Minister of Finance Jim Flaherty today tabled the 2014 Federal Budget (the "Budget") entitled The Road to Balance: Creating Jobs and Opportunities.We are pleased to provide our summary of proposed tax measures contained in the Budget.
There were no changes proposed to corporate income tax rates or to personal income tax rates. There were certain favourable changes to tax credits available to individuals.
The Federal Government continued its focus on integrity and tax fairness measures, sometimes described by the Federal Government as closing tax loopholes, albeit to a lesser extent than in past years. Some of the proposed measures appear to be based on changed policy rationale rather than addressing technical deficiencies in the Income Tax Act(Canada) (the "Tax Act"). The revenues that are projected to be raised through integrity measures contained in the Budget total $1.765 billion over the next five years compared with 5-year revenue projections relating to integrity measures proposed in the 2013 budget and the 2012 budget of $6.066 billion and $3.131 billion respectively.
The Budget contains certain proposed and potential upcoming changes in the areas of international taxation, trusts and the charitable and not-for-profit sectors. Certain of the proposed international tax measures specifically target arrangements perceived by the Federal Government to erode the Canadian tax base.
From a fiscal perspective, the Budget reports a much improved budgetary balance than was projected in the 2013 budget. In particular, the Budget forecasts a deficit of $16.6 billion for 2014 (compared to a 2014 deficit of $18.7 billion that was projected in the 2013 budget), a deficit of $2.9 billion for 2015 (compared to a 2015 deficit of $6.6 billion that was projected in the 2013 budget) and a surplus of $6.4 billion for 2016.
Our summary of tax highlights contained in the Budget follows.
Captive Insurance Companies
Current FAPI Regime
The Tax Act treats foreign accrual property income ("FAPI") earned by a controlled foreign affiliate of a taxpayer resident in Canada as taxable in the hands of the Canadian taxpayer on an accrual basis, whether or not actually distributed back to Canada.
Under the current provisions of the Tax Act, income of a foreign affiliate ("FA") from the insurance of risks in respect of persons resident in Canada, property situated in Canada or businesses carried on in Canada ("Canadian Risks") is FAPI, unless more than 90% of the FA's gross premium revenue (net of reinsurance ceded) is in respect of non-Canadian Risks of persons with whom the FA deals at arm's length.
The Federal Government says it is concerned about insurance swap arrangements where Canadian Risks, originally insured in Canada, are transferred to an FA of a Canadian taxpayer and then exchanged with a third party for foreign risks that were originally insured outside of Canada, but without changing the FA's overall risk profile and economic returns. The Federal Government is challenging these insurance swap arrangements under the existing provisions of the Tax Act, including under the general anti-avoidance rule.
Proposed Anti-Avoidance Rule
The Budget proposes to introduce an anti-avoidance rule to deem non-Canadian Risks (the "Foreign Policy Pool") to be Canadian Risks for FAPI purposes where:
- the FA, or a person or partnership that does not deal at arm's length with the FA, enters into one or more agreements or arrangements in respect of the Foreign Policy Pool;
- as a result of those agreements or arrangements, the FA's risk of loss or opportunity for gain or profit in respect of the Foreign Policy Pool and those agreements or arrangements can reasonably be considered to be determined, in whole or in part, by reference to the fair market value of, the revenue, income, loss or cash flow from risks insured by another person or partnership (the "Tracked Policy Pool"); and
- 10% or more of the Tracked Policy Pool is comprised of Canadian Risks.
If the above deeming rule applies in respect of an FA of a taxpayer (or an FA of another taxpayer with which the taxpayer does not deal at arm's length) and an FA of the taxpayer (or a partnership of which that FA is a member) has entered into agreements or arrangements as described above (the "Targeted Arrangements"), then the activities performed in connection with the Targeted Arrangements and for the purpose of obtaining the risk profile and economic return results described above are deemed to be a separate business other than an active business. As a result, any income of the FA from this deemed separate business (including income that pertains to or is incident to such business) will be treated as FAPI.
Taxpayers with FAs involved in insurance swaps, insurance pooling arrangements or similar arrangements should review these arrangements to determine if this proposed change will affect them.
This anti-avoidance rule will apply to taxation years of taxpayers that begin on or after Budget Day.
Offshore Regulated Banks
Current FAPI Regime
Under the current FAPI regime, income from an "investment business" (as defined in subsection 95(1) of the Tax Act) carried on by an FA of a taxpayer is included in the FA's FAPI. An investment business is generally a business the principal purpose of which is to derive income from property (including interest, dividends, rents, royalties or any similar returns or substitutes therefore), income from the insurance or reinsurance of risks, income from the factoring of accounts receivable, or profits from the disposition of investment property, subject to certain exceptions. Most financial services businesses would generally be considered investment businesses but for certain exceptions.
