Canada: Trouble Scoring? Just Increase The Size Of The Net

Highlights

Resource Measures

  • Expansion of Accelerated CCA and CRCE Treatment to Geothermal Heating
  • Reclassification of Discovery Wells as CDE
  • Phase Out of Rule Deeming First $1M of CDE to be CEE
  • Extension of the Mineral Exploration Tax Credit

Changes to Timing of Recognition of Income from Derivatives

  • Option to elect to have mark-to-market treatment of certain derivates
  • New stop-loss rules relating to certain "straddle transactions"

Other Income Tax Changes

  • Clarification of de facto control of a corporation
  • Increased ability for switch funds and segregated funds to merge
  • Changes to rules impacting foreign branches of life insurers

Introduction

The Liberals ran for office on a pledge of running deficits of no more than $10 billion per year until the time of the next election, when the books would be balanced. When that became a difficult task, they chose to change the rules to make the game easier. Last fall the goal became not to increase the federal debt-to-GDP ratio. Whether this leads to a better game for the fans, the immediate consequence was to legitimize a deficit of $23 billion this year and $28.5 billion next year. In other words, the government has an extra $15 billion to spend this year and next without needing to raise the money to do so. The current path would add $150 billion to the federal debt by 2022, when it would reach $757 billion.1

The more pertinent issue is not whether there is a deficit, or whether the debt to GDP ratio has increased, but rather the effect that any particular government expenditure intended to increase productivity has on GDP. The Institute of Fiscal Studies and Democracy at the University of Ottawa found that the vast majority of federal spending on innovation and skills development, $23 billion on 143 different programs, is not accompanied by any assessment requirements. 21 of such expenditure items, totaling $8 billion, had no public assessment of their effectiveness.2

These are indeed uncertain times and "You've got to be very careful if you don't know where you are going, because you might not get there".3 Even in the most certain of times, governments are careful not to let good tax policy get in the way of good politics. The politics of today involve promising a more certain and "fairer" future for the middle class (the 2016 Budget mentioned "middle class" 111 times)4 without doing anything that might unwittingly upset a delicate fiscal and societal balance.5 As Alice might have said to the Queen, "Will there ever be a good time for real reform?"6 "Work is ongoing and to the extent that there's any major conclusions on tax changes, we need to take some time to get them right".7 We shall see.

There was speculation that Budget 2017 might raise the inclusion rate on capital gains. That has only happened twice before: in 1972 and in 1987 (although the latter involved a two stage increase from 50 to 67 to 75 percent).8 In both of those cases, the change was announced as part of a broad tax reform package that offered certain tax advantages to the groups that felt they were harmed by the increase in the taxation of capital gains, as well as being part of a reform package that was arguably necessary to maintain a proper social contract within the country. In both cases, advance warning was provided to enable people to adjust their financial situations and to prepare for the new rules. Announcing such a change and not giving taxpayers a chance to prepare is politically counter-productive. We would expect the government to follow a similar path with respect to any major changes to the basic framework of the tax system.

Budget 2017 announces that within the coming months a report will be issued on the use of private corporations to sprinkle income among family members, to accumulate low taxed income and to enable owners to realize earnings by selling shares at a gain.

The 2016 Fall Economic Statement indicated that the government would invest $10.1 billion over 11 years in trade and transportation products. As announced in Budget 2017, the government is repealing the transit tax credit which will save $1 billion over the next 5 years. The budget indicates that the government will directly and indirectly provide $25.1 billion for improved public transit over the coming years.

The infirm dependent credit, the caregiver credit and the family caregiver tax credit are being combined into one new Canada caregiver credit to "better support families that need it most". And yet it remains non-refundable, so presumably people paying tax need it more than those not paying tax.

In addition to the more significant changes described below, Budget 2017 also includes changes to the disability tax credit, the medical expense tax credit, and the ecological gifts program. Budget 2017 also increases sales taxes on beer, wine and spirits, and imposes sales tax on Uber fares.

