Canada: 2014 Federal Budget: Tax Changes

The Minister of Finance delivered the 2014 Canadian federal budget today. In terms of new tax policy measures, Budget 2014 is thin when compared to the last few years, but seeks input from stakeholders on a number of future measures. The principal business and international changes include:

  • Passive income rules for foreign subsidiaries. Income that is considered "foreign accrual property income" ("FAPI") of a controlled foreign subsidiary of a Canadian taxpayer is taxed in Canada on a current basis notwithstanding that such income is not distributed to the Canadian taxpayer. Budget 2014 includes two amendments to the FAPI rules: 
    • An existing exception from FAPI for a foreign subsidiary's income from a regulated financial business has been substantially narrowed by, among other things, making the exception only available where the Canadian taxpayer in respect of the foreign subsidiary is a regulated Canadian financial institution or a subsidiary or parent of such a regulated financial institution. This amendment applies to taxation years of a taxpayer that begin after 2014.
    • An anti-avoidance rule that deems income of a foreign subsidiary from insuring Canadian risks to be FAPI has been expanded to catch derivative "insurance swap" arrangements between foreign subsidiaries of Canadian taxpayers and third parties where at least 10% of the tracked risks are Canadian risks. This amendment applies to taxation years of a taxpayer that begin on or after Budget Day.
  • Thin Capitalization and Withholding Tax Changes. The Income Tax Act denies the deduction of interest on debt owing by Canadian businesses to non-residents who hold 25% or more of the equity in the Canadian businesses, or who are connected to persons holding 25% or more of the equity, (a "relevant non-resident") in excess of 1.5 times the relevant equity of the Canadian business. These rules have been expanded in recent budgets, and are further expanded in Budget 2014. The proposed amendments are described as addressing "back-to-back loans" under which a third party lends funds to the Canadian business and a relevant non-resident provides security for the loan or lends funds to the third party on a limited recourse basis, or on condition that a loan be made to the Canadian business. Such arrangements will now be treated as loans by a relevant non-resident to the extent of the credit support provided by the non-resident. Importantly, foreign parent guarantees of the debts of a Canadian business — a common situation — will now trip the thin capitalization rules where the guarantee is secured. Unsecured guarantees are unaffected.

In addition, interest paid where there is a back-to-back arrangement may be subject to withholding tax where the non-resident providing the security or loan does not deal at arm's length with the Canadian business. Both parent and subsidiary guarantees may be caught in this proposed rule if they are secured, although the inclusion of subsidiary guarantees may be unintended.

These rules will apply to new and existing arrangements, beginning in 2015.

  • Non-Resident Trust Rules and Immigration Trusts. The Income Tax Act taxes non-resident trusts where Canadian residents contribute property to the trust, in order to prevent inappropriate tax avoidance through offshore trusts. Budget 2014 will eliminate an exception that has existed from these rules for "immigration trusts" — trusts whose contributors are individuals who have been resident in Canada for not more than 60 months. This change will apply to trusts for taxation years ending on or after Budget Day. Existing immigration trusts will remain exempt throughout 2014 provided no contributions are made to the trust on or after Budget Day and before 2015.
  • More Consultations on Treaty Shopping. Coming out of a consultation paper last year on possible approaches to "treaty shopping", Budget 2014 invites comments on a proposed rule to prevent treaty shopping to be included in the Income Tax Conventions Interpretation Act, and therefore made applicable for all of Canada's treaties. The heart of the proposal is a "main purpose" rule, to be complemented by two rebuttable presumptions.

If it is reasonable to conclude that one of the main purposes for undertaking a transaction or series of transactions is for a person to obtain a benefit under a tax treaty with respect to income, the benefit under the treaty will be provided only to the extent, if any, that it is reasonable having regard to the circumstances. In the absence of proof to the contrary, the main purpose requirement would be presumed satisfied if the relevant income is primarily used directly or indirectly to make payments, distributions or transfers to others who would not have been entitled to equivalent or more favourable treatment had the relevant income been received directly — the so-called "conduit presumption". Unless the conduit presumption applies, a safe harbour rebuttable presumption may apply: the main purpose test will not be satisfied where there is sufficient business activity in the treaty country, the non-resident is a publicly traded entity or the non-resident is not controlled (de facto or de jure) by persons who would not be entitled to at least equivalent benefits.

The Budget recognizes that one of the objectives of treaties is to encourage trade or investment and accordingly treaty benefits may be a relevant consideration to a resident of the treaty country in deciding whether to invest in Canada. The proposed rule is not intended to apply to "an ordinary commercial transaction solely because obtaining a tax treaty benefit was one of the considerations for making an investment".

Finance has invited comments with particular reference to five examples in the Budget Papers. The first three are, respectively, the facts in the Velcro, Prevost Car and MIL Investment cases, all of which might be characterized as "treaty shopping" cases. The consultation period is 60 days from Budget Day.

  • Other Consultations. Tied to the international focus and work on base erosion, Finance seeks input from stakeholders on issues related to international tax planning by multinational enterprises and effective collection of sales tax on e-commerce sales by foreign-based sellers. Input is also sought on a proposal to create a new class of depreciable property to replace the existing regime for eligible capital property, which includes goodwill and other intangibles not included in a class of depreciable property.

Other Amendments. Budget 2014 includes a number of other non-business tax measures such as (i) the elimination of graduated rates for estates and testamentary trusts after 36 months, at which time they become subject to tax at a flat rate that is the top marginal tax rate for individuals and (ii) the extension of the so-called "Kiddie Tax", which likewise taxes certain income received by minors at a flat top rate to prevent income splitting, to income from a business or rental property if a person related to the minor is actively engaged in the activity of the trust or partnership from which the income is derived or has an interest in the partnership. 

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.

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