On March 22, 2016 ("Budget Day"), Minister of Finance Morneau of the recently-elected Liberal Government tabled his first federal budget ("Budget 2016"), themed "Growing the Middle Class." The basic narrative underlying Budget 2016 is one that juxtaposes the challenges faced by "David" and "Neera," two individuals belonging to Canada's middle class, against "friends who earn more and are already talking about when they will retire." The narrative and underlying juxtaposition represents a clear change in policy and direction when compared to the previous Conservative government's general narrative of austerity.
Budget 2016 expands on one of the Government's first actions, taken on December 7, 2015, of introducing a tax cut for the middle class by reducing the second personal federal income tax rate to 20.5% from 22% and raising taxes on Canadians earning more than $200,000 by introducing a top federal income tax rate of 33% (which, in most provinces, translates into a combined federal and provincial top marginal income tax rate in excess of 50%). The Government's stated priorities in Budget 2016 include help and growth for the middle class, which, it says, is reflected in a revamped Canada Child Benefit, the elimination of poorly targeted tax breaks, the above-noted middle-class tax cut and establishment of a new top tax rate, additional investment in student financial assistance, and significant investments in infrastructure and innovation.
Budget 2016 also continues on the previous Government's theme of making the tax system fairer. To this end, Budget 2016 proposes a number of measures to prevent evasion and improve compliance, such as:
- Investing $444.4 million over five years for the Canada Revenue Agency ("CRA") to hire additional auditors and specialists, develop robust business intelligence infrastructure, increase verification activities, and improve the quality of investigative work. Budget 2016 projects a revenue impact of $2.6 billion over five years from the investment.
- Investing $351.6 million over five years for the CRA to improve its ability to collect outstanding tax debts. Budget 2016 projects that this will lead to the collection of an additional $7.4 billion in tax debt over five years.
Budget 2016 also continues on the previous Government's commitment to enhancing the integrity of the tax system. In the domestic context, Budget 2016 proposes key measures to:
- Prevent business owners from multiplying access to the $500,000 small business deduction using complex partnership and corporate structures;
- Ensure that investment income derived from an associated corporation's active business is ineligible for the small business deduction in certain circumstances;
- Ensure that associated corporations cannot avoid the $15 million taxable capital limit in certain circumstances;
- Close perceived loopholes that allow private corporations to use life insurance policies to distribute amounts tax-free that would otherwise be taxable;
- Expand the debt-parking rules to include transactions designed to avoid recognition of foreign currency gains;
- Prevent the asymmetrical recognition of gains and losses on derivatives by eliminating the ability of taxpayers to value derivatives that are an inventory by using the lesser of cost and fair market value method;
- Prevent the deferral of capital gains tax by investors in mutual fund corporations structured as switch funds; and
- Introduce a new rule that would effectively treat the portion of any gain realized on the sale of a linked note that is attributable to the variable return on the note as accrued interest on the note.
In the international context, Budget 2016 proposes to:
- Strengthen transfer pricing documentation by introducing country-by-country reporting for large multinational enterprises;
- Extend the application of the existing back-to-back loan rules to royalty arrangements and introduce a similar set of rules in the shareholder loan rules; and
- Narrow the application of the exception contained at subsection 212.1(4) of the Income Tax Act (Canada) (the "Tax Act") to the cross-border anti-surplus stripping rules in situations of perceived artificial increases in cross-border paid-up capital.
Budget 2016 also reaffirms the Government's commitment to the OECD base erosion and profit shifting (BEPS) project by noting that it is participating in international work to develop a multilateral instrument to streamline the implementation of treaty-related BEPS recommendations, including addressing treaty abuse.
What follows is a summary of the key income tax measures contained in Budget 2016. Notably absent are proposed changes to the stock options regime contained in the Tax Act or a change to the capital gains inclusion rate.
PERSONAL INCOME TAX MEASURES
Income Splitting Credit
Budget 2016 proposes to eliminate the income splitting tax credit, which allows couples with at least one child under the age of 18 to notionally transfer up to $50,000 of taxable income to their spouse for the purpose of reducing the couple's total income tax liability by up to $2,000.
Labour-Sponsored Venture Capital Corporations Tax Credit
Budget 2016 proposes to restore the federal labour-sponsored venture capital corporations ("LSVCC") tax credit from 5% to 15% for share purchases of provincially registered LSVCCs prescribed under the Tax Act for the 2016 and subsequent taxation years. The federal LSVCC tax credit for federally registered LSVCCs will remain at 5% for the 2016 taxation year and be eliminated for the 2017 and subsequent taxation years.