Resource Measures

Expansion of Accelerated CCA and CRCE Treatment to Geothermal Heating

In line with the Government's continued commitment to reduce greenhouse gas emissions and air pollutants, it announced measures to expand incentives for investments in clean energy, and in particular, geothermal heating. In brief, geothermal heating is the extraction and direct use of thermal energy generated in the earth's interior.

Under the current capital cost allowance ("CCA") regime, Classes 43.1 and 43.2 provide accelerated CCA rates (30% and 50%, respectively, on a declining balance) for investments in specified clean energy generation and conservation equipment. In addition, if the majority of tangible property in a project is eligible for inclusion in either of these accelerated CCA classes, certain intangible start-up expenses (for example, engineering and design work and feasibility studies) are treated as Canadian renewable and conservation expenses ("CRCE"). Expenses that qualify as CRCE are fully deductible in the year they are incurred, and may be renounced to investors in flow-through shares.

Only geothermal equipment that is primarily used for the purpose of generating electricity is currently eligible for inclusion in Class 43.2 (depreciable at 50% rate), while such equipment that is primarily used for heating purposes is depreciable under Class 1 at the substantially lower rate of 4%. Furthermore, the costs of drilling and completing exploratory wells are fully deductible in the year they are incurred as CRCE when it is reasonable to expect that at least 50% of the capital cost of the depreciable property will be used in an electricity project included in Classes 43.1 and 43.2. By way of contrast, the costs of drilling and completion of geothermal wells may not currently qualify for the accelerated CCA if they do not meet certain electricity generation thresholds. Moreover, while certain equipment that is part of a district energy system, for the transmission of energy between a central generation plant and one or more buildings using thermal energy, is generally included in Classes 43.1 and 43.2, geothermal heat is not currently an eligible thermal energy source.

Budget 2017 proposes three changes to expand the eligibility requirements described above for geothermal heating. Firstly, Classes 43.1 and 43.2 will be expanded to include geothermal equipment that is used primarily for the generation of heat (or a combination of electricity and heat). Secondly, geothermal heating will be made an eligible thermal energy source for use in a district energy system, thereby allowing additional equipment to be included in Classes 43.1 and 43.2. Finally, expenses incurred for the purpose of determining the extent and quality of a geothermal resource and the cost of geothermal drilling (including geothermal production wells) will now qualify as CRCE. An important caveat is that the expenses will only be eligible for the accelerated CCA or CRCE treatment if they comply with all requirements of applicable environmental laws, by-laws and regulations. These measures will apply in respect of expenditures acquired for use on or after the Budget Day.

Reclassification of Discovery Wells as CDE

Budget 2017 claims that expenses incurred in drilling oil and gas discovery wells, which are currently treated as Canadian exploration expense ("CEE") and fully deductible in the year they are incurred, can more clearly be linked to successful exploration than other mining exploration expenses. Therefore, it proposes that expenses for discovery wells should be deducted gradually over time.

Both Canadian development expense ("CDE") and CEE can be renounced by a corporation to investors in flow-through shares. The existing "look-back" rule provides the additional benefit of allowing eligible resource expenditures, such as CEE and certain CDE, to be renounced to investors in flow-through shares with an effective date in the calendar year in which the funds are raised, even though the expenditures are only renounced in the subsequent year.

Budget 2017 introduces changes that would reclassify expenditures that relate to drilling or completing an oil and gas discovery well (or in building a temporary access road to, or in preparing a site in respect of, any such well) as CDE (deductible at a rate of 30% (on a declining balance basis) versus 100% for CEE). This measure will apply to expenditures made after 2018 (including expenses deemed to have been incurred in 2018 under the "look-back" rule).

