Canada: Mining & The 2012 Federal Budget

The 2012 federal budget (Budget) was presented by Canada's Finance Minister Jim Flaherty in the House of Commons on March 29, 2012. The Budget proposes a number of tax initiatives of importance to the mining community.

PRE-PRODUCTION MINING INVESTMENT

TAX CREDIT

Certain mining sector activities relating to qualifying minerals undertaken in Canada by taxable Canadian corporations entitle those corporations to an investment tax credit (ITC) equal to 10% of the amount of qualifying expenditures.1 Qualifying expenditures are those included in the taxpayer's pool of "Canadian exploration expenses" (CEE) by virtue of being incurred on (1) "grass roots" exploration to determine the existence, location, extent or quality of a mineral deposit in Canada (exploration expenses), or (2) activities undertaken in order to bring a new mine in Canada into production (development expenses), in each case incurred before the mine is producing in reasonable commercial quantities. Expenditures on these activities ("pre-production expenses") are added to a pool, and the corporation is entitled to claim an ITC (i.e., a reduction in tax payable) equal to 10% of the pool balance for the year.

The Budget announces the elimination of the pre-production mining expenditure ITC. For pre-production exploration expenditures, the credit will continue to apply at the 10% rate for expenditures incurred in 2012, with the rate dropping to 5% for expenditures incurred in 2013 and no ITC for expenditures in subsequent years. For pre-production development expenditures, the 10% rate will apply for expenditures incurred in 2012 and 2013, dropping to 7% for expenditures incurred in 2014, 4% for expenditures incurred in 2015 and no ITC in subsequent years. Transitional relief is provided for pre-production development expenditures by maintaining the 10% rate for such expenditures incurred before 2016 under a written agreement entered into before March 29, 2012 or as part of the development of a new mine the construction of which (or the engineering and design work for the construction of which) had commenced before March 29, 2012.2

ATLANTIC INVESTMENT TAX CREDIT

The Atlantic investment tax credit offers a 10% ITC for expenditures on property used in certain activities occurring in Atlantic Canada (Prince Edward Island, Nova Scotia, New Brunswick, Newfoundland and Labrador, the Gaspe Peninsula or a prescribed offshore region). The Budget will phase out this ITC for expenditures incurred on mining and oil and gas activities (expenditures on other activities are unaffected). The 10% ITC rate will apply for expenditures on qualifying property acquired before 2014, with a reduction to a 5% rate for property acquired in 2014-2015, and no ITC thereafter. The 10% rate will be maintained for qualifying expenditures incurred before 2017 under a written agreement entered into before March 29, 2012 or as part of a project phase the construction of which (or the engineering and design work for the construction of which) had started by March 29, 2012.3 For this purpose, a "project phase" means a discrete expansion in the extraction, processing or production capacity of a project beyond that existing on March 29, 2012, and which expansion was the taxpayer's demonstrated intention immediately before that date. The elimination of this ITC is unfortunate, as it takes away an important incentive for conducting high-risk exploration activities.

MINERAL EXPLORATION TAX CREDIT

Individuals (other than trusts) who invest in flow-through shares may be entitled to additional tax benefits above and beyond the renounced exploration expenses available on all flow-through shares.4 When certain qualifying expenditures (essentially expenses incurred in mining exploration above or at ground level conducted in Canada) are incurred and renounced to a holder of flow-through shares that is an individual (other than a trust), that holder is entitled to an investment tax credit equal to 15% of the renounced qualifying expenditures. This tax credit on "grass-roots" surface exploration expenditures is called the "mineral exploration tax credit."

The Income Tax Act (Canada) currently requires that qualifying expenditures must be incurred by the corporation by the end of 2012 and renounced to the investor under an agreement made before April 2012.The Budget proposes to extend the 15% mineral exploration tax credit for another year, by extending (1) the date for incurring qualifying expenditures to the end of 2013, and (2) the deadline for the corporation and the investor to enter into the flow-through share subscription agreement governing renunciation to March 31, 2013.

OTHER TAX INITIATIVES

Thin Capitalization

Canadian corporations are limited in the amount of interest expense they can deduct for tax purposes on debt owing to non-residents of Canada who are (or are related to) significant shareholders of the Canadian corporation, e.g., a foreign parent of a Canadian subsidiary. Pre-Budget the amount of such debt that was interest-deductible for tax purposes was limited to $2 for every $1 of equity.5 The Budget reduces this limit to $1.5 of debt for every $1 of equity (effective for taxation years beginning after 2012), and extends this rule to debt owing by a partnership of which a Canadian corporation is a member.