One of the exceptions is for a business (other than any business conducted principally with persons with whom the FA does not deal at arm's length) carried on by an FA as a foreign bank, a trust company, a credit union, an insurance corporation or a trader or dealer in securities or commodities where the activities of the FA are regulated under the laws of: (a) the countries in which the financial business is carried on through a permanent establishment and the country under whose laws the FA is governed and exists, (b) the country in which the financial business is principally carried on, or (c) in certain circumstances, member states of the European Union. It is also necessary for the FA to employ more than five employees full-time in the active conduct of the financial business or, in certain circumstances, have the benefit of the equivalent through certain inter-company services. The Budget refers to this exception as the "regulated foreign financial institution exception". The purpose of the regulated foreign financial institution exception is to treat certain bona fide financial services businesses carried on by FAs as active businesses rather than as investment businesses.
Targeted Foreign Financial Institution
The Federal Government is concerned that certain Canadian taxpayers that are not financial institutions are taking advantage of the regulated foreign financial institution exception where their main purpose is to engage in proprietary activities that consist of investing or trading in securities on their own account rather than facilitating financial transactions for customers.
New Proposed Conditions for Regulated Foreign Financial Institution Exception
The Federal Government believes that, depending on the particular facts, it may be possible to challenge existing arrangements on the basis that they do not qualify for the regulated foreign financial institution exception. However, since such challenges can be time consuming and costly, the Budget proposes to address this concern by adding new conditions for qualifying under the regulated foreign financial institution exception.
The Budget proposes that the regulated foreign financial institution exception will be available only where the following conditions are satisfied:
(a) the Canadian taxpayer is:
(i) a bank listed in Schedule I to the Bank Act, a trust company, a credit union, an insurance corporation or a trader or dealer in securities or commodities resident in Canada, the business activities of which are subject by law to the supervision of a regulating authority such as the Superintendent of Financial Institutions or a similar authority of a province (the "Canadian FI"),
(ii) a subsidiary wholly-owned subsidiary of a Canadian FI, or
(iii) a corporation of which a Canadian FI is a wholly-owned subsidiary corporation and that is subject by law to the supervision of the same regulating authority; and
(i) the Canadian FI is a bank, trust company or insurance corporation that has, or is deemed for certain purposes to have, $2 billion or more of equity
(A) in the case of a bank, under the Bank Act,
(B) in the case of a trust company, under the Trust and Loan Companies Act, or
(C) in the case of an insurance corporation, under the Insurance Companies Act, or
(ii) more than 50% of the taxable capital employed in Canada (within the meaning assigned by Part I.3 of the Tax Act) of the taxpayer, or a corporation resident in Canada that is related to the taxpayer, for the year is attributable to a business carried on in Canada, the activities of which are subject to the supervision of a regulating authority such as the Superintendent of Financial Institutions or a similar authority of a province.
The general effect of these new conditions appears to be to restrict the regulated foreign financial institution exception to FAs of Canadian resident/ Canadian regulated financial companies having substantial Canadian assets.
The Federal Government indicates that even satisfying the new conditions will not guarantee that an FA will qualify for the regulated foreign financial institution exception. The FA will still have to demonstrate that it is carrying on a regulated foreign financial business in accordance with applicable laws and that any proprietary activities comprise part of that business.
The Federal Government indicates that it will continue to monitor developments in this area to determine whether any further action is required to ensure that the regulated foreign financial institution exception, as proposed to be amended, is not used by taxpayers to obtain unintended tax advantages.
The proposed new conditions for the regulated foreign financial institution exception will apply to taxation years that begin after 2014. In order to ensure that the proposed measures are appropriately targeted, the Federal Government invites stakeholders to submit comments concerning the scope of these proposals within 60 days after Budget Day.
Current Taxation and Deductibility of Interest on Loans to Non-Residents of Canada
Canadian Thin Cap Regime
Under the current Canadian thin capitalization rules, the deductibility of interest expense in computing the income of a corporation or a trust for a taxation year from a business or property is limited where the amount of debt owing to certain non-residents exceeds a 1.5-to-1 debt-to-equity ratio.
The rules apply, in the case of a corporation, to debts owing to a specified non-resident shareholder of the corporation or a non-resident person that is not dealing at arm's length with a specified shareholder of the corporation (referred to herein as "specified non-resident"). A specified shareholder of a corporation generally means a person that, either alone or together with persons with which such person is not dealing at arm's length, owns shares representing 25% or more of the votes or value of the corporation.
In the case of a trust, the rules apply to debts owing to a non-resident specified beneficiary of the trust or a non-resident person that is not dealing at arm's length with a specified beneficiary of the trust (also referred to herein as "specified non-resident"). A specified beneficiary of a trust generally means a person that, either alone or together with persons with which such person is not dealing at arm's length, owns an interest as beneficiary under the trust with a fair market value of 25% or more of the fair market value of all interests under the trust.
Canadian Withholding Taxes on Interest on Non-Arm's Length Loans under Part XIII of the Tax Act
Interest paid or credited by a Canadian resident person (or a non-resident person if the interest is deductible in computing the non-resident person's taxable income earned in Canada) to a non-arm's length non-resident person is subject to Canadian withholding taxes at the rate of 25% unless a reduced rate is available under a tax treaty.
The Federal Government is concerned that some taxpayers have sought to avoid either or both the thin capitalization rules (including an existing anti-avoidance provision for back-to-back loans in those rules) and Part XIII withholding tax through the use of so-called "back-to-back loan" arrangements. The targeted arrangements generally involve interposing a third party (e.g., a foreign bank) between two related taxpayers (such as a foreign parent corporation and its Canadian subsidiary) in an attempt to avoid the application of rules that would apply if a loan were made, and interest paid on the loan, directly between the two taxpayers.
