Although the 2008 Canadian federal budget delivered by the Minister of Finance on February 26, 2008 (the Budget) contained a number of tax changes, they were much more modest than those released in the 2007 federal budget. Businesses will be relieved that there is nothing comparable to last year's proposal to restrict interest deductibility for investments in foreign affiliates. Instead, the Budget includes a number of relatively smaller measures which will not generate much excitement, but will probably be welcome.
Non-residents investing in Canada will be pleased with the relaxation of compliance obligations relating to qualifying dispositions of "taxable Canadian property" where a treaty-based exemption is available. For individuals, the most significant proposal is the introduction, for 2009 and subsequent years, of a "tax-free savings account" described by the government as the most important savings vehicle since the introduction of the RRSP. Others will point out that this proposal is quite different from, and much more limited than, the broad capital gains deferral mechanism originally promised by the Conservatives in the 2006 federal election.
Business Tax Measures
Relief from Notification and Withholding Procedures for Cross-border Transactions
The Budget proposes significant changes to the reporting and withholding requirements under section 116 of the Income Tax Act (Canada) (the Act). The rules in section 116 apply where a non-resident of Canada disposes of "taxable Canadian property" (TCP), such as shares of a Canadian private corporation. Section 116 generally requires the purchaser in such a transaction to withhold 25% of the purchase price until such time as the seller obtains a certificate of compliance (a section 116 certificate). Under the current regime, a non-resident seller of TCP is also required to file a Canadian federal income tax return for the taxation year in which the disposition occurs.
For dispositions after 2008, the Budget proposes to eliminate the seller's obligation to apply for and obtain a section 116 certificate and, subject to the specific requirements described below, to eliminate the purchaser's obligation to withhold from the purchase price, in each case where the disposition of TCP is exempt from Canadian tax by virtue of a tax treaty. The Budget also proposes to eliminate the requirement for non-resident sellers of TCP to file Canadian federal income tax returns to report "excluded dispositions". These proposals will be welcomed as easing a compliance obligation in circumstances where it was of limited utility. There are other circumstances, such as where the transaction takes place on a tax-free rollover basis, where an approach similar to that proposed in the Budget would also be welcomed. Under the Budget proposals, unless a treaty-based exemption is applicable, such transactions would still have to comply with the existing section 116 certificate procedures.
a) Extended Definition of Excluded Property
A non-resident seller of TCP is not required to apply for a section 116 certificate in respect of a disposition of TCP that is "excluded property", such as shares that are publicly listed and units of a mutual fund trust. The Budget proposes to extend the definition of excluded property to include property that is, at the time of its disposition, a "treaty-exempt property" of the seller. A property will be considered to be treaty-exempt property if, at the time of disposition, the seller is exempt from tax on any gain from disposing of the property because of a tax treaty.
Where the seller and the purchaser are "related", the purchaser must also comply with the notice provisions described below in order for the property to constitute treaty-exempt property.
b) Simplified Purchaser Notice Provisions
Currently, where a non-resident disposes of TCP, the purchaser generally withholds 25% of the purchase price and is liable to remit such withheld amount to the Receiver General for Canada unless a section 116 certificate is delivered. The Budget proposes adding a new carve-out from this provision which will apply if:
(a) the purchaser concludes, after reasonable inquiry, that the seller is, under a Canadian tax treaty with a particular country, resident in that particular country;
(b) the property disposed of would be treaty-protected property of the seller if the seller was, under the relevant tax treaty, a resident in the particular country; and
(c) the purchaser provides to the Minister, on or before the 30th day after the date the purchaser acquires the property, a notice setting out the date of the acquisition, the name and address of the seller, the purchase price paid for the property and the name of the particular country referred to in (a) and (b) above.
The language of this new exemption gives the purchaser the option of whether to employ the new simplified notice procedure or to withhold under the old section 116 provisions. For related-party transactions, these provisions should be very helpful as they will save the administrative cost of applying for and obtaining a section 116 certificate. However, in an arm's-length context, it may be more difficult to employ these provisions for the reasons discussed below.
The first requirement under the new exemption appears to be easily satisfied by having the seller represent and warrant in a purchase and sale agreement that it is a resident of the relevant treaty country.
