Canada: Federal Budget 2016 — Incremental, Not Fundamental Tax Changes

On March 22, 2016 the Minister of Finance tabled Budget 2016, the first budget of the current government's mandate. As telegraphed by the title, "Growing the Middle Class," Budget 2016 contains a variety of measures to assist families, youth, students, the unemployed, seniors, First Nations communities and the environment. Consistent with previous rumours, an important component of the government's plan is to facilitate economic growth by improving Canada's infrastructure. Budget 2016 proposes $120 billion of infrastructure spending over 10 years. The result of these and other proposed fiscal measures is a $29.4-billion deficit for the 2016-17 fiscal year.

Although Budget 2016 proposes changes to address perceived tax leakage, it does not propose increased tax rates beyond those previously announced in December 2015.

Budget 2016 measures intended to enhance the integrity of the tax system include preventing tax avoidance through the use of certain partnership and corporate structures and addressing the long-standing proposal to change the eligible capital property (ECP) regime. Further, Budget 2016 proposes to increase international co-operation and integration with a view to protecting Canada's tax base from international tax planning arrangements. A few perennial favourites included in Budget 2016 are the extension of the mineral exploration tax credit for another year, as well as additions to the categories of clean-tech equipment benefitting from accelerated capital cost allowance (CCA).

Perhaps most newsworthy is what is not included in Budget 2016. Contrary to initial speculation, Budget 2016 does not propose to increase the capital gain inclusion rate and does not touch on the preferential tax treatment of employee stock options.

Taxpayers will be relieved that the new government chose to make incremental rather than fundamental changes to Canada's tax system.

Cross-Border Surplus Stripping

A Canadian corporation can make a tax-free distribution by way of return of capital up to the amount of the paid-up capital (PUC) of the shares of the corporation. By way of contrast, a return of capital in excess of PUC is generally treated as a deemed dividend and subject to Canadian withholding tax. Because of the potential for abuse, the Income Tax Act (ITA) includes an anti-surplus stripping rule in section 212.1 intended to prevent non-residents from entering into certain transactions targeted at extracting retained earnings in excess of PUC free of Canadian tax. When applicable, this anti-surplus stripping rule results in a deemed dividend to the non-resident or a reduction of PUC.

Subsection 212.1(4) contains an exception to this anti-surplus-stripping rule. The exception applies where the non-resident corporation is "sandwiched" between two Canadian corporations and the non-resident corporation sells the shares of the lower-tier Canadian corporation to the upper-tier Canadian corporation in order to unwind the sandwich structure. The exception has been used by certain non-resident corporations who reorganize their corporate group to qualify for the exception in order to artificially increase the PUC of shares of their Canadian subsidiaries.

Budget 2016 proposes to deny the use of the exception in subsection 212.1(4) in cases where a non-resident owns shares of the upper-tier Canadian corporation, directly or indirectly, and the non-resident does not deal at arm's length with the upper-tier Canadian purchaser corporation. The proposed amendments to section 212.1 of the ITA will also address situations where it may be uncertain whether consideration has been received by a non-resident from the upper-tier Canadian corporation for the disposition of shares of the lower-tier Canadian corporation. The proposals will effectively deem the non-resident to receive non-share consideration from the upper-tier Canadian corporation equal to the fair market value (FMV) of the shares of the lower-tier Canadian corporation.

The new anti-avoidance rule will apply in respect of dispositions occurring on or after March 22, 2016. As well, the Canada Revenue Agency (CRA) might apply the general anti-avoidance rule to challenge prior transactions which it believes misuse subsection 212.1(4).

Debt Parking to Avoid Foreign Exchange Gains

Under the ITA income must generally be computed in Canadian dollars. This necessitates the conversion of amounts denominated in a foreign currency to Canadian dollars. As a result, a foreign exchange gain or loss may be realized on the repayment of a debt denominated in a foreign currency if the foreign currency has fluctuated relative to the Canadian dollar.

Some taxpayers have entered into transactions referred to as debt-parking transactions in order to avoid realizing a foreign exchange gain on the repayment of a foreign currency debt. For example, a debtor might enter into an arrangement where a non-arm's length party acquires the debt from the original creditor for a price equal to its principal amount. The original creditor would be repaid, but the new creditor, which is a friendly party, would allow the debt to remain outstanding to avoid the debtor realizing a foreign exchange gain.