Proposed New Anti-Avoidance Rule and Amendment to Existing Anti-Avoidance Rule
Notwithstanding that the Federal Government believes that such arrangements could be subject to challenge under existing anti-avoidance rules, the Budget proposes to address back-to-back loan arrangements by adding a specific anti-avoidance rule in respect of withholding tax on interest payments, and by amending the existing anti-avoidance rule for back-to-back loans in the thin capitalization rules.
Amendment to Existing Anti-Avoidance Rule For Back-to-Back Loans
A back-to-back loan arrangement will be considered to exist under the proposed amendments where the following conditions are met:
- a taxpayer has an outstanding interest-bearing obligation owing to a person or partnership (referred to as the "intermediary");
- as part of a transaction, or series of transactions or events,
which includes the taxpayer becoming obligated to pay the
particular amount, the intermediary, or any person that does not
deal at arm's length with the intermediary,
- has an interest in property that secures payment of the particular amount which interest was provided directly or indirectly by a specified non-resident (according to the Federal Government, a guarantee would not, in and of itself, satisfy this condition); or
- has an amount outstanding as or on account of a debt or other obligation to pay an amount to a specified non-resident for which recourse is limited, either immediately or in the future and either absolutely or contingently, to the particular debt or other obligation, or that was entered into on condition that the particular debt or other obligation also be entered into; and
- the intermediary is not a specified non-resident.
Where a back-to-back loan arrangement exists, the taxpayer will, in general terms, be deemed to owe an amount to the specified non-resident (referred to herein as the "deemed amount owing") and not to the intermediary that is equal to the lesser of:
- the outstanding amount of the obligation owing to the intermediary; and
- the total of all amounts each of which is at that time the fair market value of property that secures the obligation and any outstanding amount of debt for which recourse is limited or that was entered into on condition that the particular loan also be entered into as described above.
The taxpayer will, in general terms, also be deemed to have an amount of interest paid or payable to the specified non-resident that is equal to the proportion of the interest paid or payable by the taxpayer on the obligation owing to the intermediary that the deemed amount owing is of that particular obligation.
New Anti-Avoidance Rule
Part XIII withholding tax will generally apply in respect of interest that is deemed paid or payable by the taxpayer in respect of a back-to-back loan arrangement described above to the extent that it would otherwise be avoided by virtue of the arrangement. The specified non-resident and the taxpayer will be jointly and severally (or solidarily) liable for the additional Part XIII withholding tax.
These measures will apply in respect of the thin capitalization rules to taxation years that begin after 2014, and in respect of Part XIII withholding tax to amounts paid or credited after 2014.
Consultation on Tax Planning by Multinational Enterprises
The Federal Government confirmed its commitment to continue to improve the integrity of Canada's international tax rules and reiterated its growing concerns that substantial corporate tax revenue is being lost due to international tax planning that seeks to shift profits away from nations where income-producing activities take place through an exploitation of the interaction between domestic and international tax rules. The Federal Government indicated that it is actively involved in the work being done by the Organization for Economic Co-operation and Development ("OECD"), of which Canada is a member, and the G-20, including the OECD's project regarding "base erosion and profit shifting" ("BEPS") strategies used by multinational enterprises ("MNE"s).
In order to address concerns regarding certain tax planning undertaken by MNEs, the Federal Government is seeking input from stakeholders on the following questions:
- what are the impacts of international tax planning by MNEs on other participants in the Canadian economy?;
- which of the international corporate income tax and sales tax issues identified in the BEPS Action Plan should be considered the highest priorities for examination and potential action by the Federal Government?;
- are there other corporate income tax or sales tax issues related to improving international tax integrity that should be of concern to the Federal Government?;
- what considerations should guide the Federal Government in determining the appropriate approach to take in responding to the issues identified – either in general or with respect to particular issues?; and
- would concerns about maintaining Canada's competitive tax system be alleviated by coordinated multilateral implementation of base protection measures?
The Federal Government is also inviting input from stakeholders on the actions that it should take to ensure the effective collection of sales tax on e-commerce sales to Canadian residents by internationally-based vendors. In particular, the Federal Government is requesting input regarding the possibility of adopting similar approaches to those taken in certain countries (such as South Africa and the European Union), requiring foreign-based vendors to register with the Canada Revenue Agency and to charge the Goods and Services Tax/Harmonized Sales Tax, as applicable, if they engage in e-commerce sales to Canadian residents.
The Federal Government asks interested parties to submit comments within 120 days after Budget Day by e-mail to: firstname.lastname@example.org or by mail to:
International Tax Consultation
Tax Policy Branch
Department of Finance
140 O'Connor Street
Consultation on Treaty Shopping
In the 2013 budget, the Federal Government expressed its concerns regarding "treaty shopping" and indicated its intention to seek input from stakeholders. "Treaty shopping" is a term commonly used to refer to arrangements under which a person not entitled to the benefits of a particular tax treaty with Canada uses an entity that is a resident of a state with which Canada has concluded a tax treaty to obtain certain Canadian tax benefits.
