The Minister of Finance delivered the 2012 Canadian federal budget on March 29, 2012. Budget 2012 continues the government's practice of selectively adopting recommendations of the 2008 government-mandated Advisory Panel, by including significant changes to the Canadian thin capitalization rules and rules targeting transactions sometimes referred to as "debt dumping".
Budget 2012 includes a number of other significant proposals, including tax avoidance rules targeting sales of partnership interests and a reduction in the available tax incentives under the Scientific Research and Experimental Development regime. Additional proposals include, among other things, relieving changes in respect of eligible dividend designations, the codification of the CRA's administrative practice with respect to secondary adjustments under the transfer-pricing rules and rules imposing limitations on charities.
Thin Capitalization Rules
Canada's thin capitalization rules limit the deductibility of interest expense of a Canadian-resident corporation in respect of debt owing to certain non-residents where the amount of the debt exceeds two times the equity contributed by such non-residents and retained earnings. These rules do not currently apply to partnerships or trusts.
In December 2008, the government-mandated Advisory Panel on Canada's System of International Taxation (the "Advisory Panel") made a number of recommendations relating to the thin capitalization rules, including reducing the debt-to-equity ratio from 2-to-1 to 1.5-to-1 and extending the rules to partnerships, trusts and Canadian branches of non-resident corporations.
To address these recommendations in part, Budget 2012 proposes the following three main changes to the thin capitalization rules:
- The debt-to-equity ratio is reduced from 2-to-1 to 1.5-to-1 for taxation years that begin after 2012.
- The application of the thin capitalization rules is extended to debts of partnerships of which a Canadian-resident corporation is a member. The application of the thin capitalization rules to partnerships will apply for taxation years that begin on or after March 29, 2012.
- Disallowed interest under the thin capitalization rules is treated as dividends for withholding tax purposes. This recharacterization rule is to apply for taxation years that end on or after March 29, 2012.
An Annex to the budget document suggests that reducing the debt-to-equity limit to 1.5-to-1 will result in $310 million of tax revenues to the Canadian federal government over a five-year period.
In the case of partnerships having a Canadian-resident corporate partner, debt obligations of the partnership will be allocated to its partners based on their proportionate interest in the partnership. In circumstances where a corporate partner's permitted debt-to-equity ratio is exceeded, the partnership's interest deduction will not be denied, but an amount equal to the amount of the excess interest expense will be included in computing the income of the partner. The source of this income inclusion will be determined by reference to the source against which the interest is deducted at the partnership level.
Budget 2012 proposes to recharacterize disallowed interest expense as a dividend for non-resident withholding tax purposes, which was not a recommendation of the Advisory Panel. This recharacterization rule is likely a result of the elimination of withholding tax on related-party interest paid to U.S. residents entitled to the benefits of the Canada-U.S. tax treaty.
Budget 2012 does not extend the thin capitalization rules to trusts and Canadian branches of non-resident corporations as was suggested by the Advisory Panel. While technical changes are made with respect to interest paid to foreign affiliates that is subject to thin capitalization limits, there is no attempt to address the many anomalies in these rules.
Addressing another of the Advisory Panel's recommendations, Budget 2012 includes proposals targeting "debt dumping". Although there are many variations of these transactions, they generally involve a non-Canadian parent transferring shares of a non-Canadian subsidiary to a wholly owned Canadian corporation for inter-company debt and shares of the Canadian corporation. The issuance of shares by the Canadian corporation is generally to comply with the debt-to-equity thin capitalization limit. The interest on the intercompany debt is deductible by the Canadian corporation, but the income from the foreign subsidiary is generally exempt from Canadian taxation under Canada's foreign affiliate system. This allows the Canadian corporation to use the interest expense on the inter-company debt to shelter income from its existing Canadian operations. An Annex to the budget document suggests that, in the absence of these measures, debt dumping transactions would cost the Canadian federal government approximately $1.3 billion in tax revenues over a five-year period.
