The following is a summary of certain fundamental tax measures contained in the Canadian federal government's budget released on March 21, 2013.
MINING AND ENERGY SECTOR
Budget 2013 contains several proposals relevant to the mining and energy sectors, some of which will be welcome by certain taxpayers while other changes may have adverse implications to taxpayers incurring pre-production expenses and making investments in new mines and mine expansion.
Flow-Through Shares: Extension of the Mineral Exploration Tax Credit ("METC")
Flow-through shares provide a major source of new capital to junior mining companies. These shares are attractive to investors for various reasons, including (i) the ability to deduct at the investor-level certain exploration expenses incurred by the issuing corporation; and (ii) the ability in certain circumstances to claim a special 15% METC in respect of the investment in the share. The existing METC is scheduled to expire on March 31, 2013; however, consistent with the past several federal budgets, Budget 2013 proposes to extend the 15% METC for an additional year, until March 31, 2014. Otherwise, flow-through shares are unaffected by Budget 2013.
Expansion of Accelerated Capital Cost Allowance ("CCA") for Clean Energy
Several proposals have been introduced by the Department of Finance ("Finance") over the past few years to provide a tax incentive for investment in clean energy generation equipment, including wind and solar equipment. These incentives are in the form of rapid deductions for CCA in respect of the cost of the equipment (50% deduction on a declining balance basis). Budget 2013 proposes to expand the existing category of eligible assets to include certain biomass production equipment and associated cleaning and upgrading equipment.
Phase-out of Accelerated CCA for Certain Mining Expenses
Budget 2013 proposes to phase-out certain preferential CCA deduction rates in respect of the cost of capital assets (i.e., machinery, equipment and structures) used in new mines and major mine expansions.
Natural resource companies, including mining and oil and gas companies, are currently entitled to claim capital cost allowance deductions in respect of most capital assets at a 25% declining-balance basis. Mining companies are entitled to an additional accelerated CCA in respect of capital assets used in new mines or certain mine expansions. Budget 2013 proposes to phase-out this accelerated CCA over the 2017-2020 taxation years, which in the view of Finance will better align the tax regimes of the mining sector with those applicable to other natural resource sectors (i.e., oil and gas).
Both this measure and the proposed phase-out of preferential deductions for pre-production expenses (discussed below) will apply to expenses incurred on or after March 21, 2013, subject to certain exceptions. Accordingly, taxpayers in the mining sector should closely review the types of expenses that will be subject to this phasing out and determine whether any such expenses may qualify for certain limited grandfathering.
Phase-out of Preferential Deductions for Pre-Production Mine Development
Budget 2013 proposes to phase-out preferential deduction rates in respect of pre-production mine development expenses (i.e., intangible expenses for removing overburden or sinking a mine shaft) that are incurred for the purpose of bringing a new mine for a mineral resource located in Canada into production.
Such expenses are currently treated as Canadian exploration expense ("CEE") and may be deducted in full in the year incurred or carried forward indefinitely for use in future years. This is to be contrasted with similar expenses incurred after a mine comes into production, which are treated as Canadian development expense ("CDE") and are deductible at a much less favourable rate of 30% per year on a declining-balance basis.
Budget 2013 proposes to recharacterize such expenses as CDE instead of CEE (phased-in over the 2014 to 2017 taxation years), resulting in the loss of the favourable 100% deduction in the year the expenses are incurred and a migration over to the less-favourable 30% deduction regime. As with the phase-out of preferential depreciation rates for certain mining expenses (discussed above), Finance considers this measure as better aligning the tax treatment available across the natural resources sector.
BUSINESS TAX MEASURES
A synthetic disposition is an arrangement under which a taxpayer economically disposes of a property but retains ownership of the property. The arrangement may be designed to alienate property without triggering the income tax consequences that would result from a disposition.