The Federal Government indicated that one of the issues identified in the Action Plan released in July 2013 by the OECD on BEPS by multinational enterprises is the abuse of tax treaties. The OECD is expected to issue its recommendations in this regard in September 2014. The Federal Government confirmed that the OECD's recommendations will be relevant in developing a Canadian approach to address treaty shopping.
August 2013 Consultation Paper and Stakeholder Input
The Federal Government released a consultation paper on treaty shopping in August 2013 to seek the views of interested parties regarding possible approaches to address treaty shopping. Stakeholders had until December 13, 2013 to provide comments.
The consultation paper noted that most countries that have addressed the issue in their tax treaties have used a general rule, i.e., a rule that denies a tax treaty benefit if one of the main purposes for entering into a transaction is to obtain the benefit. The consultation paper also noted that some countries (e.g., the United States and Japan) address the issue with relatively more specific rules governing limitations on benefits.
According to the Federal Government, as stated in the consultation paper, in the Canadian context, there are several factors that support the use of a general approach based on a main purpose provision. Canada has already included such a rule in several of its tax treaties, as have other countries in hundreds of tax treaties worldwide. Thus, a main purpose rule is an approach that is relatively familiar to Canadian taxpayers, tax professionals and Canada's tax treaty partners.
The Federal Government received several comments from stakeholders on the consultation paper, addressing the respective merits of a general approach and of a more specific approach, and the advantages and disadvantages of a domestic law approach, a treaty-based approach, or a combination of both.
Stakeholders expressed concerns that a general approach might produce less certain outcomes in some cases (compared to a more specific approach). Several stakeholders indicated a preference for the adoption of a more specific rule that would, they suggest, provide greater certainty for taxpayers. The example cited in this regard is the limitation on benefits provision included in U.S. tax treaties (such as Article XXIX-A of the Canada-U.S. tax treaty).
According to the Federal Government, while the U.S. limitation on benefits provision arguably provides a high level of certainty, it does not capture, at least on its own, all forms of treaty shopping. In particular, it does not prevent treaty shopping arrangements that use certain entities, such as publicly-traded corporations or trusts. A general approach may serve to prevent a wider range of treaty shopping arrangements.
Several stakeholders expressed a preference for a solution to treaty shopping that would require the re-negotiation of Canada's tax treaties. This is based in large part on the view that a domestic law response to treaty shopping would alter the balance of compromises reached in the negotiation of tax treaties. However, the Federal Government expressed the view that the absence of an anti-treaty shopping rule in a tax treaty does not mean that there is an implicit obligation to provide benefits in respect of abusive arrangements. It reiterated its argument on this point that domestic law provisions to prevent tax treaty abuse are not considered by the OECD or the United Nations to be in conflict with tax treaty obligations and a number of other countries have enacted legislation to that effect.
In addition, the Federal Government indicated that some stakeholders have asserted that only a few of Canada's tax treaties would need to be re-negotiated in order to significantly curtail treaty shopping. As stated in the consultation paper, even if it were possible to re-negotiate within a reasonable period of time Canada's treaties with certain countries where conduit entities are common, this would not address the Federal Government's concern that other conduit countries may emerge. Accordingly, the Federal Government expressed the view that a treaty-based approach would not be as effective as a domestic law rule.
Main Elements of New Proposed Anti-Treaty Shopping Domestic Rule
The Federal Government invites comments from interested parties on a proposed rule to prevent treaty shopping. The rule would address arrangements identified as an improper use of Canada's tax treaties in the consultation paper and, therefore, protect the integrity of Canada's tax treaties. This proposed rule would use a general approach focussed on avoidance transactions and, in order to provide more certainty and predictability for taxpayers, building on comments received on the 2013 consultation paper, the rule would contain specific provisions setting out the ambit of its application.
According to the Federal Government, the approach would ensure that treaty benefits are provided with respect to ordinary commercial transactions and that, if the rule applies, the benefit that would be reasonable under the circumstances would be provided.
In order to further advance the discussion, the Federal Government has set out the main elements of a proposed rule to address treaty shopping as follows:
- Main purpose provision: subject to the relieving provision, a benefit would not be provided under a tax treaty to a person in respect of an amount of income, profit or gain (relevant treaty income) if it is reasonable to conclude that one of the main purposes for undertaking a transaction, or a transaction that is part of a series of transactions or events, that results in the benefit was for the person to obtain the benefit.
- Conduit presumption: it would be presumed, in the absence of proof to the contrary, that one of the main purposes for undertaking a transaction that results in a benefit under a tax treaty (or that is part of a series of transactions or events that results in the benefit) was for a person to obtain the benefit if the relevant treaty income is primarily used to pay, distribute or otherwise transfer, directly or indirectly, at any time or in any form, an amount to another person or persons that would not have been entitled to an equivalent or more favourable benefit had the other person or persons received the relevant treaty income directly.
