Currently, the Tax Act provides an incentive for investments in environmentally friendly energy generation equipment, by allowing for accelerated depreciation of specified clean energy generation and conservation equipment. Accelerated capital cost allowance ("CCA") is an exception to the general practice of setting CCA rates based on the useful life of assets.
Classes 43.1 and 43.2 of Schedule II to the Income Tax Regulations provide accelerated CCA rates of 30% and 50%, respectively. Both classes include eligible equipment that generates or conserves energy by:
- using a renewable energy source (e.g., wind, solar or small hydro);
- using a fuel from waste (e.g., landfill gas, wood waste or manure); or
- making efficient use of fossil fuels (e.g., high efficiency cogeneration systems, which simultaneously produce electricity and useful heat).
Additionally, if the majority of the tangible property in a project is eligible for inclusion in Class 43.1 or 43.2, certain intangible project start-up expenses (for example, engineering and design work and feasibility studies) may be treated as Canadian renewable and conservation expenses. These expenses may be deducted in full in the year incurred, carried forward indefinitely for use in future years, or transferred to investors using flow-through shares.
In step with the Federal Sustainable Development Strategy objectives, the Budget proposes to expand the types of equipment eligible for accelerated CCA rates to include certain electric vehicle charging stations and certain electrical energy storage properties.
Electric Vehicle Charging Stations
Electric vehicle charging stations have to date been generally depreciated at a rate of 20%, in Class 8 of the CCA regime.
The Budget proposes to expand Classes 43.1 and 43.2 to include electric vehicle charging stations that meet certain power thresholds. Charging stations set up to supply at least 90 kilowatts of continuous power will be eligible for inclusion in Class 43.2. Charging stations set up to supply more than 10 kilowatts but less than 90 kilowatts of continuous power will be eligible for inclusion in Class 43.1.
Eligible equipment will include equipment downstream of an electricity meter, owned by an electric utility and used for billing purposes or owned by the taxpayer to measure electricity generated by the taxpayer, provided that more than 75% of the annual electricity consumed in connection with the equipment is used to charge electric vehicles, including charging stations, transformers, distribution and control panels, circuit breakers, conduits, wiring and related electrical energy storage 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.
Electrical Energy Storage
Electrical energy storage equipment converts electricity into a form of energy that can be stored and converted back into electricity at a later time. Only limited kinds of electrical energy storage equipment are currently eligible for accelerated CCA treatment when they are ancillary to electricity generation technologies that are eligible for inclusion in CCA Classes 43.1 and 43.2.
The Budget proposes 2 changes in this area. First, to clarify and expand the range of electrical energy storage property that is eligible for accelerated CCA on the basis that it is ancillary to eligible generation equipment, to include a broad range of short- and long-term storage equipment. Second, to allow stand-alone electrical energy storage property to be included in Class 43.1, provided that the round trip efficiency of the equipment is greater than 50 per cent.
For both proposals, eligible electrical energy storage property will include equipment such as batteries, flywheels and compressed air energy storage. It will also include any ancillary equipment and structures. Eligible electrical energy storage property will not include pumped hydroelectric storage, hydroelectric dams and reservoirs or a fuel cell system where hydrogen is produced via steam reformation of methane. Consistent with the policy intent of Classes 43.1 and 43.2, back up electricity generation, motive uses (e.g., in battery electric vehicles or fuel cell electric vehicles) and mobile uses (e.g., consumer batteries) will be excluded from eligibility.
Accelerated CCA will only be available in respect of eligible stand-alone property if, at the time the property first becomes available for use, the requirements of all Canadian environmental laws, by-laws and regulations applicable in respect of the property have been met.
These measures 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.
Emissions Trading Regimes
The Budget proposed specific income tax rules to clarify the income tax treatment of emission allowances and ensure the appropriate tax treatment of emissions under such regimes.
Under emission trading regimes, regulated emitters are obliged to deliver emissions allowances to the government. The amount of the allowances required to be delivered is determined by reference to the amount of emissions produced (e.g. greenhouse gases). These allowances may be purchased by emitters, earned by engaging in emissions reduction activities or provided by the government at a reduced price or no cost.