In a somewhat unexpected move, Budget 2013 proposes that agreements and arrangements entered into by a taxpayer that have the effect of eliminating all or substantially all of the taxpayer's risk or loss and opportunity for gain or profit in respect of the property for a period of more than one year, will give rise to a deemed disposition of the property by the taxpayer at fair market value and a deemed reacquisition of the property at that same amount. Despite the deemed reacquisition of the property, the taxpayer would not be regarded as being the owner of the property for certain holding period tests relating to stop-loss rules and foreign tax credits. The taxpayer would re-commence to be regarded as the owner of the property when all or substantially all the risk of loss/opportunity for profit ceases to lie with someone other than the taxpayer. The proposal can extend to agreements and arrangements entered into by persons or partnerships not dealing at arm's length with the taxpayer, where it may reasonably be considered to have been entered into with the purpose of eliminating the taxpayer's risk of loss/opportunity for profit.
The proposal is quite broad and, according to Finance, could apply to certain forward sales of property, put-call collars and certain indebtedness that is exchangeable for property. There is no discussion in the Budget materials concerning the potential application of this proposal to exchangeable share arrangements, which have been widely used in the market. Also, there is no mention of the potential application of these rules to convertible debentures, which presumably should not be within the ambit of these proposed rules. The proposal is generally not intended to apply to hedging transactions, ordinary securities lending arrangements or ordinary commercial leasing transactions.
The proposal is to apply to agreements and arrangements entered into on or after March 21, 2013, as well as agreements and arrangements entered into before that date, the term of which is extended on or after that date.
Character Conversion Transactions
A character conversion transaction is designed to reduce income tax by converting what would otherwise be ordinary income into a capital gain, only half of which is included in taxable income. The transaction involves an agreement to purchase or sell a capital property in the future at a price determined by reference to a derivative, often a portfolio of investments. If a taxpayer invested in the derivative directly, the return would generally be included as fully-taxable income rather than a capital gain.
Budget 2013 proposes to treat the return (or loss) under such an arrangement as being on income account, distinct from the disposition of the particular capital property. Changes would be made to the adjusted cost base rules, to avoid double taxation in respect of the particular capital property. The measure would apply to all such agreements that have a duration of more than 180 days, entered into on or after March 21, 2013, as well as agreements entered into before that date, the term of which is extended on or after that date.
Budget 2013 proposes to introduce rules prohibiting "loss trading" transactions that circumvent the existing "loss streaming" rules that are triggered on the acquisition of control of a corporation having net operating losses.
"Loss trading" transactions have been a hot topic for several years. Tax attributes such as losses and credits are not assets that can be directly bought and sold. Moreover, the Income Tax Act (Canada) ("ITA") significantly limits the use by a corporation (or its successor as a result of a wind-up or amalgamation) of its non-capital losses (i.e., business losses) after the loss corporation experiences an acquisition of control. For this purpose, an acquisition of control is triggered generally upon the acquisition by a person of shares carrying the right to elect the majority of the board of directors. Accordingly, transaction structures have developed to allow a profitable corporation to effectively benefit from the losses of another corporation without triggering a legal acquisition of control of the loss corporation. These structures generally involve some combination of the assets of the profitable and loss corporations and the acquisition by the profitable corporation of a non-controlling block of shares in the loss corporation; however, the profitable corporation will obtain an economic interest in the loss corporation that is often significantly greater than 50%. While such structures were initially considered by the Canada Revenue Agency ("CRA") to not offend the "general anti-avoidance rule" ("GAAR") in section 245 of the ITA (see, e.g., the "Hemosol" Advance Tax Rulings in 2003 and 2004), there has subsequently been significant criticism from the Canadian government, including the Auditor General. Accordingly, there has been some measure of risk that such transactions may be attacked by the CRA under the GAAR.
Budget 2013 will make it much more difficult to implement such transactions by proposing to deem an acquisition of control of the loss company where a person has acquired more than 75% of the fair market value of the shares of the loss corporation regardless of the voting control of such shares. Accordingly, the CRA would not need to consider, or rely upon, the application of the GAAR when assessing loss trading transactions that fall within the ambit of this proposed rule. It is interesting to note that a measure designed to combat the abuse of a bright-line test (i.e., the threshold for a legal acquisition of control) itself introduces a new bright-line test (i.e., 75% of the fair market value of the shares of the loss company).