- Safe harbour presumption: subject to the conduit presumption, it would be presumed, in the absence of proof to the contrary, that none of the main purposes for undertaking a transaction was for a person to obtain a benefit under a tax treaty in respect of relevant treaty income if:
- the person (or a related person) carries on an active business (other than managing investments) in the state with which Canada has concluded the tax treaty and, where the relevant treaty income is derived from a related person in Canada, the active business is substantial compared to the activity carried on in Canada giving rise to the relevant treaty income;
- the person is not controlled, directly or indirectly in any manner whatever, by another person or persons that would not have been entitled to an equivalent or more favourable benefit had the other person or persons received the relevant treaty income directly; or
- the person is a corporation or a trust the shares or units of which are regularly traded on a recognized stock exchange.
- Relieving provision: If the main purpose provision applies in respect of a benefit under a tax treaty, the benefit is to be provided, in whole or in part, to the extent that it is reasonable having regard to all the circumstances.
Even if a transaction results in a tax treaty benefit for a taxpayer, the Federal Government acknowledges that it does not necessarily follow that one of the main purposes for undertaking the transaction was to obtain the benefit. One of the objectives of tax treaties is to encourage trade and investment and, therefore, it is expected that tax treaty benefits will generally be a relevant consideration in the decision of a resident of a state with which Canada has a tax treaty to invest in Canada. Accordingly, the proposed anti-treaty shopping domestic rule would not apply in respect of an ordinary commercial transaction solely because obtaining a tax treaty benefit was one of the considerations for making an investment.
The Federal Government proposes that the rule, if adopted, could be included in the Income Tax Conventions Interpretation Act so that it would apply in respect of all of Canada's tax treaties.
The rule would apply to taxation years that commence after the enactment of the rule into Canadian law. The Federal Government also requests comments as to whether transitional relief would be appropriate.
Treaty Shopping Examples
The Federal Government invites comments on the following examples in relation to the intended application of the proposed rule to a number of arrangements. We note that the first three examples appear to be based on the treaty shopping cases that the Federal Crown lost in Velcro Canada Inc. v. R. (TCC-2012), Prévost Car Inc. v. R. (FCA-2009) and MIL (Investments) S.A. v. R. (TCC-2006) respectively.
Example 1 – Assignment of income
Aco, a company that is a resident of State A, owns intellectual property used by its subsidiary, Canco, a corporation that is a resident of Canada. State A does not have a tax treaty with Canada and, therefore, payments of royalties by Canco to Aco would be subject to a withholding tax rate of 25 per cent in Canada.
Aco incorporates Bco, an intermediary corporation in State B, a state with which Canada has a tax treaty that provides for a nil rate of withholding tax in Canada on royalties paid to a resident of State B.
Aco assigns to Bco the right to receive royalty payments from Canco. In exchange for the rights granted under the assignment agreement, Bco agrees to remit 80 per cent of the royalties received to Aco within 30 days.
Bco pays tax in State B on its net amount of royalty income. State B does not impose a withholding tax on the payment of royalties made to non-residents.
The royalties received by Bco from Canco are primarily used to pay an amount to Aco and Aco would not have been entitled to a tax treaty benefit had it received the royalties directly from Canco.
As a result, under the conduit presumption it would be presumed, in the absence of proof to the contrary, that one of the main purposes for the assignment of the royalties is for Bco to obtain the benefit of the withholding tax reduction under the tax treaty between Canada and State B. Consequently, the main purpose provision would apply to deny the benefits under the tax treaty between State B and Canada in respect of the royalty payments.
Depending on all the circumstances, it might be possible that, by virtue of the relieving provision, Bco would be allowed the benefits of the tax treaty in respect of the portion of the royalty payments that is not used by Bco to pay an amount to Aco.
If, instead, only 45 per cent of the royalties received by Bco from Canco were used to pay an amount to Aco, the conduit presumption would not apply to create a presumption as to the main purpose of the transaction, and it would be a question of fact whether the main purpose provision applied.
Example 2 – Payment of dividends
The shares of Canco, a Canadian resident corporation, are owned by Bco, a corporation that is a resident of State B. The sole investment of Bco consists of the shares of Canco. Bco was established in State B by its two corporate shareholders, Aco and Cco, residents of State A and State C respectively.
Canada has a tax treaty with State B. Canada also has tax treaties with States A and C, which provide a higher rate of withholding tax on dividends than the rate under the tax treaty with State B.
Under the terms of a shareholders agreement, Bco is required to distribute the entire dividend received from Canco to Aco and Cco almost immediately. Under the domestic laws of State A and State C, dividends received from foreign corporations are subject to tax.
Canco pays a dividend to Bco and Bco uses the dividend to pay a dividend to Aco and Cco. Aco and Cco would not have been entitled to an equivalent or more favourable tax treaty benefit had they received the dividend directly from Canco.
As a result, under the conduit presumption it would be presumed, in the absence of proof to the contrary, that one of the main purposes for the establishment of Bco is to obtain the benefit of the withholding tax reduction under the tax treaty between Canada and State B and, subject to the relieving provision, the benefit would be denied.
In this example, the benefits that would have applied if Bco had not been established may be provided under the relief provision to the extent it is reasonable having regard to all the circumstances. For instance, if Aco and Cco are taxable in State A and State C respectively on the dividend they received from Bco, it may be reasonable in the circumstances to provide the benefits that Aco and Cco would have been entitled to under the tax treaty between Canada and States A and C respectively had the dividend they received been paid directly from Canco.
