The Minister of Finance delivered the 2013 Canadian Federal Budget on March 21, 2013. Budget 2013 includes a number of significant proposals, including rules aimed at certain monetization transactions and character conversion forward transactions, expanding the rules limiting the trading of corporate losses and extending these rules to trusts and the extension of the thin capitalization rules to trusts and branches of non-resident entities. Additional proposals include denying Canadian exploration expense treatment of mine development costs, changes to the non-resident trust rules, further targeting of offshore accounts, changes to the effective tax rate for non-eligible dividends and a modest increase to the lifetime capital gains exemption.
Thin Capitalization Rules
Canada's thin capitalization rules limit the deductibility of interest expense of a Canadian-resident corporation where a specified debt-to-equity ratio is exceeded. In December 2008, a government-mandated Advisory Panel on Canada's System of International Taxation 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. Budget 2012 adopted a number of the Advisory Panel's recommendations including reducing the debt-to-equity ratio from 2-to-1 to 1.5-to-1, extending the application of the rules to debts of partnerships of which a Canadian-resident corporation is a member, and deeming interest expense the deduction of which is denied under the thin capitalization rules as a dividend for withholding tax purposes.
Budget 2013 continues to implement the recommendations of the Advisory Panel by extending the rules to Canadian trusts and to certain non-resident trusts and corporations that carry on business or own rental properties in Canada. These changes will apply for taxation years beginning after 2013, both for new and existing borrowings.
If interest expense of a trust is non-deductible under the thin capitalization rules, the trust may designate the interest as a payment of trust income to the non-resident creditor as a beneficiary of the trust. If such a designation is made, the trust will be entitled to deduct the interest, although the payment may be subject to non-resident withholding tax or Part XII.2 tax, depending on the nature of the underlying income.
In the case of non-resident corporations and trusts that carry on business in Canada, the thin capitalization rules are modified to take into account the fact that a Canadian branch is not a separate legal entity. Instead of a debt-to-equity ratio, a debt-to-asset ratio will be applied. These Canadian branch rules will also apply to a non-resident corporation or trust that elects under section 216 of the Income Tax Act (Canada) (the "Tax Act") to be taxed as a resident on its net Canadian rental income under Part I of the Tax Act.
The thin capitalization rules will also be extended to apply to partnerships of which a Canadian trust is a member, as well as to partnerships of which a non-resident corporation or trust is a member.
Budget 2013 includes specific anti-avoidance rules intended to target "synthetic disposition arrangements", such as so-called "monetization" transactions that limit a person's economic gain or loss from a security which the person continues to own. These rules are generally intended to deem a person to have disposed of a property at fair market value where the person enters an agreement that eliminates all or substantially all of the person's risk of loss and opportunity for gain or profit from the property for a period of more than one year - and the property in fact is not disposed of within one year. For this purpose, most transactions entered into by non-arm's length persons are treated as if they were the taxpayer's transactions.
The synthetic disposition arrangement rules also deem the person not to own the property for purposes of certain holding period tests. For example, the dividend stop-loss rules generally restrict a person from claiming a loss on a disposition of a share unless the person owned the share for the 365 days immediately before the disposition and the person together with non-arm's length persons do not hold more than 5% of any class of the stock of the corporation. A person who has entered into a synthetic disposition arrangement in respect of a security is deemed not to own the share for purposes of this 365 day test for the term of the synthetic disposition arrangement.
Budget 2013 notes that synthetic disposition arrangements are often entered into to defer the tax associated with a sale or to obtain a tax benefit, although the rules are not limited to tax-motivated transactions. The scope of the synthetic disposition arrangement rules is potentially very broad. The following are examples of synthetic disposition arrangements identified in Budget 2013: a forward sale of property, a put-call collar in respect of property, exchangeable debentures, a total return swap in respect of a property and certain short sale transactions of securities owned by the taxpayer or a non-arm's length person.
Budget 2013 notes that these rules are not intended to apply to ordinary hedging transactions which typically mitigate the risk of loss but not gain, or to typical securities lending transactions. Although leasing transactions in respect of tangible property are also specifically excluded, it is unclear if these rules can apply to leases of real property or licenses of intangible property. In many cases, a careful examination of the relevant facts and, in particular, the extent to which the participant can realize a loss or gain from an underlying property will be required to determine whether the rules apply to a transaction.
The synthetic disposition arrangement rules apply to arrangements entered into, or the terms of which are extended, on or after March 21, 2013.
Character Conversion Forward Transactions
Budget 2013 targets forward transactions that are used to convert what would otherwise be ordinary income into capital gains. These transactions generally involve a taxpayer (often a mutual fund trust) entering into a forward agreement to sell capital property (typically securities) to a counterparty such as a bank. The price for the capital property that is disposed of by the taxpayer generally has no relation to the value of such property but rather is determined by reference to the return on income-generating assets, a trading portfolio or commodities. As a result, the taxpayer realizes a capital gain on the disposition of the capital property under the forward agreement but receives a return that would, in the absence of the forward transaction, be taxed on income account. Furthermore, there is deferral of gain if the referenced assets are actively traded. A variation of these transactions are forward sale transactions where the taxpayer enters into an agreement to acquire capital property. The taxpayer often prepays the purchase price for the capital property under the forward agreement. The value of the capital property to be acquired by the taxpayer pursuant to the forward agreement is once again determined by reference to the return on income-generating assets. The taxpayer would then sell the capital property with any gain realized on the sale intended to be a capital gain.