No specific tax rules exist at present to deal with emissions trading regimes. There are currently no Canadian or international accounting standards that are specific to these regimes. There is uncertainty about the tax treatment of transactions under emissions trading regimes and there existed the possibility of double taxation.
For a regulated emitter, emissions allowances are generally treated as an eligible capital property. The Budget proposes to replace the eligible capital property regime with a new class of depreciable property.
The characterization of emissions allowances as eligible capital property raises a number of tax policy concerns. First, capital property is typically thought of as an asset with an enduring value, whereas an emission allowance may be viewed as a onetime -use property. Second, if such allowances are treated as capital property, but the obligation to remit allowances is deductible as a current expense, a mismatch may occur.
Free emissions allowances
Government assistance is normally included in business income. Where an emissions allowance is provided by a government for no consideration and included in income as government assistance, there is no tax rule to adjust the cost amount of the emissions allowance to reflect this income inclusion. This would result in taxpayers being subject to double tax on disposition of the emissions allowance.
Timing – Income and Expense Recognition
The Budget proposes to amend the Tax Act to introduce specific rules to clarify the tax treatment of emissions allowances and to eliminate the double taxation of certain free allowances. These rules will provide that emissions allowances be treated as inventory for all taxpayers.
If a regulated emitter receives a free allowance, there will be no income inclusion on receipt of the allowance. In addition, the deduction in respect of an accrued emissions obligation will be limited to the extent that the obligation exceeds the cost of any emissions allowances that the taxpayer has acquired and that can be used to settle the obligation.
Each year that a taxpayer claims a deduction in respect of an emissions obligation, the taxpayer will quantify its deduction based on the cost of emission allowances that it has acquired and which can be used to settle its emissions obligation, plus the fair market value of any emissions allowances that it still needs to obtain to fully satisfy its obligation.
If a taxpayer disposes of an emissions allowance otherwise than in satisfaction of an obligation under the emissions allowance regime, any proceeds received in excess of the taxpayer's cost, if any, for the allowance will be included in computing income.
This measure will apply to emissions allowances acquired in taxation years beginning after 2016. It will also apply on an elective basis in respect of emissions allowances acquired in taxation years ending after 2012.
Small Business Taxation
Small businesses in Canada are able to benefit from the small business deduction for their first $500,000 per year of qualifying active business income (if the business is a Canadian-controlled private corporation ("CCPC")). The small business deduction results in certain CCPCs being entitled to a reduced federal income tax rate of 10.5%, as compared to the general corporate income tax rate of 15%. The Tax Act requires that the annual eligible limit of $500,000 (the "business limit") be allocated among corporations which are "associated" for the purposes of the Tax Act. Associated corporations are, in general, corporations which are effectively owned or controlled by the same person or group of persons.
Under the Tax Act, for businesses which are carried on through a partnership, the members of the partnership share one $500,000 limit in respect of that business. Access to the small business deduction is also phased out on a straight-line basis for a CCPC and its associated corporations having between $10 million and $15 million of taxable capital employed in Canada. Currently, gradual reductions in the small business tax rate are legislated for 2017, 2018 and 2019.
The Tax Act presently includes a dividend tax credit ("DTC"), which is intended to compensate a taxpayer who receives taxable dividends for the corporate income taxes that are presumed to have been paid on the corporate income which funded the payment of the dividends. In general, the purpose of the DTC is to ensure that the concept of integration is, as best as possible achieved within the income tax system. Under an integrated tax system, income earned by a corporation and paid out to an individual as a dividend should, in general, be taxed at the same amount as income earned directly by the individual.
Small Business Tax Rate
The Budget proposes that the small business tax rate remain at 10.5% after 2016, and reductions in the small business tax rate legislated for 2017, 2018 and 2019 be deferred. In order to preserve the integration of the personal and corporate income tax systems, the Budget also proposes to maintain the current gross-up factor and DTC rate applicable to non-eligible dividends (generally, dividends distributed from corporate income taxed at preferential tax rates such as the small business tax rate). Specifically, the gross-up rate applicable to non-eligible dividends will be maintained at 17% and the corresponding DTC rate at 21/29 of the gross-up amount.