Example 3 – Change of residence
Aco, a corporation that is a resident of State A, owns shares of a corporation that is a resident of Canada and is contemplating their sale. Such a sale would trigger a capital gain that would be taxable in Canada. Canada does not have a tax treaty with State A. Shortly before the sale, Aco is continued into, and becomes a resident of, State B, a state that does not impose tax on capital gains.
The tax treaty between Canada and State B provides an exemption from tax for capital gains on shares of a Canadian corporation disposed by residents of State B. Aco sells the shares and retains the proceeds of disposition. Aco claims the capital gains exemption available under the tax treaty.
In this example, since the proceeds of disposition remain with Aco, the conduit presumption would not apply. However, the main purpose provision would apply because, based on these facts and in the absence of other circumstances, it is reasonable to conclude that one of the main purposes of the continuation of Aco into State B was to obtain the benefit of the capital gains exemption provided under the tax treaty.
If, instead of becoming a resident of State B shortly before the sale, Aco was already a resident of State B at the time of the initial acquisition of the shares of the Canadian corporation, it would need to be determined whether is it reasonable to conclude that one of the main purposes for the establishment of Aco as a resident of State B was to obtain the capital gains exemption under the tax treaty between Canada and State B.
This is a question of fact and all the relevant circumstances would need to be considered, including, for example, the lapse of time between the establishment of Aco in State B and the realization of the capital gains, and any other intervening events.
Example 4 – Bona fide investments
B-trust is a widely held trust that is a resident of State B, a state with which Canada has a tax treaty. B-trust pursues a strategy of managing a diversified portfolio of investments in the international market. Through recent investments in Canada, B-trust currently holds 10 per cent of its portfolio in shares of Canadian corporations, in respect of which it receives annual dividends. Under the tax treaty between Canada and State B, the withholding tax rate on dividends is reduced to 15 per cent.
Investors in B-trust seek to maximize the return on their investments and rely on the solid reputation of B-trust's management to make optimal investment decisions. These investment decisions take into account the existence of tax benefits provided under State B's extensive tax treaty network.
Several investors in B-trust are residents of State B, but a majority of investors are residents of states with which Canada does not have a tax treaty. B-trust annually distributes all of its income to its investors.
In this example, because dividends received by B-trust from Canadian corporations are primarily used to distribute income to persons that are not entitled to tax treaty benefits, it would be presumed under the conduit presumption that one of the main purposes for B-trust to undertake its investments in Canadian corporations and for third state investors to undertake their investments in B-trust, either alone or as part of a series of transactions, was to obtain the benefit under the tax treaty between Canada and State B.
To rebut this presumption, it would have to be clearly established that none of the main purposes for undertaking these investments, either alone or as part of a series of transactions, was to obtain the benefit of the tax treaty between Canada and State B. Investors' decisions to invest in B-trust are not driven by any particular investments made by B-trust, and B-trust's investment strategy is not driven by the tax position of its investors.
In this example, and in the absence of other circumstances, there would be sufficient facts to rebut the above presumptions. It follows that the main purpose provision would not apply to deny the tax treaty benefit.
Example 5 – Safe harbour (active business)
Aco is a corporation that is a resident of State A, a state with which Canada does not have a tax treaty. Aco owns all the shares of Finco, a corporation that is a resident of State B. Canada has a tax treaty with State B. Finco acts as a financing corporation for Aco's wholly owned subsidiaries, including Canco (a resident of Canada) and Bco (a resident of State B).
Bco carries on an active business in State B and that business is substantial in comparison to the activities carried on by Canco. Aco's other subsidiaries are residents of other states with which Canada has tax treaties which provide tax treaty benefits on payments of interest that are equivalent to those provided under the tax treaty between Canada and State B. Finco receives payments of interest from Aco subsidiaries and reinvests its profits.
In this example, since the interest payments received by Finco from Canco are primarily used to pay an amount to persons that would have been entitled to an equivalent benefit had they received the interest payment directly from Canco, the conduit presumption would not apply.
The safe harbour presumption describes categories of persons that, unless they are used in conduit arrangements, are generally considered not to be engaged in treaty shopping in the course of their normal operations. Since Bco carries on a substantial active business in State B and is related to Finco, it would be presumed under the safe harbour presumption, in the absence of proof to the contrary, that none of the main purposes for Finco to undertake the investment in Canada was for Finco to obtain the benefits of the tax treaty between Canada and State B.
To rebut this presumption, it would have to be clearly established that one of the main purposes for undertaking the investment in Canada was to obtain the benefits of the tax treaty. In this example and in the absence of other circumstances, the above presumption would not be rebutted and the main purpose provision would not apply to deny the tax treaty benefit.
Update on the Automatic Exchange of Information for Tax Purposes
Exchange of Information Provisions Under Tax Treaties
The Federal Government confirmed that the exchange of tax information between countries is an important tool for implementing its commitment to combat tax evasion in order to protect the revenue base and ensure public confidence in the fairness and equity of the tax system. Provisions to facilitate the exchange of tax information are a long-standing feature of many of Canada's tax treaties.