Phase Out of Rule Deeming First $1M of CDE to be CEE

The Income Tax Act (the "Tax Act") contains a rule in subsection 66(12.601) that allows an eligible small oil and gas corporation with taxable capital employed in Canada of not more than $15 million to treat up to $1 million of CDE as CEE when renouncing the expense under a flow-through share agreement. CDE is deductible at a rate of 30% (on a declining balance basis), whereas CEE is fully deductible in the year it is incurred or deemed to have been incurred under the "look-back" rule.

Budget 2017 proposes to no longer permit eligible small oil and gas corporations to treat the first $1 million of CDE as CEE, excluding expenses incurred before 2018 under a flow-through share agreement entered into after 2016 but before Budget Day.

Extension of Mineral Exploration Tax Credit for Flow-Through Share Investors

Budget 2017 proposes to extend eligibility for the Mineral Exploration Tax Credit, currently set to expire on March 31, 2017, for an additional year in respect of flow-through share agreements entered into on or before March 31, 2018. This extension of the credit will support eligible exploration expenses up to the end of 2019. The credit, which equals 15% of specified mineral exploitation expenses incurred in Canada and renounced to individual investors, is an additional incentive for individuals to invest in flow-through shares issued by such mining companies to fund exploration. The credit was first introduced in the early 2000s and has traditionally been set to expire after one year, but thus far has been renewed in each annual Federal Budget.

Timing of Recognition of Gains and Losses on Derivatives

Budget 2017 contains two proposals to clarify the timing of the recognition of gains and losses on derivatives held on income account by persons that are not financial institutions (within the meaning of the Tax Act). Derivatives are financial instruments that derive their value from the value of an underlying interest. With the exception of the mark-to-market rules applicable to financial institutions, the Tax Act does not contain specific rules pertaining to the timing of the recognition of gains and losses on derivatives held on income account.

Elective Use of the Mark-to-Market Method

There has been uncertainty pertaining to whether taxpayers that are not financial institutions could use the mark-to-market method to value their derivatives held on income account in reliance upon the general principles of profit computation and section 9 of the Tax Act. The Federal Court of Appeal in Kruger

Incorporated v The Queen, 2016 FCA 186, recently permitted a taxpayer that was not a financial institution to use the mark-to-market method to value certain of its derivatives on the basis that it provided an accurate picture of the taxpayer's income.

Budget 2017 aims to provide clarity as to whether a taxpayer may choose to use the mark-to-market method. Specifically, Budget 2017 proposes to introduce an elective mark-to-market regime for derivatives that are held on income account that qualify as "eligible derivatives". An "eligible derivative" is generally any derivative that is held on income account that meets certain conditions. These conditions include a requirement that the derivative is valued in accordance with generally accepted accounting principles at its fair market value in the taxpayer's audited financial statements, or that the derivative has a readily ascertainable fair market value.

The mark-to-market election applies to the year of election, and all subsequent taxation years. The proposed elective regime is designed to ensure that the choice to use the mark-to-market method does not lead to avoidance opportunities. In this regard, the election may only be revoked with the consent of the Minister of National Revenue.

If a taxpayer makes the election, such taxpayer will be required to include an increase or decrease in the value of its eligible derivatives on an annual basis when computing its income. Accrued gains or losses on eligible derivatives, which were previously subject to tax on a realization basis at the beginning of the first election year, will be deferred until the derivative is disposed of. The mark-to-market election will be available for taxation years that begin on or after Budget Day.

Straddle Transactions

The Government is concerned that the use of the realization method for computing gains and losses on derivatives held on income account may permit taxpayers to selectively realize gains and losses. Budget 2017 specifically identifies the use of a straddle transaction to remain economically neutral, while for tax purposes, the taxpayer realizes a loss in a particular taxation year and defers an accrued gain to a subsequent taxation year.