Multiplication of the Small Business Deduction
The Tax Act provides rules that are intended to preclude the multiplication of access to the small business deduction. The Budget proposes changes to address concerns about partnership and corporate structures that multiply access to the small business deduction.
The specified partnership income rules in the Tax Act are intended to eliminate the multiplication of the small business deduction in respect of a partnership of corporations that are not associated with each other. In such a case, a single business limit applies with respect to the partnership's business. In the absence of these rules, each CCPC that is a member of a partnership could claim a separate small business deduction of up to $500,000 in respect of the portion of the partnership's active business income allocated to it.
In general terms, the small business deduction that a CCPC that is a member of a partnership can claim in respect of its income from the partnership is limited to the lesser of the active business income that it receives as a member of the partnership (its "partnership ABI") and its pro-rata share of a notional $500,000 business limit determined at the partnership level (its specified partnership income limit, or "SPI limit"). A CCPC's specified partnership income is added to its active business income from other sources, if any, and the CCPC can claim the small business deduction on this total amount (subject to its annual business limit).
Some taxpayers have implemented structures to circumvent the application of the specified partnership income rules. In a typical structure, a shareholder of a CCPC is a member of a partnership and the partnership pays the CCPC as an independent contractor under a contract for services. As a result, the CCPC claims a full small business deduction in respect of its active business income earned in respect of the partnership because, although the shareholder of the CCPC is a member of the partnership, the CCPC is not a member.
To address this tax planning, the Budget introduced the concept of a "designated member" which proposes to extend the specified partnership income rules to partnership structures in which a 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, for the purpose of the specified partnership rules:
- a CCPC will be deemed to be a member of a partnership (a
"designated member") throughout a taxation year if:
- it is not otherwise a member of the partnership in the taxation year;
- it provides services or property to the partnership (directly or indirectly, in any manner whatever) at any time in the CCPC's taxation year;
- a member of the partnership does not deal at arm's length with the CCPC, or a shareholder of the CCPC, in the taxation year; and
- 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 designated member) will have its active business income from providing services or property to the partnership deemed to be partnership ABI; and
- the SPI limit of a designated 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 designated member of the partnership will be entitled to notionally assign to the designated member all of or a portion of the actual member's SPI limit in respect of a fiscal period of the partnership that ends in the designated member's taxation year (and where the actual partner is an individual, the assignable SPI limit of all members of the partnership will be determined as if they were corporations).
This measure will apply to taxation years that begin on or after Budget Day. However, an actual member of a partnership will be entitled to notionally assign all or a portion of the member's SPI limit in respect of their taxation year that begins before and ends on or after Budget Day, if the assignment is made to a designated member for their taxation year that begins on or after Budget Day.
The tax planning described above could involve the use of a corporation rather than a partnership to multiply access to the small business deduction. This multiplication could occur in circumstances where a CCPC earns active business income from providing services or property (directly or indirectly, in any manner whatever) to a private corporation during the CCPC's taxation year when, in the taxation year, the CCPC, one of its shareholders, or a person who does not deal at arm's length with such a shareholder has a direct or indirect interest in the private corporation.
The Budget proposes to amend the Tax Act to address such corporate structures. A CCPC's active business income from providing services or property (directly or indirectly, in any manner whatever) in its taxation year to a private corporation will be ineligible for the small business deduction 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 a shareholder has a direct or indirect interest in the private corporation. This appears to be a very broad provision, and appears to capture situations where a CCPC provides services or property to another private corporation, notwithstanding that it is not associated, if the service provider CCPC or a person with whom the CCPC is not at arm's length (such as a spouse of the shareholder of the CCPC) has even a minimal direct or indirect interest in the service recipient. It is also not clear what is meant by the concept of direct or indirect "interest", and whether same is restricted to shares in the service recipient. This restriction or ineligibility for the small business deduction 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 private corporation that is a CCPC will be entitled to assign all or any portion of its unused business limit to one or more CCPCs that are 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:
- the CCPC's income from providing services or property to the private corporation (directly or indirectly, in any manner whatever);
- the amount, if any, of a 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
- the amount determined by the Minister of National Revenue to be reasonable in the circumstances.