The ITA has debt-parking rules to help ensure that the debt forgiveness rules are not avoided in transactions like this. However, under the debt-parking rules the debt is deemed to be repaid for an amount equal to the cost of the debt to the new creditor. Although the debt-parking rules deem the foreign currency debt to have been settled at the time of the acquisition by the new creditor, any foreign exchange gain realized on the debt is not taken into account.

Budget 2016 proposes rules whereby accrued foreign exchange gains on foreign currency debt will be realized when the debt becomes a parked obligation. To do this, the debtor will be deemed to have realized the gain that would apply if it had repaid a principal amount of the debt equal to:

  • Where the debt becomes a parked obligation as a result of its acquisition by the current holder, the amount for which the debt was acquired; and
  • In other cases, the FMV of the debt.

For this purpose a foreign currency debt will become a parked obligation at any time where:

  • At that time, the current holder of the debt does not deal at arm's length with the debtor or, where the debtor is a corporation, has a significant interest in the corporation; and
  • At any previous time, a person who held the debt dealt at arm's length with the debtor and, where the debtor is a corporation, did not have a significant interest in the corporation, typically being shares having 25 per cent or more of the votes or value.

Certain exceptions will be provided to ensure that foreign currency debt does not become a parked obligation as a result of a bona fide commercial transaction where one of the main purposes was not to avoid a foreign exchange gain.

Additional relief will be provided to financially distressed debtors. For example, in the case of a Canadian resident corporate debtor, a rule will ensure that the combined federal and provincial taxes payable on a deemed foreign exchange capital gain will not result in corporation's liabilities exceeding the FMV of its assets.

This measure will apply to a foreign currency debt that meets the conditions to become a parked obligation on or after March 22, 2016. There may also be an exception where there is a written agreement entered into before that date.

Extension of the Back-to-Back Rules to Royalties

Budget 2014 introduced back-to-back loan rules that applied for purposes of both the thin capitalization regime and certain withholding tax provisions. These anti-avoidance rules provide that where an intermediary is interposed between a Canadian borrower and certain related non-resident lenders to circumvent application of the thin capitalization rules, the intermediary will be ignored and the back-to-back loan provisions would deem the loan to be between the Canadian borrower and the non-resident lender, thus making the thin capitalization rules applicable to the loan. Related withholding tax rules introduced by Budget 2014 require the rate of withholding to be equal to the rate that would otherwise have applied to interest paid to the related non-resident lender (assuming it is greater) rather than to the intermediary.

Extension to royalty payments

Budget 2016 introduces an extension of these rules to apply to back-to-back arrangements involving royalty payments. The ITA generally imposes a 25 per cent withholding tax on cross-border payments of rents, royalties or similar payments. The 25 per cent withholding tax rate is often reduced by an applicable tax treaty. Taxpayers therefore may interpose an intermediary located in a favourable treaty country for the payment of royalties.

Under the new rules, where a Canadian taxpayer makes a royalty payment to a person resident in a treaty country (the intermediary) under the terms of a lease, licence or similar agreement, the intermediary has an obligation to pay an amount to another non-resident under the terms of a lease, licence or similar agreement, and the payments are established in reference to each other or are interconnected in some way, the withholding tax rules currently in place in respect of interest payments will also apply to the royalty payments. The applicable withholding tax rate will be the rate on royalties paid to the ultimate non-resident recipient (assuming it is greater) rather than to the intermediary. These rules will apply to royalty payments made after 2016.

Character Substitution Rules

Budget 2016 also proposes to extend the back-to-back rules to prevent avoidance of the higher withholding tax rate by substituting payments that are economically similar to interest and royalties as part of a back-to-back arrangement between an intermediary and a non-resident. These rules will also apply to payments made after 2016.