The proposed debt dumping provisions will apply where a Canadian corporation is controlled by a non-resident parent, the Canadian corporation makes an investment in a foreign corporation that becomes a "foreign affiliate" of the Canadian corporation and the investment may not reasonably be considered to have been made by the Canadian corporation (rather than by the foreign parent or another foreign person that does not deal at arm's length with the Canadian corporation) primarily for bona fide purposes other than to obtain a tax benefit. Factors that are to be given primary consideration in applying this bona fide purpose test are listed and include, among others, whether the business activities of the foreign subsidiary is more connected to those of the Canadian corporation or the foreign members of the group, whether the Canadian corporation only acquired a preference-share-type interest in the foreign subsidiaries, whether the investment was made by the Canadian corporation at the direction or request of a non-arm's length foreign corporation and whether Canadian-resident officers of the Canadian corporation initiated the negotiations and had principal decision-making authority in respect of making the investment. The specific introduction of an economic substance test through this list of factors is a departure in Canadian tax legislation.
Where the new rules apply, the consequences are as follows:
- The Canadian corporation is deemed to have paid, at the time it acquires the investment in the foreign subsidiary, a dividend to the foreign parent in an amount equal to the fair market value of any non-share consideration paid by the Canadian corporation for such acquisition. The dividend would be subject to non-resident withholding tax at a statutory rate of 25% that is reduced to 5% under many of Canada's tax treaties.
- No amount will be added to the Canadian corporation's tax paid-up capital in respect of any shares issued by the Canadian corporation in consideration for the acquisition of the investment in the foreign subsidiary. This will prohibit any addition in the equity component of the debt-to-equity thin capitalization ratio, and will impede the ability to extract assets from Canada on a tax-efficient basis in the future.
- No amount will be reflected in the contributed surplus of the Canadian corporation as a result of the acquisition of the investment in the foreign subsidiary for the purposes of: (i) the debt-to-equity thin capitalization ratio; and (ii) the rules allowing for a conversion of contributed surplus to tax paid-up capital without triggering a deemed dividend.
Corresponding rules apply where partnerships are involved.
These rules will apply for transactions on or after March 29, 2012, except in certain cases where the transaction occurs before 2013 and there was an obligation to complete the transaction before March 29, 2012 (and there is no provision allowing the parties to not complete the transactions because of amendments to the Income Tax Act (the "Tax Act")).
A separate provision under the heading of debt dumping will apply to generally increase the exit tax on the emigration from Canada of a Canadian corporation (the "emigrating corporation"), which has a Canadian corporate shareholder where that shareholder is itself controlled by a non-resident parent, regardless of whether the emigrating corporation or its Canadian parent had at any time undertaken any debt dumping transactions. This provision will apply to emigrations that occur on or after March 29, 2012.
Partnerships can provide opportunities in tax planning not available where other business vehicles are used. It is possible to transfer property to a partnership without recognizing any accrued gain, and a sale of partnership interests typically is taxed like a sale of shares – often resulting in a capital gain where an asset sale would result in much more tax. This would make a sale of a partnership interest to a tax-exempt purchaser much more attractive than a sale of assets, because the flow-through nature of the partnership means the tax-exempt purchaser will not pay tax on the income or gains of the partnership going forward, while the vendor will pay tax only at the favourable capital gains rate on the sale. The Tax Act has recognized this possibility through a specific anti-avoidance rule that increases the vendor's rate of tax on a sale of a partnership interest to a tax-exempt purchaser (by denying the 50% inclusion rate for capital gains) where the gain on the partnership interest is not related to increases in value of non-depreciable capital property of the partnership. This rule achieves its purpose, but applies much more broadly than is appropriate.