This measure will apply to taxation years that begin on or after Budget Day. 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, if the assignment is made to a CCPC for their taxation year that begins on or after Budget Day.
Avoidance of the Business Limit and the Taxable Capital Limit
The associated corporation rules (as previously discussed) are relevant for applying both the $500,000 business limit and the $15 million taxable capital limit to CCPCs. The rules enable different family members to carry on businesses through separate CCPCs (which would be eligible for the small business deduction), while preventing a group of related taxpayers (or taxpayers who form part of a single economic group or unit) from multiplying the small business deduction.
The associated corporation rules are complex and must be applied on a case-by-case basis. One specific rule in subsection 256(2) of the Tax Act provides that two corporations that would not otherwise be associated will be treated as associated if each of the corporations is associated with the same third corporation. Since the $15 million taxable capital limit is based on the capital of associated corporations, none of the corporations is eligible to claim the small business deduction if the total taxable capital of the three associated corporations exceeds $15 million.
There is an exception to this special rule: 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 (i) the third corporation is not a CCPC or, (ii) 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.
The above exception does not affect the associated corporation status for the purpose of another rule that treats a CCPC's investment income (e.g., interest and rental income) as active business income eligible for the small business deduction if that income is derived from the active business of an associated corporation (subsection 129(6)). Accordingly, two corporations may not be associated for the purpose of claiming the maximum small business deduction while retaining the ability to treat investment income that one receives from the other as active business income.
Where the third corporation is not a CCPC, or is a CCPC that files an election, the other two corporations may claim the small business deduction on investment income that traces to the active business of the third corporation, even though the third corporation could not have claimed the deduction either because the third corporation is not a CCPC or because an election was filed. In addition, where the other two corporations directly earn active business income, their small business deductions are determined without regard to the taxable capital of the third corporation to which they are each associated.
CCPCs that are currently misusing the election to multiply their small business deduction are being challenged by the Federal Government under a specific anti-avoidance rule, and under the general anti-avoidance rule, where the small business deduction is being claimed on investment income that is treated as active business income. However, as any such challenge could be time-consuming and costly, the Federal Government is introducing specific legislative measures to ensure that the appropriate tax consequences apply.
The Budget 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 (e.g., an election not to be associated is made or the third corporation is not a CCPC). In addition, where this exception applies (such that the two corporations are deemed not to be associated with each other), 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.
This measure will apply to taxation years that begin on or after Budget Day.
Consultation on Active versus Investment Business
Budget 2015 announced a review of 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. The consultation period ended August 31, 2015.
Whether the principal purpose of a business is to earn income from property is a question of fact. The Canada Revenue Agency has published guidance and a significant body of case law has developed relating to the factors that are relevant in making this determination. The examination of the active versus investment business rules is now complete. The Federal Government is not proposing any modification to these rules at this time.
Life Insurance Policies
Distributions Involving Life Insurance Proceeds
Life insurance proceeds received as a result of the death of an individual insured under a life insurance policy (a "death benefit") are generally not subject to income tax. A private corporation may add the amount of a death benefit it receives to its capital dividend account, and then pay capital dividends out tax-free to its shareholders. Similarly, the adjusted cost base of a partner's interest in a partnership is increased to the extent of the partner's share of a death benefit received by the partnership. Consequently, a partner can generally withdraw funds from a partnership tax-free to the extent of the partner's adjusted cost base.
The Budget proposes to amend the Tax Act to ensure that the capital dividend account rules for private corporations, and the adjusted cost base rules for partnership interests, apply as intended. The reason is that while only the portion of the death benefit received by the corporation or partnership that is in excess of the policyholder's adjusted cost basis of the policy (the "insurance benefit limit") may be added to the capital dividend account of a corporation or to the adjusted cost base of a partner's interest in a partnership, taxpayers have structured their affairs so that there is what the Budget document refers to as an "artificial" increase in a corporation's capital dividend account balance, or increase in the adjusted cost base of a partner's interest in a partnership. Such structuring attributes the adjusted cost basis of the policy to the policyholder and not the corporation or partnership that receives the death benefit as beneficiary. As a result, the corporation or partnership receiving the death benefit is not subject to the insurance benefit limit and the whole death benefit would be added to the capital dividend account of a corporation or to the adjusted cost base of a partner's interest in a partnership, and be paid out to a shareholder or withdrawn by a partner tax-free.