Partnerships

The Budget also introduces new anti-avoidance measures directed at the use of partnerships, which are common in the mining sector. First, the Budget extends an existing rule dealing with the sale of interests in a partnership to a tax-exempt entity. This new rule will now also apply to sales of a partnership interest to a non-resident of Canada (unless the partnership is using all or substantially all of its property in a business carried on at a permanent establishment in Canada), effective to sales occurring after March 28, 2012.6 Where this new rule applies, the seller will not compute its taxable capital gain simply as 50% of the difference between the sale price and the adjusted cost base of the partnership interest, as is usually the case. Instead, the capital gain will be computed by effectively looking through the partnership interest to the partnership's property, so that the seller's gain will be:

  • 50% of the portion of the gain attributable to gains in the value of non-depreciable capital property (e.g., land that is not a natural resource property, and shares of corporations); and
  • 100% of the portion of the gain attributable to other property, e.g., depreciable property, Canadian and foreign resource property, most intangibles and inventory (collectively, "income property").

In addition, an analogous rule is being added to the rules governing the s. 88(1)(d) bump, a provision that applies where one Canadian corporation (the subsidiary) is wound up into or merged with another Canadian corporation (the parent) that owns all the shares of the subsidiary, and allows the parent to increase the cost for tax purposes of the subsidiary's non-depreciable capital property. Instead of being permitted to increase the cost for tax purposes of a partnership interest owned by the subsidiary up to an amount equal to its fair market value, no increase will be permitted to the extent that the accrued gain on the partnership interest is attributable to Canadian or foreign resource property or to accrued gains on other income property. This rule is very broad, as it does not distinguish between partnerships created for business reasons and those created for tax planning purposes. It applies to mergers and wind-ups occurring after March 28, 2012.7

Foreign Affiliate Dumping

For some time the Department of Finance had been concerned that Canadian subsidiaries of foreign companies could inappropriately generate tax-deductible interest expense by incurring debt to purchase shares of sister companies in other countries. The Budget has proposed a very broad rule which goes beyond this concern. It applies whenever a Canadian corporation (Canco) that is controlled by a non-resident corporation (Parent) makes an investment in another non-resident corporation (Forco), if immediately thereafter Forco is (or as part of the series of transactions that includes the investment becomes) a "foreign affiliate" of Canco, unless it is reasonable to conclude that the investment was made for reasons other than to obtain a tax benefit (i.e., for business purposes).8 Where the rule applies:

  • Canco is deemed to have paid a dividend to Parent equal to the value of any property (other than Canco shares) transferred by Canco or any obligation assumed by Canco in respect of the investment; and
  • no amount is to be added to the paid-up capital (PUC) of any Canco shares as a result of Canco having made the investment, i.e., to the extent that Canco pays using shares of itself, the value received in exchange is not included in the PUC of the Canco shares issued. Since PUC is a key component of "equity" under the thin capitalization debt/equity test, this result effectively limits a Canadian subsidiary's ability to create more PUC (and thereby increase its maximum potential tax-deductible intra-group debt) by acquiring foreign group members in exchange for issuing shares of the Canadian subsidiary.9

An "investment" is defined very broadly, and can include the purchase of shares of Forco from an arm's-length seller or a direct subscription for shares in (or contribution of capital to) Forco by Canco. The scope of this rule is very broad indeed, and foreign mining companies with Candian subsidiaries will need to consider it carefully when transferring any property (including issuing shares) or incurring any obligation that relates to a foreign affiliate. The Department of Finance is soliciting submissions from the tax community on the scope of the "business purpose" test exception to this new rule.

Footnotes

1 Qualifying minerals are diamonds, base or precious metal deposits, or industrial minerals in Canada that produce base or precious metals when refined.

2 For this purpose "construction" and "engineering and design work" does not include obtaining permits or regulatory approvals, conducting environmental assessments, community consultations or impact benefit studies, and similar activities.

3 See note 2.

4 For more on the taxation of flow-through shares see http://miningtaxcanada.com/flow-through-shares/.

5 For this purpose, "equity" means the sum of the Canadian corporation's retained earnings, plus the paid-up capital of any shares of the Canadian corporation owned by non-residents who own 25% or more of the corporation's shares (by votes or value).

6 The coming into force rule exempts a disposition of a partnership interest occurring after March 28, 2012 if the disposition was (1) made to a person dealing at arm's length with the vendor, (2) completed before the end of 2012 and (3) the subject of a binding written agreement entered into before March 29, 2012.

7 Except where the parent acquired control of the subsidiary before (or was legally obligated to do so pursuant to a written agreement entered into before) March 29, 2012, and had before that date evidenced in writing its intention to merge or wind up the subsidiary. Any such merger must be completed before 2013, or in the case of a wind-up be initiated before 2013.

8 In general terms, a foreign corporation is a "foreign affiliate" of a Canadian taxpayer if the Canadian taxpayer owns (directly or indirectly), alone or together with related persons, 10% or more of any class of the foreign corporation's shares. "Foreign affiliate" status is necessary in order for dividends received by a Canadian corporation from a foreign corporation to be eligible for exemption from Canadian taxation.

9 Similar rules are proposed to prevent contributed surplus (which is also included in "equity" for thin capitalization purposes) from being created on a contribution of foreign group member shares to Canco for no consideration, viz., a capital contribution.

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