A straddle transaction is generally a transaction where a taxpayer concurrently enters into two or more positions, often derivative positions, that are expected to result in offsetting gains and losses. The perceived abuse occurs where a taxpayer disposes of the position with the accrued loss shortly before its taxation year-end, thus triggering a loss in the particular taxation year. Shortly thereafter, in the subsequent taxation year, the taxpayer disposes of the offsetting position with the accrued gain. This strategy permits the taxpayer to deduct the realized loss against other income from the particular taxation year, and defer the recognition of the offsetting gain to a subsequent taxation year, while remaining economically neutral. There is also concern that a taxpayer may indefinitely defer the recognition of the accrued gain by entering into successive straddle transactions.

The Government is concerned with the impact of straddle transactions on the tax base and fairness. Straddle transactions have been challenged using judicial principles and existing provisions of the Tax Act, including the general anti-avoidance rules. However, these challenges can be expensive and time- consuming. Consequently, Budget 2017 proposes a specific anti-avoidance rule that targets straddle transactions.

To curb the perceived abuses, Budget 2017 proposes a stop-loss rule that will defer the realization of any loss on the disposition of a position to the extent that there is any unrealized gain on an offsetting position. In this regard, a gain on an offsetting position would generally be unrealized where the offsetting position has not been disposed of and is not subject to the mark-to-market regime. A "position" will generally be defined to include any interest in derivatives, certain debt obligations, and actively traded personal properties. An "offsetting position" in respect of a position held by a taxpayer will generally be defined as a position that has the effect of eliminating all or substantially all of the taxpayer's risk of loss and opportunity for gain or profit in respect of the particular position.

There are several proposed exceptions to the application of the proposed stop-loss rule. Specifically, Budget 2017 provides that the stop-loss rule will generally not apply to a position if (i) it is held by a financial institution (as defined for purposes of the mark-to-market regime), a mutual fund trust or a mutual fund corporation, (ii) it is part of certain types of hedging transactions entered into in the ordinary course of the taxpayer's business (e.g. in respect of commodities that the holder manufactures, grows, or produces), (iii) the taxpayer continues to hold the offsetting position throughout a specified period that begins on the date of disposition, or (iv) it is part of a transaction or a series of transactions none of the main purposes of which is to defer or avoid tax.

The proposed stop-loss rule will apply to any loss realized on a position entered into on or after Budget Day.

De Facto Control

There has always been considerable uncertainty as to the scope of the concept of de facto control.

For the purposes of the Tax Act, where the expression "controlled directly or indirectly in any manner whatever" is used, one corporation is considered to be controlled by another corporation (the "controller") if the controller has control in fact of the corporation. Specifically, the controller is considered to have control in fact if it has any direct or indirect influence that, if exercised, would result in control in fact of the corporation. Uncertainty surrounds what is meant by control in fact and what factors can be considered when determining control in fact.

In the seminal case on control in fact, Silicon Graphics Ltd. v. R., 2002 FCA 260, the Federal Court of Appeal held that in order for a person to have control in fact, the person must have the clear right and ability to effect a significant change in the board of directors or, the powers of the board or to influence in a very direct way the shareholders who would otherwise have the ability to elect the board.

Subsequent cases, while citing Silicon Graphics, tended to expand the concept of control in fact and the factors that could be considered in determining such control. These cases tended to apply the list of factors set out in former Interpretation Bulletin IT-64R4 which include commercial or contractual relationships and, in particular, economic dependence on a single customer or supplier. The Bulletin also suggests that control of day-to-day management and operation of the business would be considered. A recent decision of the Federal Court of Appeal, McGillivray Restaurant Ltd. v. R., 2016 FCA 99, re-affirmed the original scope of the test. In McGillivray Restaurant, the Court noted that in order for a factor to be considered in determining control in fact, it must include a "legally enforceable right and ability to effect a change to the board of directors or its powers, or to exercise influence over the shareholders who have that right and ability".

Budget 2017 proposes to amend the Tax Act to clarify that, in determining whether control in fact exists, factors may be considered that extend beyond the requirements set out in McGillivray Restaurant.