Teacher and Early Childhood Educator School Supply Tax Credit
Budget 2016 proposes to introduce a teacher and early childhood educator school supply tax credit, which allows an eligible educator to claim a 15% refundable tax credit based on an amount of up to $1,000 in expenditures made by the eligible educator in a taxation year for eligible supplies, as long as certain conditions are met.
Mineral Exploration Tax Credit for Flow-Through Share
Budget 2016 proposes to extend the eligibility of the mineral exploration tax credit for one year to flow-through share agreements entered into on or before March 31, 2017. The mineral exploration tax credit is equal to 15% of specified mineral exploration expenses incurred in Canada and "flowed-through" to flow-through share investors.
Children's Fitness and Arts Tax Credit
Budget 2016 proposes to phase out the children's fitness and arts tax credits by reducing the 2016 maximum eligible amounts to $500 from $1,000 for the children's fitness tax credit (which will remain refundable for 2016) and to $250 from $500 for the children's arts tax credit. Both credits will be eliminated in 2017 and subsequent years.
Top Marginal Income Tax Rate – Consequential Amendments
In order to reflect the new top personal federal tax rate of 33% on taxable income in excess of $200,000, Budget 2016 proposes the following amendments that will: (1) provide a 33% charitable donation tax credit on donations above $200 to inter vivos trusts; (2) apply the new 33% top rate on excess employee profit sharing plan contributions; (3) increase from 28% to 33% the tax rate on personal services business income; (4) amend the definition of "relevant tax factor" in the foreign affiliate rules to reduce the relevant tax factor from the current 2.2 to 1.9; (5) amend the capital gains refund mechanism for mutual fund trusts to reflect the new 33% top rate in the formulas that are used in computing refundable tax; (6) increase the Part XII.2 tax rate on the distributed income of certain trusts from 36% to 40%; and (7) amend the recovery tax rule for qualified disability trusts to refer to the new 33% top rate. These measures will apply to the 2016 and subsequent taxation years. However, the charitable donation tax credit measure will be limited to donations made after the 2015 taxation year.
BUSINESS INCOME TAX MEASURES
Expanding Tax Support for Clean Energy and Electric Vehicle Charging Stations
Class 43.1 and 43.2 of Schedule II to the Tax Act provides accelerated CCA rates (30% and 50%, respectively, on a declining-balance basis) for investments in specified clean energy generation and conservation equipment. Budget 2016 proposes to expand these classes to include electric vehicle charging stations and related equipment. This measure will apply in respect of property acquired for use on or after Budget Day that has not been used or acquired for use before Budget Day.
Small Business Tax Rate
Budget 2016 proposes to halt the gradual reductions to the small business tax rate that are currently legislated for 2017, 2018 and 2019 and maintain the rate at 10.5% after 2016. Budget 2016 also proposes to maintain the current gross-up factor and dividend tax credit rate applicable to non-eligible dividends at 17% and 21/29 of the gross up amount, respectively.
Multiplication of the Small Business Deduction
Budget 2016 proposes changes to address concerns about partnership and corporate structures that multiply access to the small business deduction. With respect to partnerships, Budget 2016 proposes to extend the specified partnership income rules to partnership structures in which a Canadian-controlled private corporation ("CCPC") provides (directly or indirectly, in any manner whatever) 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.
In general terms, Budget 2016 proposes to deem a CCPC to be a member of a partnership throughout a taxation year if: (1) it is not otherwise a member of the partnership in the taxation year; (2) it provides services or property to the partnership at any time in the taxation year; (3) a member of the partnership does not deal at arm's length with the CCPC, or is a shareholder of the CCPC, in the taxation year; and (4) it is not the case that all or substantially all of the CCPC's active business income for the taxation year is from providing services or property to arm's length persons other than the partnership.
A CCPC that is a member of a partnership (including a deemed member) will have its active business income from providing services or property to the partnership deemed to be partnership active business income. Also, the specified partnership income limit of a deemed member of a partnership will initially be nil (as it does not receive any allocations of income from the partnership). However, an actual member of the partnership who does not deal at arm's length with a deemed member of the partnership will be entitled to notionally assign to the deemed member all of or a portion of the actual member's specified partnership income limit in respect of a fiscal period of the partnership that ends in the deemed member's taxation year.
Where the actual partner is an individual, the assignable specified partnership income limit of all members of the partnership will be determined as if they were corporations.