Budget 2012 proposes to extend the current anti-avoidance rule to additional circumstances involving partnerships that the Ministry of Finance considers to provide inappropriate tax benefits. First, the existing anti-avoidance rule is expanded in two ways. It will apply to dispositions to non-residents as well as tax-exempt persons, and it will apply to direct or indirect transfers to such persons. Transfers to non-residents will not be caught where all of the property of the partnership is used in carrying on a business in Canada through a permanent establishment. The concern is that Canada is not able to recapture depreciation or other tax shield claimed on partnership assets to reduce taxable income in prior years where the partnership interest is sold to a non-resident. This concern does not arise where the partnership assets are used in a permanent establishment in Canada, as the non-resident purchaser remains within the Canadian tax system in that case. However, like the existing rule, the new rule is much too broad. The protective carve-out does not exclude gain to the extent of assets used in a permanent establishment. It is an either/or test, and where even an extremely small amount of assets are not associated with the Canadian permanent establishment the exception does not apply at all. It is not at all clear why the carve out should be so unreasonably restricted.
Similar beneficial results can occur in "tax bump" transactions, which permit a purchaser of a Canadian corporation to increase, or "bump", the tax cost of certain of the target's assets – chiefly land, securities of other issuers and partnership interests – following an acquisition of control. Where the target's assets include a partnership interest, it is possible to bump the tax cost of the partnership interest and sell it to a tax-exempt purchaser without any tax being paid on the sale. The purchaser is indifferent between this and a purchase of assets (which would be taxable) as its income from the partnership will not be taxable going forward.
Budget 2012 proposes that the bump rules be changed where the asset being bumped is a partnership interest. The existing ability to bump the tax cost of the partnership interest to its fair market value at the time of the acquisition of the Canadian corporation will be restricted. The bump will be denied to the extent the fair market value of the partnership interest is attributable to accrued gain on underlying depreciable property or non-capital property, or to the value of resource properties. In each case, the fair market value of the underlying asset is to be determined without reference to associated liabilities. Assets held by corporate subsidiaries or trusts are not taken into account, but those held through other partnerships are. The proposal takes a broad approach by not distinguishing between operating partnerships and those that may have been established in order to facilitate bump planning.
These rules will generally apply for transactions that occur on or after March 29, 2012, except in certain cases where the transaction occurs before 2013 and there was an obligation to complete the transaction before March 29, 2012 (and there is no provision allowing the parties to not complete the transactions because of amendments to the Tax Act).
Scientific Research and Experimental Development ("SR&ED") Tax Credits
The current SR&ED rules provide a deduction for qualifying current and capital SR&ED expenditures and provide a 20% investment tax credit that may be applied against taxes payable. The rules also provide a more generous 35% refundable tax credit for qualifying Canadian-controlled private corporations ("CCPCs") on the first $3 million of SR&ED expenditures incurred in a year.
In October 2011, the government-commissioned Expert Review Panel on Research and Development called for the government to "simplify" the SR&ED program by narrowing the base for the investment tax credit to labour-related costs, decreasing the refundable portion of the investment tax credit and increasing direct expenditures by the government on SR&ED. Budget 2012 implements certain of the recommended changes to the SR&ED tax incentive rules while leaving other aspects of the program unchanged:
- The 20% investment tax credit is reduced to 15% for taxation years ending after 2013.
- There is no change to the 35% refundable tax credit for the first $3 million of SR&EDs incurred by CCPCs, but a CCPC's excess SR&EDs will only benefit from the reduced 15% rate.
- The deduction and tax credit for capital SR&ED expenditures is eliminated for taxation years ending after 2013.
- The portion of overhead expenditures and certain arm's length contract payments that are eligible for the investment tax credit is reduced for taxation years ending after 2012.
- The CRA will improve the Notice of Objection process to allow for a second review of scientific eligibility determinations.
- The government proposes to increase direct funding of research and development by private businesses, including making up to $400 million available to support venture capital activities. The government is considering how best to structure this funding to increase private sector investment and seed large-scale venture capital funds.
An Annex to the budget document suggests that the tax component of these changes will save the Canadian federal government approximately $1.3 billion over a four-year period.