The amendments announced in Budget 2013 apply to forward agreements for the sale or purchase of capital property where the return is not determined by reference to the performance of the capital property being sold or purchased, and the term of the forward agreement exceeds 180 days or the agreement is part of a series of agreements with a term exceeding 180 days. In the case of such forward agreements for the sale of capital property, any gain or loss realized by the taxpayer will be on income account. Where the forward agreement is in respect of the acquisition of capital property, the taxpayer will realize a gain or loss on income account to the extent that the fair market value of the capital property received by the taxpayer exceeds (or is exceeded by) the amount paid by the taxpayer for the capital property.
This measure will apply to forward agreements entered into, or extended, on or after March 21, 2013.
Trading in Trust Tax Attributes
Although the Tax Act restricts or denies the use of losses and certain other tax attributes of a corporation following an acquisition of control of the corporation, it does not currently have any rules that restrict or deny the use of losses or other tax attributes of a trust where there has been a significant change in the ownership of interests in the trust. To place corporations and trusts ostensibly on an even footing, Budget 2013 proposes to extend the rules applicable to an acquisition of control of a corporation to a trust that has experienced a "loss restriction event". In general terms, a loss restriction event will occur when a person, partnership or affiliated group of persons acquires, directly or indirectly, beneficial interests in the trust that represent more than 50% of the fair market value of all beneficial interests in the trust. (This contrasts with the corporate loss-trading rules, which - subject to the Budget 2013 changes discussed further below - focus on changes in voting control.) Exceptions analogous to those in the corporate context are proposed, including where the interests are acquired from affiliated persons. While the primary focus is on commercial trusts, the rules are not so restricted. Nonetheless, the Government promises a 180 day consultation period to identify other exceptions that might be appropriate in the family trust and estate context. If there has been a loss restriction event, the trust's taxation year will be deemed to end immediately before such event, the trust will be required to recognize all accrued but unrealized losses in that taxation year, and will be subject to the same restrictions as corporations following an acquisition of control in respect of capital losses, non-capital losses, resource expenses, investment tax credits, etc. Unlike a corporation, however, the trust will not be permitted to select a new taxation year end but will be required to have a calendar taxation year end (unless the trust is a testamentary trust). These proposals are intended to apply to loss restriction events occurring on or after March 21, 2013 (except for transactions which the parties were obligated to undertake pursuant to an agreement in writing entered into before March 21, 2013 from which they cannot be excused on the basis of changes in tax legislation).
Augmenting the Corporate Loss Trading Restrictions
Although the Tax Act contains rules that restrict or deny a corporation's use of certain of its tax attributes (including losses, resource expenses, charitable donations, etc.) following an acquisition of control of the corporation, these rules may have been avoided in some transactions by permitting the taxpayer seeking to utilize the tax attributes to acquire a significant portion of the equity of the corporation without acquiring voting control. In fact, at least one of these transactions was the subject of a favourable ruling from the Canada Revenue Agency ("CRA"), although in a context where there was perhaps significant sympathy for the taxpayers involved. The principle was applied in broader contexts than presumably was seen as appropriate and the Government now proposes to stop this "aggressive tax avoidance". Effective for transactions undertaken on or after March 21, 2013 (subject to an exception for certain transactions parties are obligated to undertake pursuant to an agreement in writing), a person or group of persons will be considered to have acquired control of a corporation where such person or group acquires shares of the corporation that represent more than 75% of the value of all of the corporation's shares without acquiring control and one of the reasons control was not acquired was to avoid one or more of the restrictions that would apply if there was an acquisition of control.
The current attribution rule in subsection 75(2) of the Tax Act may apply to attribute to a taxpayer income from property contributed to a trust where the contributed property may revert to the taxpayer or where the taxpayer retains certain control or veto rights over the future distribution or disposition of the property. In a recent decision of the Federal Court of Appeal (The Queen v. Sommerer), this attribution rule was held not to apply where a taxpayer sold property to a non-resident trust for fair market value consideration. In response to that decision, which the Budget papers state is "not in accordance with the intended tax policy" of the attribution rule, Budget 2013 proposes to extend the non-resident trust rules in the Tax Act to a non-resident trust that holds property on a condition that would otherwise result in the application of the attribution rule. Such rules generally deem a non-resident trust that has received a contribution of property from a Canadian resident to be resident in Canada for tax purposes in certain circumstances. In this case, any transfer or loan of the property made directly or indirectly by the Canadian resident taxpayer to the non-resident trust, regardless of the consideration paid by the trust, will generally result in the application of the non-resident trust rules. The trust may also be prevented from distributing property to its beneficiaries on a tax-deferred basis. To avoid double taxation, Budget 2013 further proposes to restrict the application of the current attribution provision to trusts that are resident in Canada (clarifying that it will not apply to deemed resident trusts). This measure will apply to taxation years that end on or after March 21, 2013.