With respect to corporations, Budget 2016 proposes to disqualify a CCPC's active business income from the small business deduction where the CCPC provides services or property (directly or indirectly, in any manner whatever) in its taxation year to a private corporation where, at any time during the year, the CCPC, one of its shareholders, or a person who does not deal at arm's length with such shareholder has a direct or indirect interest in the private corporation. However, this proposal will not apply to a CCPC if all or substantially all of its active business income for the taxation year is earned from providing services or property to arm's length persons other than the private corporation. A CCPC will be entitled to assign all or a portion of its unused business limit to one or more CCPCs that are that ineligible for the small business deduction under this proposal because they provided services or property to the private corporation. The amount of active business income earned by a CCPC from providing services or property to the private corporation that will be eligible for the small business deduction (subject to the CCPC's own business limit) will be the least of: (1) the CCPC's income from providing services or property to the private corporation; (2) the amount, if any, of the private corporation's unused business limit — for its taxation year(s) ending in the taxation year of the CCPC in which it provided services or property to the private corporation — that is assigned to the CCPC; and (3) the amount determined by the Minister of National Revenue to be reasonable in the circumstances. This measure will apply to taxation years that begin after March 22, 2016. However, a private corporation will be entitled to assign all or a portion of its unused business limit in respect of its taxation year that begins before and ends on or after Budget Day.
Avoidance of the Business Limit and the Taxable Capital Limit
Two corporations that are associated because they are associated with the same third corporation will not be treated as being associated with each other if the third corporation is not a CCPC or, if it is a CCPC, it elects not to be associated with the other two corporations for the purpose of determining entitlement to the small business deduction. The effect of this exception is that the third corporation cannot itself claim the small business deduction (if it is a CCPC), but the other two corporations may each claim a $500,000 small business deduction subject to their own taxable capital limit. However, this exception does not affect the associated corporation status for the purpose of treating a CCPC's investment income as active business income eligible for the small business deduction if that income is derived from the active business of an associated corporation.
Budget 2016 proposes to amend the Tax Act to ensure that investment income derived from an associated corporation's active business will be ineligible for the small business deduction and be taxed at the general corporate income tax rate where the exception to the deemed associated corporation rule applies. In addition, where this exception applies, Budget 2016 proposes that the third corporation will continue to be associated with each of the other corporations for the purpose of applying the $15 million taxable capital limit in relation to the small business deduction. This measure will apply to taxation years that begin on or after Budget Day.
Consultation on Active Versus Investment Business
Budget 2016 specifies that the Government is not proposing any modification to the rules applicable to the circumstances in which income from a business, the principal purpose of which is to earn income from property, should qualify as active business income and therefore potentially be eligible for the small business deduction.
Transfers of Life Insurance Policies
A policyholder can transfer an interest in a life insurance policy to a non-arm's length person and the proceeds received by the policyholder will be deemed to be the cash surrender value of the interest in the policy transferred. In many cases, due to changes in the ratings of the insured, increases in the cost of providing insurance or other factors, the fair market value of the policy could be far higher than the cash surrender value of the policy. This permitted individual policyholders to effectively remove retained earnings from a non-arm's length transferee corporation on a tax-free basis by transferring an interest in their policy to the corporation for full fair market value consideration.
Budget 2016 proposes amendments to the policy transfer rule that will include the amount, if any, by which the fair market value of any consideration given exceeds the cash surrender value in both the proceeds of the transferring policyholder and the cost to the transferee of the interest in the policy acquired. In addition, if a corporation acquires a life insurance policy as a result of a capital contribution of such a policy, any resulting increase in the paid-up capital or adjusted cost base of any shares of the corporation will be limited to the deemed proceeds.
This measure will apply to dispositions that occur on or after Budget Day.
Budget 2016 also proposes (with retrospective effect) to change the calculation of the capital dividend account of a corporation that acquired a life insurance policy prior to Budget Day in circumstances where the fair market value consideration paid by the corporation exceeded the cash surrender value of the interest in the policy transferred to the corporation.
Under the new rule, the amount added to the capital dividend account of a corporation that has received a death benefit on or after Budget Day, will be reduced by the amount, if any, by which the consideration paid by the corporation exceeded the cash surrender value at the time of transfer.
The change will, in effect, reduce the amount of the tax-free capital dividends the corporation would otherwise have been permitted to pay by an amount equal to the amount, if any, by which the consideration paid by the corporation and received by the transferring policyholder free of tax exceeds the cash surrender value of the policy.
Budget 2016 further provides that where a corporation has acquired a life insurance policy before Budget Day as a capital contribution from the policyholder, any increase in the adjusted cost base and the paid-up capital of the shares of the corporation is effectively limited to the cash surrender value of the policy transferred.
Similar rules will apply in the partnership context to avoid an increase in the adjusted cost base of any partnership that has received a life insurance policy in similar circumstances.
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