Although the Federal Government is challenging a number of these structures under the existing tax rules, the Budget proposal will provide that the insurance benefit limit applies regardless of whether the corporation or partnership that receives the death benefit is the policyholder of the policy. To that end, the measure will also introduce information-reporting requirements that will apply where a corporation or partnership is not a policyholder but is entitled to receive a death benefit.
This measure will apply to death benefits received as a result of a death that occurs on or after Budget Day.
Transfers of Life Insurance Policies
The Budget proposes 2 amendments with respect to transfers of life insurance policies.
The first proposed amendment ensures that amounts are not inappropriately received tax-free by a policyholder as a result of a disposition of an interest in a life insurance policy.
Generally, where a policyholder disposes of an interest in a life insurance policy to an arm's length person, the fair market value of any consideration is included in computing the proceeds of the disposition. In contrast, where a policyholder disposes of such an interest to a non-arm's length person, a special rule (the "policy transfer rule") deems the policyholder's proceeds of the disposition, and the acquiring person's cost, of the interest to be the amount that the policyholder would be entitled to receive if the policy were surrendered (the "cash surrender value").
Where the policy transfer rule applies, the amount by which any consideration given for the interest exceeds the interest's cash surrender value is not taxed as income under the rules that apply to dispositions of interests in life insurance policies. In addition, this excess will ultimately be reflected in the policy benefit under that policy. Where the policy benefit is received by a private corporation, it can be paid tax-free to that corporation's shareholders. Where this is the case and consideration to acquire the interest was not recognized under the policy transfer rule, the amount of the excess is effectively extracted from the private corporation a second time as a tax-free, rather than as a taxable, amount. Similar concerns also arise in the partnership context and where an interest in a policy is contributed to a corporation as capital.
The proposal will apply to include the fair market value of any consideration given for an interest in a life insurance policy in the policyholder's proceeds of the disposition and the acquiring person's cost. In addition, where the disposition arises on a contribution of capital to a corporation or partnership, any resulting increase in the paid-up capital in respect of a class of shares of the corporation, and the adjusted cost base of the shares or of an interest in the partnership, will be limited to the amount of the proceeds of the disposition.
This measure will apply to dispositions that occur on or after Budget Day.
The second proposed amendment is to amend the capital dividend account rules for private corporations and the adjusted cost base rules for partnership interests. This amendment will apply where an interest in a life insurance policy was disposed of before Budget Day for consideration in excess of the proceeds of the disposition determined under the policy transfer rule. In this case, the amount of the death benefit otherwise permitted to be added to a corporation's capital dividend account, or the adjusted cost base of an interest in a partnership, will be reduced by the amount of the excess. In addition, where an interest in a life insurance policy was disposed of before Budget Day under the policy transfer rule to a corporation or partnership as a contribution of capital, any increase in the paid-up capital in respect of a class of shares of the corporation, and the adjusted cost base of the shares or of an interest in the partnership, that may otherwise have been permitted will be limited to the amount of the proceeds of the disposition.
This measure will apply in respect of policies under which death benefits are received as a result of deaths that occur on or after Budget Day.
Debt Parking to Avoid Foreign Exchange Gains
Generally, the Tax Act provides that all amounts used in the calculation of income are required to be reported in Canadian dollars. As a result of fluctuations in foreign exchange rates, a taxpayer that has received a loan in a foreign currency may realize a capital gain or loss on the repayment of the loan. Such a gain or loss would generally be considered to occur when it is realized, normally, when the loan is settled or extinguished.
The Federal Government has, for some time, been concerned about taxpayers avoiding realizing a gain on the repayment of a foreign currency debt. This concern was related particularly to debt-parking transactions, whereby the debtor would arrange for a non-arm's length party (the "new creditor") to purchase the debt from the initial creditor for a purchase price equal to the principal amount of the loan. As a result of the transaction, the foreign currency debt would be settled from the initial creditor's perspective. However, since the debt would remain owing to the new creditor, the debtor would not be required to realize the foreign exchange gain for income tax purposes.