This measure appears to be targeted at certain structures that have been used by public corporations and corporations controlled by non-residents to conduct research and development activities in corporations that would qualify as Canadian-controlled private corporation ("CCPC") but for the control in fact test. As a CCPC, the corporation would be eligible for enhanced and refundable scientific research and experimental development credits. To date, the Courts, in applying the existing test, have consistently found that these research and development corporations have been controlled in fact by the public corporation or the non- residents based on the economic dependence created by the contractual relationships involved in the structures. Based on these successes, it is difficult to see why a change that may create more uncertainty was necessary.

Investment Funds

Investment Fund Mergers

Canadian tax rules allow for investment funds to be structured in a tax-efficient manner as either corporations or trusts. It often happens that, for commercial reasons, two investment funds merge with one another so that the investors of each fund become investors of a larger new fund. Up until now, special rules have allowed for the merger of a mutual fund corporation or a mutual fund trust into a single new mutual fund trust. Other rules also generally allow for mutual fund property to be transferred into a new mutual fund corporation on a tax-deferred basis.

However, up until now, there have been no rules which permit for a mutual fund corporation (or trust) to transfer property into more than one mutual fund trust. This has historically become an issue for mutual fund corporations that have multiple funds within one corporation (known as "switch funds"), and wish to merge with two or more existing mutual fund trusts. Switch funds are typically structured so that investors buy a particular class of shares of the corporation and each class of shares tracks a particular pool of assets within the corporation. For example, a single switch fund may be structured with several classes of shares which invest in different precious metals (a gold fund, a silver fund, etc.). Investors are typically permitted to switch between the underlying funds and historically these switches occurred on a tax- deferred basis (the ability to switch on a tax-deferred basis was eliminated in last year's federal budget).

Since switch funds may have various different underlying funds that are invested in specialized asset pools it may be commercially desirable for a single switch fund to reorganize into two or more mutual fund trusts. For example, a switch fund which has an underlying gold fund and an underlying silver fund may wish to reorganize into two separate mutual fund trusts, one which focuses on gold and one which focuses on silver. Budget 2017 proposes to amend the rules related to investment fund exchanges in order to allow a mutual fund corporation to transfer its property to two or more mutual fund trusts on a tax-deferred basis, effective for transfers occurring after Budget Day. Consistent with the old rules, the mutual fund corporation will still need to transfer all or substantially all of its property to the mutual fund trusts, and all or substantially all of its shareholders will need to become unitholders of the transferee mutual fund trusts. Accordingly, the circumstances in which this new rule will be relevant are likely fairly limited, but the rule will be a welcome change for a switch fund looking to merge with multiple mutual fund trusts.

Under the new rules a single mutual fund trust still will not be able to merge with multiple mutual fund trusts. The rules also do nothing to facilitate mergers of funds that are structured as partnerships, which historically has created other issues for fund managers wishing to combine their funds.

Segregated Funds

Segregated funds are life insurance policies which are structured in a way that is similar to mutual fund trusts. In order to achieve consistency with the taxation of mutual fund trusts, Budget 2017 proposes to create rules allowing for the tax-deferred merger of segregated funds. The rules will generally parallel the merger rules applicable to mutual fund trusts, and will come into force on January 1, 2018. Budget 2017 also proposes to allow segregated funds to begin carrying forward non-capital losses, subject to typical loss carrying restrictions, effective for losses arising in taxation years beginning after 2017.

Changes to the Taxation of Foreign Branches of Life Insurers

While corporations resident in Canada are generally taxable on their world-wide income, there has always been an exception to this rule for Canadian life insurance corporations that carry on business in other countries through branches. The income of these foreign branches is generally exempt from tax in Canada. The purpose of this exemption is to place these foreign branches on an equal footing with Canadian corporations that carry on a life insurance business through controlled foreign subsidiaries that, in many instances, are not taxable in Canada on the earnings of, or dividends from, such subsidiaries. The exception also recognizes the fact that historically, foreign life insurance operations have been carried on through branches rather than subsidiaries.

