Budget 2012 also proposes a number of other "tightening" measures.
The thin capitalization rules in the ITA restrict the deductibility of interest payments made by a Canadian resident corporation on debt owing to certain specified non-residents. In its 2008 report, the Advisory Panel on Canada's System of International Taxation recommended that these rules be extended to partnerships, trusts and Canadian branches of non-resident corporations and that the maximum debt-to-equity ratio be reduced from 2:1 to 1.5:1. In Budget 2012, the thin capitalization rules were extended to partnerships with a Canadian-resident corporate partner, the maximum debt-to-equity ratio was reduced to 1.5:1 for taxation years that begin after 2012, and disallowed interest expense was deemed to be a dividend paid to the specified non-resident for Part XIII withholding tax purposes.
Budget 2013 further extends the application of the thin capitalization rules to apply to Canadian-resident trusts and to non-resident corporations and trusts that operate in Canada. The proposed changes will apply for taxation years that begin after 2013 to existing and new borrowings.
Budget 2013 modifies the thin capitalization rules to reflect the legal nature of trusts. Beneficiaries take the place of shareholders in determining whether a debt owed by the trust to a non-resident should be included in the trust's 1.5:1 debt-to-equity ratio. The "equity" for purposes of the ratio will generally consist of contributions to the trust from specified non-residents plus the tax-paid earnings of the trust, less any capital distributions to specified non-residents.
If interest is not deductible by the trust under these thin-capitalization rules, the trust may designate the non-deductible interest as a payment of trust income to the non-resident beneficiary and deduct the payment from the trust's income. The payment of the trust income will be subject to Part XIII withholding tax. Part XII.2 tax may apply to the payment if the trust has income from certain sources and the trust is not otherwise exempt from such tax (mutual funds, testamentary trusts and certain other trust are exempt from Part XII.2 tax).
These thin capitalization proposals will apply to partnerships where a Canadian-resident trust is a member and may result in the inclusion of non-deductible interest in the income of the trust. The trust will be able to designate the included income as a payment of trust income to the non-resident beneficiary and deduct the payment from the trust's income.
In recognition that existing trusts may not have kept appropriate records to be able to compute amounts under these new rules, a trust that exists on March 21, 2013 may elect to determine the amount of its equity for thin capitalization purposes as at that date, in accordance with certain rules.
Non-Resident Corporations and Trusts
Budget 2013 proposes to extend the application of the thin capitalization rules to non-resident corporations and trusts "that carry on business in Canada". Although references are made to a "Canadian branch", the rules are not limited to circumstances where there is a permanent establishment in Canada (i.e., an office or fixed place of business or permanent establishment). However, a non-resident corporation or trust that is eligible for a treaty exemption from Canadian tax on its Canadian business profits (because it does not have a permanent establishment in Canada) would generally not be concerned with the denial of an interest deduction. The Supplementary Information to the Tax Measures notes that where a non-resident corporation or trust earns rental income from Canadian properties and elects to be taxed on net income under Part I of the ITA (a so-called "216 election"), the thin capitalization rules will apply in computing the non-resident's Part I tax.
A loan used in the Canadian operations of a non-resident corporation or trust will be an outstanding debt to a specified non resident for thin capitalization purposes if the lender does not deal at arm's length with the non-resident corporation or trust. A debt-to-asset ratio of 3:5 will be used, which is intended to parallel the 1.5:1 debt-to-equity ratio for Canadian resident corporations. The application of the thin capitalization rules may increase the liability of a non-resident corporation for branch tax under Part XIV of the ITA.
These thin capitalization rules will apply to partnerships in which a non-resident corporation or trust is a member. An income inclusion for a non-resident partner arising as a consequence of these rules will be deemed to have the same character as income against which the partnership's interest deduction applied.
Pre-Production Mine Development Expenses
Budget 2013 proposes to amend the definition of Canadian exploration expense (CEE) by removing from the list of expenditures that qualify as CEE, certain expenditures incurred for the purpose of bringing a new Canadian mineral resource mine into production. These expenditures will now be treated as Canadian development expenses (CDE). CEE is fully deductible by taxpayers who are not principal business corporations, and fully deductible to the extent of income by principal business corporations. In contrast, a taxpayer can deduct only 30 per cent of cumulative CDE on a declining balance in a taxation year.
The stated purpose of the Budget 2013 amendment is to bring the treatment of certain expenditures in the mining sector into alignment with the treatment of comparable expenditures in the oil and gas sector. In particular, amendments in Budget 2007 and Budget 2011 phased out accelerated CCA for tangible assets in oil sands projects and changed the deduction rates for intangible expenses for new oil sands mines.
The expenditures covered by the amendment are expenditures incurred for bringing a new mine in mineral resource in Canada into production in reasonable commercial quantities and before the mine comes into production in commercial quantities. These expenditures include clearing, removing overburden, stripping, sinking a mine shaft or constructing an underground entry.