The Tax Act includes debt-parking rules which deem a foreign currency debt to have been settled at the time the debt is acquired by the new creditor. Under these rules, the debt is deemed to have been settled for an amount equal to the cost of the debt to the new creditor. Any difference between the cost amount and the principal amount of the loan is characterized as a forgiven amount, which applies to adjust various tax attributes of the debtor. A portion of the forgiven amount is also generally included in the debtor's income. However, because the forgiven amount does not take into account any foreign exchange gain realized on the debt, the foreign exchange gain does not reduce the tax attributes of the debtor or increase the debtor's income for tax purposes.
In the Budget, the Federal Government indicated that the general anti-avoidance rule could be applied to attack such structures. Nevertheless, in what the Federal Government suggests is an exercise in time and cost savings, the Budget proposes to introduce a specific rule which will cause a foreign exchange gain on a foreign currency debt to be realized when the debt becomes a "parked obligation". Where the new rule applies, the debtor will be deemed to have realized the gain that it otherwise would have realized if it had paid an amount (in the relevant foreign currency) in satisfaction of the 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 fair market value of the debt.
Under the new rules, a foreign currency debt will become a "parked obligation" at any particular time where:
- at that time, the current holder of the debt does not deal at arm's length with the debtor or, in the case of a corporate debtor, the current holder of the debt has a "significant interest" in the debtor; and
- at any previous time, the person who held the debt dealt at arm's length with the debtor and, in the case of a corporate debtor, did not have a "significant interest" in the debtor.
For the purposes of the new rules, a person will have a "significant interest" in a corporation if the person (together with other related persons) owns shares of the corporation representing 25% or more of the votes or value of the corporation. Where a partnership or trust is involved, each partnership or trust will be treated as a corporation having a single class of capital stock of 100 voting shares. The members of the partnership or the beneficiaries of the trust (as the case may be) will be treated as owning shares in the partnership or trust in accordance with their proportionate interests in the partnership or trust.
The new rules will provide for exceptions for bona fide commercial transactions. In particular, a foreign currency debt will not be characterized as a parked obligation if the debt is acquired by the current holder in the course of a transaction or a series of transactions that results in the acquisition of a significant interest in, or control of the debtor by the current holder (or a related person), unless one of the main purposes of the transaction or the series of transactions was to avoid a foreign exchange gain. Additionally, where a transaction or a series of transactions results in the current holder and the debtor becoming non-arm's length persons or, in the case of a corporate debtor, the current holder owning a significant interest in the debtor, the foreign currency debt will not become a parked obligation unless one of the main purposes of the transaction or the series of transactions was to avoid a foreign exchange gain.
The new rules will also provide relief for financially distressed debtors. For corporate debtors that are resident in Canada, the combined federal/provincial tax payable by the debtor on a deemed foreign exchange gain will not result in the corporation's liabilities exceeding the fair market value of its assets.
The Budget proposal will apply to a foreign currency debt that is a parked obligation on or after Budget Day. However, there will be an exception where the foreign currency debt meets the conditions for being a parked obligation before 2017 and results from a written agreement entered into before Budget Day.
Valuation for Derivatives
The Budget proposes to exclude derivatives from the general rule that inventory can be valued at the lower of cost and fair market value at year end. This general rule results in taxpayers being entitled to a deduction when inventory decreases in value, but not being subject to an income inclusion when inventory increases in value. Concerned by a recent Tax Court of Canada decision, the Federal Government has concluded that this valuation rule was never intended to apply to derivatives and thus the Budget provides that derivatives entered into after March 22, 2016, although they still may constitute inventory, will be excluded from the normal inventory valuation rule. It is to be noted that this will not affect derivatives that constitute mark-to-market property (since they are not considered inventory) and derivatives that are property of a business that is an adventure in the nature of trade (since existing rules require valuation at cost).