This measure will apply to acquisitions of shares that occur after March 21, 2013, subject to limited exceptions.
Trust Loss Trading
As discussed above, the ITA contains restrictions on the trading of losses between arm's length corporations. Budget 2013 proposes to extend these rules to trusts to combat arrangements under which a person would (i) acquire an interest in the trust with unused losses, (ii) transfer an income-producing property to the trust, and (iii) use the trust's losses to offset the income from the property. This may be relevant to certain income trust conversion transactions. The new measure would apply where a trust is subject to a "loss restriction event", being the acquisition by a person or partnership of a beneficial interest in the trust having a fair market value greater than 50% of all the beneficial interests in the trust. This measure, which is not anticipated to impact family trust structures, will be effective for transactions that occur on or after March 21, 2013, other than transactions that the parties are obligated to complete pursuant to a written agreement concluded before that date.
Extension of Accelerated CCA for Manufacturing Equipment
Prior Budgets introduced an accelerated CCA rule for machinery and equipment acquired between 2007 and 2014, for use primarily in Canada for the manufacturing or processing of goods for sale or lease. Budget 2013 proposes to extend this measure to such equipment acquired in 2014 or 2015, thus extending the 50%, straight-line CCA rate for another two years.
Corporate Group Consolidation
In prior years, Finance had indicated that it was reviewing whether the introduction of a formal group consolidation regime (similar to what has been adopted in other countries such as the United States) should be introduced into the Canadian corporate tax landscape. The general benefit of consolidation is the ability to apply the losses of one corporate group member against the profits of another, without the need to enter into complex inter-company loss or profit-shifting transactions.
Budget 2013 confirms that corporate group consolidation is not something that we should expect to see in the near future. After a lengthy consultation process with various members of the tax and business communities, it appears that group consolidation "is not a priority at this time". This does not come as a surprise since the issue of group consolidation regularly surfaces from time to time and no consensus concerning an efficient means of implementing such system in Canada has yet emerged.
INTERNATIONAL TAX MEASURES
Thin Capitalization – Extended Application to Trusts and Branches
Budget 2013 proposes to extend the scope of Canada's thin capitalization rules and, as a result, non-residents that hold Canadian businesses or investments through a trust or non-resident corporation will need to review the potential thin capitalization implications to new and existing indebtedness.
Canada's thin capitalization regime generally restricts the amount of interest expense that a Canadian corporation can deduct on debt owed to a "specified non-resident shareholder" as defined in the ITA. As a result of changes made in 2012, similar rules would apply to a partnership of which a Canadian-resident corporation is a partner. Generally, if the ratio of such debt as compared to certain "equity" of the corporation exceeds a ratio of 1.5:1, the corporation will be denied an interest deduction in respect of the excess and will be deemed to have paid a dividend subject to Canadian withholding tax.
Many changes were made to the thin capitalization regime in 2012 on the basis of recommendations by the 2008 Advisory Panel on Canada's System of International Taxation. Budget 2013 seeks to further implement the recommendations of the Advisory Panel, notably to extend the application of the thin capitalization rules to Canadian-resident trusts and non-resident corporations and trusts that operate in Canada. These have long been perceived as deficiencies in the thin capitalization rules that, in certain cases, may influence the manner through which non-residents seek to hold businesses or investments in Canada. For example, there may be a tax benefit for a corporation resident in a low-tax jurisdiction to highly leverage a non-resident trust or another non-resident corporation to acquire Canadian real estate. Rather than be subject to high Canadian withholding tax rates on its rental income, the entity holding the Canadian real estate could elect to pay Canadian tax on its income but could reduce its income significantly through large interest deductions that are not currently subject to any thin capitalization restrictions. In contrast, if the real estate was held through a Canadian corporation, the corporation would be limited in the amount of interest-bearing debt that it could issue to its non-resident parent.