Extension to Shareholder Loans

The ITA contains shareholder benefit rules that generally apply where a Canadian corporation makes a loan to a shareholder or a related party and the loan remains outstanding for more than one year after the end of the taxation year in which it was made. If the loan was made to a non-resident, the amount of the benefit is deemed to be a dividend subject to withholding tax. Similar to the back-to-back loan rules outlined above, Budget 2016 introduces back-to-back rules that will apply where an intermediary is interposed between a Canadian corporation and a shareholder or related party: the Canadian corporation will be deemed to have made the loan directly to the shareholder rather than to the intermediary, such that the shareholder benefit provisions will apply in respect of the loan. These rules will apply to loan arrangements in place on March 22, 2016.

Base Erosion Profit Shifting

Following the release of the report Addressing Base Erosion and Profit Shifting (BEPS) in February 2013, the Organisation for Economic Co-operation and Development (OECD) and G20 countries quickly adopted a 15-point action plan to address BEPS. BEPS generally refers to tax planning arrangements undertaken by multinational enterprises (MNEs) which, although often using legal means, exploit the interaction between domestic and international rules to minimize tax. One of the main objectives of the OECD with the BEPS project was to ensure that an MNE's profits be allocated based on the location of the economic activities which generate profits and the location where value is created. On October 5, 2015, after more than two years of work, the OECD released its final reports with recommendations from the BEPS project.

Upon the release of the OECD's recommendations, the tax community's focus turned to whether these recommendations would be endorsed, in whole or in part, by tax administrations around the world. Whether the BEPS project will ultimately be declared a success will hinge on how widespread and consistently its recommendations are adopted. At the November 2015 G20 Leaders' Summit, Canada and the other G20 members endorsed the OECD's BEPS recommendations. Budget 2016 provides a more detailed update on the implementation of some of these recommendations.

Country-By-Country Reporting — Transfer Pricing Documentation

One of the most talked about recommendations put forward by the OECD is the requirement for MNEs to provide country-by-country (CbC) reporting of their transfer pricing arrangements. Transfer pricing refers to the price at which goods, services and intangibles are transacted across international borders by parties who are not dealing with each other at arm's length. Under transfer pricing rules a transfer price must be consistent with the arm's length principle, that is, the transfer price should be a price that arm's length parties would have negotiated. The objective of the CbC reporting requirement is to provide tax administrations with better information for conducting risk assessments of transfer pricing situations.

Pursuant to the transfer pricing rules in subsection 247(4) of the ITA, a Canadian taxpayer that enters into a non-arm's length transaction with a non-resident of Canada must prepare documentation which explains and substantiates the transfer price for that transaction. Subsection 247(4) currently does not require a Canadian taxpayer to maintain much of the information that the OECD's final report on BEPS is recommending for CbC reporting.

Budget 2016 proposes to implement CbC reporting, presumably by amending subsection 247(4), in accordance with the OECD's recommendations for large MNEs with total annual consolidated group revenue of €750 million or more. Such MNEs will be required to file a CbC report with the MNE's parent entity's tax administration. A CbC report will include the global allocation, by country, of key details of the MNE, including: revenue, profit, tax paid, stated capital, accumulated earnings, number of employees and tangible assets, as well as the main activities of each subsidiary.

Where the parent entity of a qualifying MNE is resident in Canada, it will be required to file a CbC report with the CRA within one year of the end of the relevant fiscal year. CbC reporting will be required for taxation years that begin after 2015. 

Jurisdictions which receive a CbC report from an MNE will automatically exchange the report with all other jurisdictions in which the MNE operates, provided that the other jurisdictions have implemented CbC reporting, have a legal framework in place for automatic exchange of information, and have entered into a competent authority agreement relating to CbC reporting. 

Given the initial concerns regarding the burden which may be placed on MNEs to comply with CbC reporting, the proposals in Budget 2016 are limited to large MNEs and only require the filing of one CbC report per MNE. This may appease some of the initial concerns expressed by the tax community. Also, since the parent companies of many MNEs are not resident in Canada, most Canadian companies which currently have to comply with subsection 247(4) will not be the entity which is required to file a CbC report.

Revised OECD Guidance

The arm's length principle is found in all of Canada's bilateral tax treaties and is mandated by section 247 of the ITA. The OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines), which Canada adheres to, provide guidance on the application of the arm's length principle. Some of the recommendations arising from the BEPS final reports include revisions to the OECD Guidelines, notably with respect to the interpretation of the arm's length principle. These revisions should be applied by the CRA since they are consistent with the CRA's current interpretation and application of the arm's length principle.

