not apply to expenses incurred before 2015 for new mines on which major construction began before March 22, 2011. For other pre-production development costs incurred after March 22, 2011, CDE treatment will be gradually phased-in starting in 2013, with the transition from CEE to CDE to be fully implemented by 2016.
(d) Extended definition of qualifying environmental trusts
The qualifying environmental trust (QET) rules in the Act permit taxpayers to set aside funds for the future reclamation of mines, quarries or waste disposal sites in a tax effective manner by permitting an operator of such a site to receive a current year deduction for amounts settled on the QET. The QET is taxed at the trust level on income earned, and the operator is also subject to tax on such income, but can claim a refundable credit for tax paid in the QET. Withdrawals from the QET are subject to tax in the hands of the operator but generally at that time the operator will be able to claim an offsetting deduction in respect of reclamation costs incurred.
The current-year deduction assists operators who set aside amounts to be used for reclamations where the trust is mandated by law or a contract with the federal Crown or a province. Absent these rules, no deduction would be permitted until the reclamation started and reclamation costs were actually incurred.
In 2009, the National Energy Board (NEB) announced that pipeline operators would be required to set aside funds on a current basis to fund reclamation costs related to pipeline abandonment. The Budget proposes to extend the definition of a QET to include trusts mandated by the NEB or any other tribunal constituted by a law of Canada or a province, and also to specifically include trusts created in connection with the reclamation of property primarily used for the operation of a pipeline where the trust is mandated by law or a contract with the federal Crown or a province. These changes would apply for 2012 and later taxation years for trusts created after 2011.
The Budget also proposes to expand the types of investments which qualify as eligible investments for a QET to generally include debt of public corporations, investment grade debt and securities listed on a designated stock exchange. However, a QET will not be permitted to invest in any debt or security issued by a person or partnership that has contributed property to or is a beneficiary under the QET, a person related to or a partnership affiliated with such a person or partnership, or a person or partnership in which a contributor to or beneficiary of the QET has a significant interest (generally 10% or above). These changes will apply to 2012 and later taxation years for trusts created after 2011. For trusts created before 2012, these changes will also apply to a particular taxation year and each subsequent taxation year of a trust that ends after 2011 if the trust and the government regulatory authority jointly so elect.
Personal Tax Measures
(a) Registered Retirement Savings Plans
The Budget proposes to add a number of anti-avoidance rules in respect of registered retirement savings plans (RRSPs). The proposed rules are similar to those that currently apply to tax-free savings accounts.
The annuitant under an RRSP will be required to pay a tax equal to the fair market value of any "advantage" obtained by the RRSP, unless the advantage is extended by the issuer, in which case the issuer will pay the tax. An advantage includes benefits of any kind conferred on an RRSP which would not arise in an arm's length situation, payments made to an RRSP in lieu of payments for services, payments of investment income to an RRSP that are tied to non-RRSP investments, benefits from swap transactions, income from non-qualified investments that are not removed from the RRSP within a certain time frame and income from "prohibited investments".
The Budget also specifically targets "RRSP strip" transactions, proposing that benefits from any RRSP strip transaction be taxable as an advantage. An RRSP strip transaction is any transaction, one of the main purposes of which is to enable the annuitant, or a non-arm's length person, to access RRSP assets without including the appropriate amount of income.
Where an RRSP holds a "prohibited investment", in addition to income therefrom being taxed as an advantage as described above, the RRSP annuitant will pay a tax equal to 50% of the fair market value of the prohibited investment when it is acquired. This tax will generally be refunded if the prohibited investment is disposed of within one year from the end of the year in which it is acquired. Prohibited investments include debt of the RRSP annuitant and any security of an entity in which the RRSP annuitant (or a non-arm's length person) owns 10% or more, or with which the RRSP annuitant does not deal at arm's length.