The determination of the thin capitalization threshold and the implications of exceeding such threshold by a Canadian-resident trust, a non-resident trust or a non-resident corporation are unique and must be carefully considered on a case-by-case basis. For example, a branch of a non-resident corporation will need to monitor its "debt-to-asset" ratio (which must be kept within a new 3-to-5 ratio) and must be aware of potential Canadian branch tax implications to any denied interest expense. Moreover, a Canadian-resident trust may be able to designate to treat the denied interest payment as a payment of income to a non-resident beneficiary, subject to Canadian withholding tax and potentially an additional tax under Part XII.2 of the ITA.
These proposals will apply to taxation years beginning after 2013 and there is no grandfathering of existing indebtedness. Accordingly, non-residents that may be affected by these proposals must evaluate their existing structures and determine if any reorganization or recapitalization may be required.
Budget 2013 does not propose to extend the thin capitalization rules to inter-company guarantees, which has previously been raised as a potential issue.
Non-Resident Trusts – Deemed Residency
Canada has complex tax rules (and proposed rules) that operate to deem a non-resident trust to be a resident of Canada in certain circumstances, including where a resident of Canada has made a "contribution" to the trust. Other rules will attribute income from a trust to a person if the trust's property may revert to that person or the person effectively controls the trust's dealings with the property. Recent case law (Sommerer v. the Queen, 2012 FCA 207) confirms that this latter attribution rule will not apply if a Canadian resident beneficiary sells property to a non-resident trust for fair market value consideration, even if the property may ultimately revert to that person.
Finance considers the result in Sommerer to be contrary to the "intended tax policy" of the ITA. Budget 2013 therefore contains a provision that will amend the rules in section 94 of the ITA and deem a trust to be resident in Canada (and therefore taxable in Canada) generally where a Canadian resident sells property at fair market value to the trust and retains some measure of "effective ownership" over the property.
This proposal will apply to taxation years ending on or after March 21, 2013 and may have far-reaching effects that should be considered by any Canadian resident that has, or is contemplating, a sale of property to a non-resident trust.
"Treaty shopping" is a term commonly used by tax authorities to describe international investment that is structured by a resident of Country A into Country B indirectly through an entity in Country C and that results in the availability of benefits under a tax treaty between Countries B and C that would not have been available between Countries A and B. The CRA has made several varied attempts to judicially challenge perceived "treaty shopping" (see, e.g., MIL (Investments) SA, 2006 TCC 460; aff'd. 2007 FCA 236; Prévost Car, Inc. 2008 TCC 231, aff'd 2009 FCA 57; Velcro Canada, 2012 TCC 57); however, the courts have not been receptive to the CRA's arguments, leaving the CRA in a position where it may have little judicial, statutory or treaty-based means of challenging such situations.
Budget 2013 does not introduce any formal measure designed to curtail "treaty shopping"; however, the Budget materials provide that Finance intends to release a consultation paper concerning potential measures. This will be an interesting consultation process, as the topics of "treaty shopping", treaty abuse, beneficial ownership, limitation on benefits, etc., have produced varied international responses and opinion.
In a surprising move, Budget 2013 will introduce a program to permit the compensation of persons who "tip" the authorities to international tax non-compliance resulting in assessments exceeding $100,000 in federal tax. The program will provide for "rewards" of up to 15% of the tax collected. To be eligible to collect the reward, the person providing the information will have to satisfy "program criteria" which are not clearly defined. The CRA will announce further details on the program.
Extended Reassessment Periods – Tax Shelters and Reportable Transactions
The tax rules require certain filings in respect of tax shelters and certain reportable transactions. The tax benefits flowing from participation in those transactions are generally not recognized until the filings are made. However, the normal reassessment period is not extended when a filing is made late or not at all. Commencing with taxation years that end after March 21, 2013, Budget 2013 proposes to extend the normal reassessment period to three years after the date the required information return is filed.
Accelerated Tax Collection – Charitable Donation Tax Shelters
Where a taxpayer objects to or appeals from an assessment that disallows a charitable donation deduction or credit, the CRA is generally prohibited from taking collection action until after the dispute is resolved. In an effort to discourage participation in charitable donation tax shelter schemes, commencing with assessments for 2013 the Budget would permit the CRA to take action to collect 50% of the disputed tax, interest and penalties.