Even though the Government of Canada states in Budget 2016 that "the clarifications provided in the revisions generally support the [CRA]'s current interpretation and application of the arm's length principle," this is a very controversial subject in the international tax community. The OECD and Government of Canada view these revisions as clarifying in nature while many view the revisions, at least in part, as representing a fundamental change to the arm's length principle from the existing OECD Guidelines. This has been the subject of much discussion in the international tax community. Taxpayers whose existing structures contain transfer pricing methodologies which are inconsistent with the new revisions should seek proper tax counsel on how to rectify.  

There is still followup work being performed by BEPS participants to develop a threshold for a proposed simplified approach to low value-adding services, as well as to clarify the definition of risk-free and risk-adjusted returns for minimally functional entities (i.e., "cash boxes"). The CRA will not adjust its administrative practices with regard to these two issues until the followup work is complete.

Treaty Shopping

Treaty shopping was one of the OECD's main concerns when it commenced the BEPS project. Treaty shopping arises where tax treaty benefits are obtained by involving an additional jurisdiction in an international transaction (for example, by creating an intermediary holding company to earn income or gains in a treaty country in order to obtain benefits under a tax treaty that country has entered into).

The BEPS project proposed minimum standards to address treaty abuse such as requiring countries to include in their tax treaties an express statement that their common intention is to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty shopping arrangements. The OECD recommends two treaty anti-abuse approaches: a principal purpose test and a limitation of benefits rule. 

The principal purpose test targets transactions for which one of the principal purposes is to obtain treaty benefits in a way that is not in accordance with the object and purpose of the treaty. A limitation of benefits rule provides a series of tests that must be satisfied in order to qualify for treaty benefits.

Budget 2016 confirms the Government of Canada's intention to adopt the OECD's treaty abuse minimum standard, using either one of the two approaches (which can already be found in some of Canada's treaties).

A multilateral instrument is currently being developed by more than 90 participating countries to streamline the implementation of treaty-related BEPS recommendations. Canada is participating in the development of this multilateral instrument which is expected to be completed in 2016. The multilateral instrument is a tax treaty which will modify provisions of existing treaties if both parties to a treaty sign the instrument. Consequently, in order to implement the treaty abuse minimum standards, amendments to Canada's existing treaties will be achieved through bilateral negotiations, or through the use of this multilateral instrument, or by a combination of the two.

As some may recall, in Budget 2013 the Government of Canada announced its intention to consult on possible measures that would protect the integrity of Canada's tax treaties. Following that announcement, the government released a consultation paper on treaty shopping in August 2013 and then Budget 2014 included a formal proposal for a domestic Canadian anti-treaty shopping rule. In a news release on August 29, 2014, the Government of Canada announced that "After engaging in consultations on a proposed anti-treaty shopping measure, the Government will instead await further work by the [OECD] and the Group of 20 (G-20) in relation to their [BEPS] initiative." It would appear, based on statements in Budget 2016, that the Government has put to rest any ideas of introducing a domestic Canadian anti-treaty shopping rule.

Exchange of Tax Rulings

In an effort to increase transparency, the BEPS project developed a framework for the automatic exchange of tax rulings between tax administrations. These exchanges are generally limited to rulings associated with an area of concern for the BEPS project, such as rulings related to preferential regimes, cross-border unilateral advance pricing arrangements, rulings giving a downward adjustment to profits, permanent establishment rulings and conduit rulings.

Budget 2016 confirms that the CRA will commence to exchange tax rulings in 2016 with other jurisdictions which have committed to the BEPS treaty abuse minimum standard. Such information will be subject to confidentiality provisions and therefore will be protected in the same manner as taxpayer information.

Taxation of Switch Fund Shares

General provisions in the ITA provide that the exchange of convertible corporate securities are deemed not to be a disposition. Mutual fund corporations (or investment corporations) referred to as "switch funds" take advantage of those provisions by offering to their investors multiple classes of shares, each providing for exposure in different funds. Where an investor modifies its asset exposure by switching investments between different classes of shares, the exchange is completed on a tax-deferred basis.