Canada reinforced its commitment to the exchange of information under tax treaties in the 2007 budget when it announced that all future tax treaties and updates to existing treaties would include the current OECD standard for information exchange and that the Federal Government would be pursuing tax information exchange agreements that include comprehensive exchange of information provisions.
In order to ensure that jurisdictions that have made commitments to exchange information in accordance with the current OECD standard actually do so, the Global Forum on Transparency and Exchange of Information for Tax Purposes has been conducting comprehensive peer reviews of the information exchange practices of its 121 member jurisdictions since 2009. The Federal Government confirmed that Canada, which was subject to a peer review in 2010-2011, has been determined to be fully compliant with the OECD standard, and that Canada supports the work of the Global Forum and recognizes the importance of its peer review process to promote best practices and monitor the effectiveness of agreements to exchange information for tax purposes.
Foreign Account Tax Compliance Act ("FATCA"), Intergovernmental Agreement for the Enhanced Exchange of Tax Information under Canada-U.S. Tax Convention ("IGA")
In 2010, the United States enacted FATCA. Pursuant to the provisions of FATCA, non-U.S. financial institutions would generally be required to identify accounts held by U.S. persons, which include U.S. citizens living abroad (including U.S. citizens who are resident in Canada for tax purposes), and report to the U.S. Internal Revenue Service ("IRS") information in respect of these accounts. FATCA was developed to combat offshore U.S. tax evasion through increased transparency, enhanced reporting and strong sanctions.
FATCA has raised a number of concerns in Canada among both U.S. citizens living in Canada and Canadian financial institutions. Without an IGA between Canada and the U.S., Canadian financial institutions and U.S. persons holding financial accounts in Canada would be required to comply with FATCA starting July 1, 2014 as per the FATCA legislation enacted by the U.S. unilaterally. The Federal Government has raised the concern that compliance with FATCA potentially violates Canadian privacy laws.
In response to these concerns, the Federal Government negotiated the IGA with the U.S. which contains significant exemptions and other relief. Under the approach adopted in the IGA announced on February 5, 2014, Canadian financial institutions will report to the CRA information in respect of U.S. persons that will be transmitted by the CRA to the IRS in accordance with the IGA and the current exchange of information provisions of the Canada-U.S. Tax Convention.
In exchange, the CRA will receive information from the U.S. in respect of Canadian resident taxpayers that hold accounts at U.S. financial institutions, which will assist Canadian tax authorities in administering and enforcing compliance with Canadian tax laws.
A variety of registered accounts (including Registered Retirement Savings Plans, Registered Retirement Income Funds, Registered Education Savings Plans, Registered Disability Savings Plans, and Tax-Free Savings Accounts) and smaller deposit-taking institutions, such as credit unions, with assets of less than $175 million will be exempt from reporting.
These new reporting requirements will come into effect starting in July 2014, with an information return filed and information between countries exchanged starting in 2015.
The IGA will not impose any new U.S. taxes or penalties for non-compliance with U.S. tax laws on U.S. persons holding accounts at Canadian financial institutions and is strictly an information sharing agreement.
Each reporting Canadian financial institution would be treated as complying with the applicable reporting under FATCA and not subject to the FATCA withholding tax.
While the Canada-U.S. tax treaty contains a provision that allows a country to collect the taxes imposed by the other country, the CRA will not collect the U.S. tax liability of a Canadian citizen if the individual was a Canadian citizen at the time the liability arose (whether or not the individual was also a U.S. citizen at that time).
This new reporting regime will come into effect starting in July 2014, with Canada and the U.S. beginning to receive enhanced tax information from each other in 2015.
Update on Tax Treaties and Tax Information Exchange Agreements ("TIEA")
The Federal government confirmed that it will continue to actively negotiate and conclude tax treaties to reduce tax barriers to international trade and investment, combat international tax evasion and aggressive tax avoidance, strengthen Canada's bilateral economic relationships, and create enhanced opportunities for Canadian businesses abroad.
The Federal Government provided the following update on negotiation of Tax Treaties and TIEA since the 2013 budget and as of February 1, 2014:
- new tax treaties with Hong Kong, Poland and Serbia have come into force;
- protocols to update tax treaties with Austria, Barbados, France and Luxembourg have come into force;
- an agreement concerning the exchange of information provisions of the Canada-Switzerland tax treaty has come into force;
- the Convention on Mutual Administrative Assistance in Tax Matters has been ratified by Canada;
- TIEAs with Liechtenstein and Panama have come into force;
- TIEAs with Bahrain, the British Virgin Islands and Brunei have been signed;
- canada now has 92 tax treaties in force, 3 tax treaties signed but not yet in force, and 8 tax treaties and protocols under negotiation; and
- since 2007, the Government has brought into force 18 TIEAs, signed 4 TIEAs that are not yet in force and is negotiating TIEAs with 8 other jurisdictions.