SR&ED Program Compliance
Budget 2013 proposes to require greater information about an SR&ED claimant's third-party SR&ED tax preparers, including the third-party's CRA business number and details regarding the billing arrangements, including the amount of the fees and whether contingency fees were involved. In addition, Budget 2013 proposes a new penalty of $1,000 for each incomplete or inaccurate SR&ED claim.
Reporting of Electronic Funds Transfers
Budget 2013 proposes to introduce a measure to require financial intermediaries such as banks to report clients' international electronic fund transfers of $10,000 or more.
Demands for Information and Foreign Reporting
Budget 2013 proposes to streamline the process relating to third-party demands for information, as well as revisions to the foreign property reporting required of taxpayers. Further, the normal reassessment period would be extended for taxpayers who fail to report income from a specified foreign property and fail to file the required form.
PERSONAL TAX MEASURES
Lifetime Capital Gains Exemption Increased and Indexed
Currently the ITA exempts from tax capital gains of up to $750,000 on the disposition of "qualified small business corporation shares" and "qualified farm property". Effective as of 2014, Budget 2013 proposes that the exemption be increased by $50,000 to $800,000 and be indexed to the rate of inflation commencing in 2015.
Dividend Tax Credit Changes
Income earned through a corporation and then distributed to shareholders as a dividend is taxed at both the corporate and personal levels. The dividend gross-up and tax credit mechanisms are intended to equate the amount of corporate and personal tax paid on dividends with the amount of tax an individual would have paid if the individual earned the income directly. There are two gross-up and tax credit factors, depending on whether the corporation paid tax at the general rate (eligible dividends) or the preferred rate applicable to certain active business income (non-eligible dividends). Budget 2013 proposes to adjust the gross-up and tax credit mechanisms for non-eligible dividends, on the basis that the current mechanism overcompensates individual shareholders. The adjustments will have the effect of increasing the rate of federal tax on such dividends from 19.58% to 21.22%.
MISCELLANEOUS TAX MEASURES
Restricted Farm Losses
For taxpayers that do not have farming as their chief source of income are limited by the restricted farm loss ("RFL") rules to claiming an annual maximum deduction for farm losses of $8,750. Budget 2013 proposes to overturn the Supreme Court of Canada's ruling in The Queen v. Craig, 2012 SCC 43, by codifying that the "chief source of income" test requires that all of a taxpayer's other sources of income must be subordinate to farming. For example, a taxpayer whose chief source of income is professional services but that also carries on a secondary farming business would be subject to the RFL rules in respect of losses from the farming business.
Charitable Donation Tax Credit
Budget 2013 proposes to introduce an enhanced charitable donation tax credit for donors who have not claimed the credit since 2008. The "First-Time Donor's Super Credit" will provide a tax federal credit of 40% for cash donations up to $200 and a 54% federal credit for donations in excess of $200 but not exceeding $1,000.
Labour-Sponsored Venture Capital Corporation ("LSVCC") Tax Credit Phase Out
The LSVCC tax credit presently provides a 15% tax credit to individuals who invest in up to $5,000 worth of shares of a LSVCC, providing tax relief of up to $750. In light of other sources of venture-capital funding, Budget 2013 proposes to phase out the credit. The credit will be reduced to 10% for 2015, 5% for 2016 and eliminated as of 2017.
Graduated Rates for Testamentary Trusts – Consultation
Budget 2013 announces the intention to initiate consultations on the elimination of graduated tax rates for testamentary trusts and certain inter vivos trusts. The government is concerned with fairness in relation to the treatment of inter vivos trusts, which pay tax at the highest marginal rate, as well as with an increased use of multiple testamentary trusts.
Withholding of GST/HST Refunds
Budget 2013 would permit the withholding of GST/HST refund payments where the claimant has failed to provide information required as part of the GST/HST registration process.
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.