Eligible Dividends Designations
A Canadian corporation wishing to pay an "eligible dividend" subject to the enhanced gross-up and dividend tax credit is currently required to designate the entire amount of a taxable dividend to be an eligible dividend at the time the dividend is paid; late-filed designations are not permitted. A corporation paying excessive eligible dividends is subject to a 20% penalty unless the corporation and its shareholders agree to treat the excess portion of the dividend as a taxable dividend subject to the regular dividend tax credit. Budget 2012 proposes to simplify the designation requirements for eligible dividends paid on or after March 29, 2012 by permitting a corporation to designate a dividend to be partially an eligible dividend and partially a non-eligible dividend, and by providing that the CRA may accept late-filed eligible dividend designations made within three years of the date the dividend is paid.
There is an enormous volume of trade between Canadians and non-residents who do not deal at arm's length with each other, such as the trade between a Canadian subsidiary and its U.S. parent company. Under "transfer-pricing" rules the prices used in non-arm's length cross-border transactions can be adjusted for tax purposes to reflect the prices that would have been used by arm's length parties, thereby ensuring that an appropriate amount of income from such transactions is allocated to Canada. This type of transfer-pricing adjustment is referred to as a "primary adjustment" (PA) and typically increases a Canadian taxpayer's income by the difference between an arm's length price and the price the taxpayer actually paid or received.
However, the PA does not address the fact that where an excessive transfer price has been paid the Canadian taxpayer's assets have been diminished and the non-resident's assets increased by the amount of the PA. Capturing this effect requires a secondary adjustment. Where the taxpayer is a Canadian corporation, the current law may treat an amount equal to the PA as a benefit conferred on the non-resident and deem a dividend to have been paid by the taxpayer to the non-resident subject to withholding tax. Administratively, the CRA permits the parties to repatriate the amount of the benefit to the Canadian corporation in order to avoid the withholding tax.
Budget 2012 proposes to treat all secondary adjustments as dividends subject to withholding tax, even where the non-resident is not a shareholder of the taxpayer (but not if it is a controlled foreign affiliate of a Canadian corporation). Consistent with the administrative practice described above, amendments will clarify that a non-resident is allowed to repatriate to the Canadian corporation that has been subject to a PA an amount equal to the PA and thereby avoid withholding tax on the deemed dividend. Thus, the Budget both institutionalizes taxation of secondary adjustments and the ability to avoid such taxation through the repatriation of funds to Canada.
Budget 2012 contains changes, which are generally restrictive in nature, to the rules applicable to charities. These proposals would permit the CRA to suspend a charity's ability to issue donation receipts if the political activities carried on by the charity exceed the applicable limitations in the Tax Act (a charity is generally permitted to engage in political activities only if such activities represent a limited portion of its resources, are non-partisan in nature and are ancillary and incidental to its charitable purposes and activities), or to the extent the charity provides inaccurate or incomplete information in its annual information return. To restrict the ability of charities to indirectly pursue political activities beyond the limitations in the Tax Act by funding the political activities of other registered charities, a gift made by a charity will be deemed to be an expenditure by the charity on political activities under these rules where a purpose of the gift was to support the political activities of another qualified donee. Budget 2012 also proposes to restrict the foreign charitable organizations eligible to apply for registration as qualified donees entitled to issue donation receipts by virtue of having received a previous gift from the Government of Canada to those that carry on activities that are related to disaster relief or urgent humanitarian aid, or are in the national interest of Canada.
Other Proposed Amendments
Proposed amendments to the tax shelter registration and reporting requirements also are included in the Budget. These proposals will increase the potential penalties applicable to a promoter in respect of participation in unregistered charitable donation tax shelters, introduce new penalties for promoters who fail to comply with existing annual information return reporting requirements, and generally limit the period during which tax shelter identification numbers will be valid to a single year.
Other changes include a phase-out of the corporate mineral exploration and development tax credit, a further one-year extension of the tax credit for individuals who invest in flow-through shares, extending the "prohibited investment" rules to retirement compensation arrangements and imposing a limit on amounts that can be contributed in respect of a "specified employee" to employee profit sharing plans.
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