There are grandfathering and phase-in rules. Expenditures incurred in existing projects are grandfathered until after 2017. For new projects, the loss of CEE is phased-in over 4 years until 2018.
Accelerated Capital Cost Allowance for Mining
The ITA currently provides for an accelerated CCA in respect of certain assets acquired for use in new mines and eligible mine expansions. This additional allowance is equal to 100 per cent of the eligible expenditure up to the taxpayer's income for the year.
Budget 2013 proposes to phase out this additional allowance over the 2017 to 2020 calendar years. Existing projects are grandfathered. The grandfathering will include assets acquired before 2018 under agreements entered into before March 21, 2013 or as part of the development of a new mine or mine expansion commenced before March 21, 2013.
Reserves for Future Services/Reclamation Obligations
A great deal of attention has been paid over the past several years to the tax treatment of environmental reclamation obligations, without many solutions. While accruals for such costs can be very large, they are not generally deductible until actually paid. Compounding the problem, reclamation expenses often become payable after the income-generating activity has ceased, at which point there may be insufficient taxable income to fully use the expenses. In some limited circumstances, tax-deductible contributions can be made to "qualifying environmental trusts", but such trusts are often not feasible. One solution was for the taxpayer to pay another entity to assume the future reclamation obligation. The taxpayer would deduct the payment on the basis that it was no longer a contingent expense. The entity assuming the obligation included the amount in income but claimed a reserve under paragraph 20(1)(m) with respect to its obligations to provide the reclamation services in the future.
Budget 2013 stops this type of planning by denying a reserve taken under paragraph 20(1)(m) where the reserve is in respect of a reclamation obligation. The Supplementary Information gives an example of a waste disposal facility that charges customers a fee to cover the cost of the future reclamation of the landfill. After this amendment, such fees will no longer qualify for the reserve and will thus be taxable in the year of receipt. Limited grandfathering is available in respect of amounts received that were previously authorized by a government or regulatory authority.
Lifetime Capital Gains Exemption and Tax Rate on Non-Eligible Dividends
Effective 2014, Budget 2013 proposes to increase the LCGE by $50,000 to $800,000 and to index the amount of the LCGE to inflation in future years. Even individuals who previously used their existing LCGE will be able to use the additional LCGE. The measure will cost the Government $110 million over five years.
Coinciding with the increase in the LCGE, Budget 2013 proposes to decrease the gross-up and dividend tax credit in respect of non-eligible taxable dividends paid after 2013. The result is an increase in the effective top federal tax rate on an individual's dividend income of 1.64 per cent to 21.22 per cent. The measure is expected to generate an additional $2.34 billion for the Government over five years, representing the single largest proposed tax change. While stated to increase tax integration, this measure will likely also off-set the benefit of the increased LCGE to private business owners that meet the requirements of a QSBC, as it will increase the tax those individuals pay on dividends paid out of the corporation's "low rate income pool."
Labour Sponsored Venture Capital Corporations Tax Credit
Labour-Sponsored Venture Capital Corporations (LSVCCs) are professionally managed funds that raise capital from individual Canadians. LSVCCs have been a significant source of venture capital for small and medium-sized Canadian companies, but federal tax credits for the investors represent a significant cost for the Government.
Budget 2013 proposes to phase out the federal LSVCC tax credit. For taxation years that end before 2015, the credit will remain at 15 per cent for investments of up to $5,000 per year. The credit will be reduced to 10 per cent for the 2015 taxation year; 5 per cent for the 2016 taxation year; and will be eliminated after 2016. There will be no new federal LSVCC registrations and provincially registered LSVCCs will not be prescribed for purposes of the federal tax credit unless the application was submitted before March 21, 2013.
Restricted Farm Losses
Budget 2013 proposes that effective for taxation years that end on or after March 21, 2013, the restricted farm loss rules will apply to taxpayers whose chief source of income is neither farming nor a combination of farming and another subordinate source of income. This measure effectively reverses the recent decision of the Supreme Court of Canada in the Craig case. In Craig, the taxpayer's primary source of income was his law practice, and he also had a substantial farming business that was a subordinate source of income. Under the pre-Budget 2013 rules, the restriction applied if the taxpayer's chief source of income was neither farming nor a combination of farming and another source of income (regardless whether the farming business or the other business was dominant). The Court found that the taxpayer's chief source of income was such a combination (even though his horse racing/farming business was subordinate to his law practice) and, therefore, he was permitted to deduct the losses of his horse racing/farming business from the income of his law practice without restrictions. Under the Budget 2013 amendment, farming must be the taxpayer's chief source of income. The concept of a chief source of income from a combination of activities has essentially been rendered meaningless, as farming is now required to be dominant in any such combination.
While the restricted farm loss rules will now apply more broadly, Budget 2013 does increase the maximum amount that may be deducted in the year from non-farming income from $8,500 ($2,500, plus half of next $12,500) to $17,500 ($2,500, plus half of next $30,000). Unused farm losses may be carried back three years and forward 20 years and deducted against farming income.
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