Remittance Thresholds for Employer Source Deductions
Employers have an obligation to withhold amounts from remuneration paid to employees in respect of income tax, Canada Pension Plan ("CPP") contributions and Employment Insurance ("EI") premiums. Employers are then required to remit such amounts to the CRA. With respect to CPP and EI, the remittance includes both the employer and employee contributions. The frequency of an employer's remittance is dependant upon the particular category of remitter the employer falls in. The basis for determining which category an employer is included in is dependant on the employer's total average monthly withholding amount in preceding calendar years. Two such categories are employers who, two calendar years ago, had a total average monthly withholding amount of:
- $15,000 but less than $50,000 and are then required to remit deductions up to twice per month, depending on their payroll frequency ("Category 1"); and
- $50,000 or greater and are then required to remit deductions up to four times per month, depending on their payroll frequency ("Category 2").
The Budget proposes to reduce the frequency of remittances of source deductions for the above categories of employers. Specifically the Budget proposes to:
- increase the threshold amount for Category 1 employers from $15,000 to $25,000; and
- increase the threshold amount for Category 2 employers from $50,000 to $100,000.
These changes will apply in respect of amounts withheld after 2014.
Tax Incentives for Clean Energy Generation
The Tax Act permits taxpayers to deduct capital cost allowance ("CCA") on depreciable assets. The rate of CCA is dependent on the class of assets on which CCA is being claimed. Class 43.2 assets (specified clean energy generation and energy conservation equipment) are subject to an accelerated CCA rate of 50% per year on a declining-balance basis. Class 43.2 assets are essentially assets that generate or conserve energy by:
- using a renewable energy source (e.g. wind, solar, small hydro);
- using fuel from waste (e.g. landfill gas, manure, wood waste); or
- making efficient use of fossil fuels (e.g. high efficiency cogeneration systems that simultaneously produce both electricity and useful heat).
Eligible equipment of this nature is listed under Class 43.1 of Schedule II of the Income Tax Regulations, which list is incorporated by reference in Class 43.2. The main difference between the two classes is that to benefit from the higher accelerated rate of depreciation under Class 43.2, cogeneration systems and waste-fuelled electricity generation systems must meet a higher efficiency standard.
The available rate of CCA is referred to as "accelerated" because it is an exception to the general rule whereby the rate of CCA is intended to be based on the useful life of the asset. The Budget proposes to expand the eligible equipment for Class 43.2 (as well as Class 43.1) to include water-current energy equipment and equipment used to gasify eligible waste fuel for use in a broader range of applications. The goal of the change is to encourage investment in technologies that are more environmentally friendly and that may contribute to the diversification of Canada's energy supply.
Water-Current Energy Equipment
"Water-current" energy equipment converts the kinetic energy of flowing water into electricity without the use of a physical barrier such as a dam. Wave and tidal energy equipment are generally already eligible under Class 43.2. The Budget would expand Class 43.2 to apply to water-current energy equipment. Eligible property will include support structures, submerged cables, transmission equipment, and control, conditioning and battery storage equipment. However, it will not include buildings, distribution equipment or auxiliary electricity generating equipment.
The availability of accelerated CCA for water-current energy equipment, as well as wave and tidal energy equipment, will be dependant on the property, when it becomes first available for use, complying with all applicable Canadian environmental laws, by-laws and regulations.
These changes will apply to property acquired on or after Budget Day that has not been used or acquired for use before Budget Day.
"Gasification" is a term used to describe the process that converts organic or fossil-based materials into hydrogen, carbon monoxide and carbon dioxide, resulting in a product known as "producer gas" or "syngas". Gasification equipment is currently eligible under Class 43.2 as "fuel upgrading equipment" when it is used in an eligible cogeneration facility or an eligible waste-fuelled thermal energy facility. The Budget would expand Class 43.2 to apply to property used to gasify eligible waste fuel for other applications (e.g. to sell the producer gas for domestic or commercial use). Eligible property will include piping, storage equipment, feeding equipment, ash-handling equipment and equipment to remove non-combustibles and contaminants from the producer gas. However, it will not include buildings, other structures, or heat rejection equipment.
The availability of accelerated CCA for eligible property will be dependant on the property, when it becomes first available for use, complying with all applicable Canadian environmental laws, by-laws and regulations.
These changes will apply to property acquired on or after Budget Day that has not been used or acquired for use before Budget Day.
Consultation on Eligible Capital Property
The Budget announces a consultation on proposed changes to the eligible capital property ("ECP") regime under the Tax Act. Currently, the Tax Act has CCA provisions for capital expenditures for tangible property (e.g. equipment, furniture and buildings) and a separate regime for capital expenditures in respect of intangible property (e.g. goodwill and customer lists). These assets are referred to under the Tax Act as ECP.
Expenditures on account of ECP are deductible (slowly) in computing income from business. Under the ECP regime, only 75% of an eligible capital expenditure is added to the cumulative eligible capital ("CEC") pool, from which a deduction of 7% may be taken on an annual declining-balance basis.
The ECP regime further provides that 75% of an eligible capital receipt, in contrast, is subtracted from the CEC pool or, if the CEC pool is depleted, results in recapture of previously-deducted CEC. Any excess eligible capital receipts are included in income from the business at a 50% inclusion rate.
The Budget acknowledges that the ECP regime has become increasingly complicated and notes that certain stakeholders have suggested a replacement regime based on a new class of depreciable property to which the CCA rules would apply. Detailed draft legislative proposals will be released for consultation shortly, and the timing for the implementation of the proposals will be determined following the consultation.
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