Corporate Tax Consolidation not a Priority
In Budget 2010, the Department of Finance announced that it would explore the possibility of adopting a formal loss transfer system or consolidated tax reporting for corporate groups, regimes that have been available in the United States and United Kingdom for many years. A discussion paper on the topic prepared by the Department of Finance was released at the end of 2010 seeking comments from taxpayers. Budget 2013 states that, while businesses indicated that they are primarily interested in a system of group taxation that would allow them to easily transfer tax attributes between members of a corporate group, the provinces signaled concerns about the possibility that a new system of corporate group taxation could reduce their revenues. Consequently, the Government has determined that moving to a formal system of corporate group taxation is not a priority at this time. In effect, the Government appears to have abandoned the concept.
The Government's attempts to challenge treaty shopping to date in Canadian courts have been unsuccessful. Budget 2013 states that the Government remains concerned that treaty shopping poses significant risks to the Canadian tax base and announced an intention to consult on possible measures to challenge treaty shopping while preserving a business tax environment that is conducive to foreign investment. Budget 2013 also notes that other countries have either implemented provisions in their domestic law to combat such practices or have successfully challenged treaty shopping arrangements in their courts. However, treaty shopping is hardly new and Canada has avoided comprehensive anti-treaty shopping measures in its tax treaties so as not to deter foreign investment.
It remains to be seen whether as a result of the consultation Canada will adopt either domestic rules (like Germany) or comprehensive treaty limitation on benefits provisions (like the US) to curb treaty shopping. It is noted that the recent tax treaties Canada has entered into with New Zealand, Poland and Hong Kong all have a form of anti-treaty shopping provision in each of the dividend, interest and royalty articles.
International Tax Evasion
Budget 2013 proposes a number of measures to strengthen the capacity of CRA to combat international tax evasion. Budget 2013's main proposals include the following:
- Requiring certain financial intermediaries (e.g. banks) to report to CRA international electronic funds transfers of $10,000 or more. Reporting will be required beginning in 2015.
- A new whistle-blower program under which CRA will pay rewards to individuals with knowledge of major international tax non-compliance when they provide information to CRA that leads to the collection of outstanding taxes due. CRA will announce further details on the program in the coming months.
- Extending the normal reassessment period by three years if a taxpayer has failed to report income from a specified foreign property on its annual income tax return and has failed to file the foreign property reporting form T1135. This measure will apply to the 2013 and subsequent taxation years.
- A revised more intrusive foreign property reporting form T1135 will be required to be used for the 2013 and subsequent taxation years.
- LSVCCs. The federal tax credit of 15% for investments of up to $5,000 per year in labour-sponsored venture capital corporations will be phased out - so that the credit will be reduced to 10%, 5% and 0% for the 2015, 2016 and 2017 (and thereafter) taxation years respectively. In addition, no further entities will be registered as LSVCCs where the registration applications were received on or after March 21, 2013.
- Dividend tax credit. There is currently an enhanced dividend tax credit available to Canadian individuals receiving "eligible dividends," typically from Canadian public companies, and a less generous dividend tax credit for other (non-eligible) dividends received from Canadian-controlled private corporations. Effective after 2013, the federal dividend tax credit for non-eligible dividends will be decreased (so that it will be 13/18 of a dividend "gross up" of 18% rather than 2/3 of a dividend gross-up of 25%). This will reduce the effective federal dividend tax credit to approximately 11% (from about 13.3%).
- Mine development CEE. Canadian exploration expenses ("CEE") of companies in the Canadian mining sector include many expenses incurred to bring a mine into production, in addition to exploration expenses. The first category of expenses incurred on or after March 21, 2013 will start to be treated as Canadian development expenses ("CDE") - which generally are deductible on a 30% declining balance basis rather than being 100% deductible. This change in treatment will be phased in over three calendar years, so that 20%, 40% and 70% of such pre-production mine development expenses incurred in 2015, 2016 and 2017, respectively will be treated as CDE rather than CEE. However, the former more generous treatment will continue to apply to such pre-production mine development expenses incurred before 2017 under a written agreement entered into by the taxpayer before March 21, 2013, or as part of the development of a new mine where the engineering and design work (as evidenced in writing), or the construction work itself, was started before March 21, 2013.
- Capital gains exemption. The lifetime capital gains exemption of $750,000 will be increased to $800,000, effective for the 2014 taxation year, with the exemption amount being indexed to inflation for taxation years after 2014.
- METC. As in prior budgets, the sunset date for the federal mineral exploration tax credit will be extended by a further year (so that it will be available for flow-through agreements entered into on or before March 31, 2014).
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