Budget 2016 proposes amendments that will result in the investors switching investments in mutual fund corporations (or investment corporations) being considered to have disposed of the investments at FMV. The proposed amendments will not apply where the shares received only differ in respect of management fees or expenses to be borne by the investors and otherwise derive their value from the same portfolio or fund within the mutual fund corporation (i.e., the switch is between different series of shares within the same class).

This measure will apply to dispositions of shares that occur after September 2016.

Derivative Valuation

The Tax Court of Canada recently held that certain derivatives held by a taxpayer on income account could be considered inventory of the taxpayer. The ITA provides that inventory held by a taxpayer at year-end may be valued at the lower of cost and FMV. These rules allow a taxpayer to deduct decreases in value prior to the disposition of a derivative while only forcing recognition of increases in value on actual disposition. Budget 2016 proposes to exclude certain derivatives (i.e. a swap agreement, a forward purchase or sale agreement, a forward rate agreement, a futures agreement, an option agreement or a similar agreement) from the application of the inventory valuation rules, while maintaining the status of such property as inventory. A related rule will ensure that taxpayers are not able to value derivatives using the lower of cost and market method under the general principles for the computation of profit for tax purposes. This measure will apply to derivatives entered into on or after March 22, 2016.

Sales of Linked Notes

Linked notes are debt obligations where the return is linked to the performance of a reference asset such as a basket of stocks, a stock index, a commodity, a currency or units of an investment fund. In general, the full amount of the return on the note is included in income when it becomes determinable, generally close to maturity. Where a note that is capital property is disposed of prior to the time the return becomes determinable, the "accrued return" can be considered a capital gain, only 50 per cent of which is included in income.

Budget 2016 proposes amendments so that any gain realized on the sale of a linked note will be deemed to be interest that has accrued on the note. Where the note is denominated in a foreign currency, foreign currency fluctuations will be ignored for the purpose of calculating this gain. Where a portion of the return on the note is based on a fixed interest rate, any portion of the gain reasonably attributable to market interest rate fluctuations will also be excluded.

This measure will apply to sales of linked notes that occur after September 2016.

Combating the Multiplicity of Small Business Deductions

There was some speculation that Budget 2016 would limit the use of Canadian-controlled private corporations (CCPC), and limit access to the corresponding preferential federal tax rate of 10.5 per cent on the first $500,000 of active business income through the small business deduction (SBD). The perception was that certain professionals were using CCPCs to unduly reduce their tax burden. In general, Budget 2016 leaves the CCPC regime intact and continues to apply the 10.5 per cent rate to incorporated businesses using the SBD. However, Budget 2016 takes aim at partnership and corporate structures that were used to multiply the SBD, including structures used by many professionals.

The ITA contains rules to limit the multiplication of the SBD through the use of a partnership of CCPCs that were not otherwise associated. Under these rules, each of the corporate partners would be obliged to share one SBD. However, structures were developed to work within the existing rules to achieve a multiplication of the SBD. Generally, this was achieved by having the relevant CCPC provide services for partnership business as an independent contractor rather than as a partner, with the result that the CCPC was entitled to a full SBD.

To address this type of tax planning Budget 2016 proposes to extend the "specified partnership income" rules in the ITA to partnership structures in which a CCPC provides services or property to a partnership during a taxation year of the CCPC where, at any time during the year, the CCPC or a shareholder of the CCPC is a member of the partnership or does not deal at arm's length with a member of the partnership. Affected CCPCs will be deemed to be members of the partnership and no longer be entitled to the full SBD.

A similar rule is proposed to deal with multiplication of the SBD through corporate structures. Generally, the proposed rule will deny the SBD to income earned by a CCPC through the provision of property or services to a private corporation in which the CCPC, a shareholder of the CCPC, or a non-arm's length person holds a direct or indirect interest in the recipient of the property or services. However, the private corporation can elect to "share" its SBD with the CCPC, so that the income from such property or services can benefit from the SBD. This is consistent with the theme of the proposal to prevent the multiplicity of SBDs, but not otherwise restrict the SBD.

One interesting aspect of this proposal is the fact that the CRA has issued many advance income tax rulings approving the partnership structures described above. Apparently, the Department of Finance has concluded that these structures offend the policy of the SBD rules. It seems equally clear that the Department of Finance is fully aware that such structures have been implemented extensively by professional services firms.

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