The Budget also proposes to replace the existing rules relating to non-qualified investments owned by an RRSP with a tax equal to 50% of the fair market value of the non-qualified investment. Generally, the tax is refunded if the non-qualified investment is disposed of prior to the end of the year after it is acquired or becomes non-qualified.
These new provisions are proposed to be effective immediately, subject to two exceptions. The advantage rules will not apply to swap transactions undertaken before July 2011, and swap transactions to remove prohibited investments or an investment which gives rise to an advantage are permitted until the end of 2012. Income generated from prohibited investments, including capital gains accruing after March 22, 2011, is subject to the new advantage rules. For prohibited investments owned on March 22, 2011, the new 50% tax will not apply until January 1, 2013. If the prohibited investment is still held on that day, it will be treated as having been acquired on that day.
(b) Split Income or "Kiddie Tax"
The Act currently contains a so-called "kiddie tax" (the Kiddie Tax) to prohibit individuals from splitting income with minor children and benefitting from lower marginal tax rates. Income subject to the Kiddie Tax is taxed at the highest marginal tax rate. The Kiddie Tax currently applies to dividends on private company shares and to income from a partnership or trust generated by providing property or services to a business carried on by a person related to the child or in which the related person participated.
The Budget proposes to extend the Kiddie Tax to capital gains realized on a non-arm's length sale of shares. The measure effectively counters plans to avoid the Kiddie Tax by not paying dividends and instead realizing capital gains on a sale of the shares to the parent. This measure is punitive, as a dividend is fully included in income (as opposed to a capital gain, only one half of which is included) and is not eligible for the lifetime capital gains exemption. The proposal applies to dispositions on or after March 22, 2011.
(c) Extension of Mineral Exploration Tax Credit
The Mineral Exploration Tax Credit, which is currently scheduled to expire at the end of March 2011, allows individuals who have invested in qualifying flow-through shares to obtain a tax credit equal to 15% of specified mineral exploration expenses incurred in Canada by the issuer of the shares and renounced to such investors. The Budget proposes extending its eligibility by one year, to flow-through share agreements entered into on or before March 31, 2012.
(d) Donations of Flow-Through Shares
The Budget proposes to restrict the capital gain exemption which currently applies to donations of publicly traded flow-through shares. With the current federal and provincial mineral exploration tax credits, flow-through deductions, capital gain exemption and the charitable tax credit or deduction, a person can generally acquire and donate flow-through shares with little out-of-pocket cost. The Budget proposes to limit the capital gain exemption on donation of flow-through shares to gains beyond the original cost of such shares. In other words, the difference between the flow-through shares' adjusted cost base (nil) and their fair market value at the time of donation will be subject to tax as a capital gain except to the extent the fair market value exceeds the original cost of the shares (ignoring the flow-through share adjustments to adjusted cost base). Thus, a gain that arises solely due to the tax credits and flow-through deductions will be subject to tax, and only a real economic gain will benefit from the exemption. Additionally, an anti-avoidance rule will apply to the donation of flow-through shares acquired by a donor in a tax-deferred (i.e., rollover) transaction. The proposals will apply where a taxpayer acquires shares issued pursuant to a flow-through share agreement entered into on or after March 22, 2011.
(e) Other Donation Issues
The Budget proposes to permit the Minister of Finance to reassess a taxpayer to deny all or a portion of a charitable donation or deduction if gifted property is subsequently returned to a taxpayer. Also, the charity will be required to issue a new receipt.
The Budget also proposes to change the timing of deductions where non-qualifying securities (NQS) of a taxpayer are gifted to a registered charity. An NQS of a taxpayer is generally a share, debt obligation or other security issued by the taxpayer or a person who does not deal at arm's length with the taxpayer. Listed securities are excluded from the NQS definition. The Budget proposes that the tax consequences of the gift of the NQS be deferred until such time, within five years from the date of the actual gift, as the qualified donee disposes of the NQS for consideration that is not an NQS to any person. An anti-avoidance rule will also be implemented to stop charities from simply trading one NQS for another through a series of transactions.
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.