Eligible Capital Property
The eligible capital property ("ECP") regime deals with the tax treatment of certain expenditures (eligible capital expenditures) and receipts (eligible capital receipts) that are not otherwise dealt with under the Tax Act.
In general, an eligible capital expenditure is a capital expenditure incurred to acquire intangible rights or benefits for the purpose of earning income from a business, other than an expenditure that is deductible as a current expense or that is incurred to acquire intangible property that is depreciable under the capital cost allowance ("CCA") rules (e.g., goodwill). Eligible capital expenditures also include the cost of certain intangible property (e.g., customer lists, licenses, franchise rights, etc.). Under the ECP regime, an eligible capital expenditure is added to the cumulative eligible capital ("CEC") pool at a rate of 75% and is deductible at an annual rate of 7% on a declining-balance basis.
In general, an eligible capital receipt is a capital receipt for intangible rights or benefits that is received in respect of a business, other than a receipt that is included in income or as proceeds from the disposition of capital property. Under the ECP regime, 75% of an eligible capital receipt is applied first to reduce the CEC pool, and then results in the recapture of any previously deducted CEC. Any excess eligible capital receipt is included in income at a rate of 50%.
The Budget proposes to repeal the ECP regime and to replace it with a new CCA class. Additionally, the Budget proposes to introduce rules to allow taxpayers to transfer existing CEC pools to the new CCA class. The proposed changes were initially referred to in the 2014 Budget.
The Budget acknowledges that the proposals will result in the elimination of the tax deferral opportunity that arises from the treatment of gains on the sale of ECP as active business income, and states that this result is consistent with the overall intent of the proposals.
Pursuant to the new proposals, a new class of depreciable property for CCA purposes will be introduced. Expenditures that are currently added to CEC at a 75% rate will be included in the new CCA class at a 100% rate with a 5% annual depreciation rate. Generally, the existing CCA rules, including the rules relating to recapture, capital gains and depreciation will continue to apply.
Eligible capital expenditures and eligible capital receipts that relate to acquisitions or dispositions of specific property will result in an adjustment to the balance of the new CCA class when the specific property is acquired or disposed of. These amounts will also impact the calculation of recapture and gains for the specific property.
The Budget provides that special rules will apply in respect of goodwill, and expenditures and receipts that do not relate to a specific property and that would be eligible capital expenditures or eligible capital receipts under the ECP regime. These expenditures and receipts will be accounted for by adjusting the capital cost of the business' goodwill. Every business will be considered to have goodwill associated with it, even where there was no expenditure to acquire goodwill.
An expenditure that does not relate to a specific property will increase the capital cost of the business' goodwill and, consequently, the balance of the new CCA class. A receipt that does not relate to a specific property will reduce the capital cost of the business' goodwill, and, consequently, the balance of the new CCA class, by the lesser of: (i) the capital cost of the goodwill; and (ii) the amount of the receipt. To the extent that the receipt exceeds the capital cost of the goodwill, the excess will be treated as a capital gain. CCA taken will be recaptured to the extent that the reduction of the capital cost of the goodwill results in a negative undepreciated capital cost ("UCC") balance.
Proposed transitional rules will allow CEC pool balances to be calculated and transferred to the new CCA class as of January 1, 2017. The opening balance of the new CCA class in respect of a business will be equal to the balance at that time of the existing CEC pool for that business. For the first 10 years, the depreciation rate for the new CCA class will be 7% in respect of expenditures incurred before January 1, 2017. Certain qualifying receipts will reduce the balance of the new CCA class at a 75% rate.
The Budget also proposes special rules to simplify the transition for small businesses. To allow small initial balances to be eliminated quickly, a taxpayer will be permitted to deduct as CCA, in respect of expenditures incurred before 2017, the greater of: (i) $500 per year; and (ii) the amount otherwise deductible for that year. This additional allowance will be available for taxation years that end prior to 2027. To reduce compliance burdens in respect of incorporation expenses, a separate business deduction will be provided for these expenditures, such that the first $3,000 of these expenditures will be treated as a current expense rather than being added to the new CCA class.
The proposals, including the transitional rules, will apply as of January 1, 2017.
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.