One important difference between the taxation of a foreign branch and a foreign subsidiary that carries on life insurance operations relates to the taxation of income received from the insurance of Canadian risks. Under the foreign accrual property income ("FAPI") rules, income from the insurance of Canadian risks earned by a controlled foreign affiliate of a Canadian life insurance corporation is taxable in Canada on an accrual basis. In addition, anti-avoidance rules introduced in the 2014 and 2015 federal budgets prevent these affiliates from swapping non-Canadian risks for Canadian risks in order to avoid the income inclusion for their Canadian shareholders. Similar rules do not apply to foreign branch operations.

Budget 2017 proposes to amend the Tax Act to ensure that Canadian life insurers are taxable in Canada on their income from the insurance of Canadian risks earned through their foreign branches. The rule will mirror the existing rule that is part of the FAPI regime and will apply in circumstances in which 10 per cent or more of the gross premium income earned by a foreign branch of a Canadian life insurer is premium income in respect of Canadian risks. Where the rule applies, the insurance of Canadian risks will be deemed to be part of a Canadian business carried on in Canada and the related insurance policies will be deemed to be life insurance policies in Canada. In addition, the anti-avoidance rules introduced in previous budgets relating to insurance rate swaps and other structures designed to avoid the FAPI inclusion for income from the insurance of Canadian risks will also apply to foreign branch operations.

Work-in-Progress of Professionals

Generally a business must include in its income the value of its inventory, which is defined to include the value of work-in-progress ("WIP") of a professional business as of the end of each taxation year. Accordingly, the business is taxable on income related to WIP in the year that the work is done, subject to any available deductions. A special rule currently exists which allows certain professionals (accountants, dentists, lawyers, medical doctors, veterinarians and chiropractors) to make an election which allows them to defer the inclusion of WIP until the year in which the work is actually billed. Budget 2017 will eliminate the opportunity for these professionals to make these elections. Subject to transitional rules, professionals will now be required to include in their income the value of WIP at the end of each year. This change will be phased in by requiring professional to include 50% of the value of WIP during the first taxation year that begins on or after Budget Day. In all subsequent years 100% of WIP needs to be included in income.

An Ominous Cloud on the Horizon

Buried away outside of the specific tax measures is a reference to a study that the Government is currently conducting into "the use of tax planning strategies involving private corporations that inappropriately reduce personal taxes of high-income earners." According to the Budget material, these strategies include: sprinkling income to family members to take advantage of lower tax rates payable by those family members, holding passive investments inside a corporation where investments accumulate because of the lower tax rates payable by corporations and converting what would otherwise be dividends from a corporation into capital gains from the sale of shares of the corporation.

The Government proposes to release a paper in the next few months setting out the nature of the relevant issues in more detail as well as the proposed policy responses.

Footnotes

1 Budget 2017, p 251.

2 Financial Post, March 22, p FP 2.

3 Yogi Berra.

4 Terance Concoran, Financial Post, March 22, p FP 1.

5 "Just as we should never balance the budget on the backs of the poor, so it is an economic delusion to think you can balance it only on the wallets of the rich." George Osborne, former UK Chancellor of the Exchequer.

6 "The rule is, jam tomorrow and jam yesterday – but never jam today." "It must come sometimes to 'jam today'," Alice objected. "No it can't" said the Queen. "It's jam every other day; today isn't any other day, you know". From Through the Looking Glass, and What Alice Found There, by Lewis Carroll.

7 Bill Curry, Globe & Mail, March 21, comment attributed to a "senior government official".

8 Valuation Day starting point. The inclusion rate was increased to 2/3rds in 1988 and then to 75% in 1990. It then fell to and was further reduced to 50% on October 18, 2000.

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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If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.