The second requirement, however, may be more difficult to determine – particularly in the context of the Canada-U.S. treaty which is proposed to be amended to include limitation on benefits (LOB) provisions. A seller may not be willing to represent that a disposition of TCP would be treaty-protected where the LOB analysis is uncertain and, moreover, a purchaser may not be satisfied by a representation on this point, as the requirement is that the statement in (b) above be factually true, unlike the first requirement which only requires reasonable inquiry. As a result, a purchaser may be unable or unwilling to agree to utilize the simplified procedure.
The potential difficulty in satisfying the second requirement with any certainty may also limit the utility of the new simplified procedure for some structures currently employed by private equity funds that invest in Canada. The notice requirement alone would, in the case of a fund structured as a partnership, appear to require disclosing the identity of all members of the fund on a disposition of TCP by the fund. Thus, the use of "blocker" entities in these structures will likely continue to be advisable.
c) Relaxed Requirement to File Canadian Income Tax Returns
In addition to the changes to the withholding requirements discussed above, the Budget also includes a new exception from the requirement to file a tax return. The Budget proposes that no tax return need be filed solely as a result of TCP dispositions that are "excluded dispositions" – meaning, essentially, that no tax is payable.
This new exemption is a welcome change, as it covers not only dispositions that are subject to the simplified reporting procedure proposed by the Budget, but also to certain dispositions of TCP that continue to be subject to the old section 116 procedures.
Capital Cost Allowance Measures
The Budget includes a number of measures extending and expanding the availability of tax depreciation for qualifying equipment.
The 2007 federal budget introduced an enhanced 50% capital cost allowance rate applicable on a straight line basis to certain eligible manufacturing and processing equipment acquired before 2009 subject to the "half-year rule". This year's Budget proposes to extend this treatment for qualifying equipment acquired in 2009. For 2010, the 50% rate will apply but on a declining balance basis, while qualifying equipment acquired in 2011 will be eligible for a 40% rate applied on a declining balance basis. After 2011, a 30% rate will apply on a declining balance basis.
The category of "specified clean energy equipment" (Class 43.2) eligible for a 50% capital cost allowance rate will be expanded to include ground source heat pump systems and bio-gas production equipment. In addition, some of the existing restrictions on the ability to qualify for the Class 43.2 capital cost allowance rate are to be lifted.
Scientific Research and Experimental Development (SR&ED)
The Budget also proposes to improve the incentives for taxpayers who incur SR&ED expenses. A taxpayer who makes SR&ED expenditures is permitted to deduct the full amount of such expenditures in computing its income and is also entitled to claim, in respect of expenditures on SR&ED carried out in Canada, an investment tax credit (ITC). The general amount of the ITC is 20%, but an enhanced rate of 35% is available to qualifying Canadian-controlled private corporations (CCPCs), up to a specified annual limit (the expenditure limit), subject to phase-out provisions based on the CCPC's taxable income and taxable capital employed in Canada for the previous year. The Budget proposes to increase the annual expenditure limit and extend the phase-out provisions, and also to extend the availability of the ITC to certain expenditures in respect of SR&ED carried on outside of Canada.
The Budget proposes to increase the annual expenditure limit from C$2-million to C$3-million (determined on an associated group basis). The Budget also proposes to extend both phase-out provisions applicable to the expenditure limit to larger companies.
The current taxable income phase-out rule reduces the expenditure limit of a qualifying CCPC for a particular taxation year by C$10 for each C$1 by which the qualifying CCPC's taxable income (as determined under the Act on an associated group basis) for the previous year exceeds C$400,000. By virtue of the proposed increase in the base annual limit from C$2-million to C$3-million, the upper limit of this phase-out range would be increased from C$600,000 to C$700,000.
The current taxable capital phase-out rule reduces a qualifying CCPC's expenditure limit incrementally for a particular taxation year where the qualifying CCPC's taxable capital employed in Canada (as determined on an associated group basis) for the previous year exceeds C$10-million, up to a maximum of C$15-million at which point the expenditure limit reaches zero. The Budget proposes increasing the upper limit of this phase-out range to C$50-million.
The enhanced expenditure limit and increased phase-out ranges described above are proposed to apply for taxation years that end on or after February 26, 2008, prorated based on the number of days in the taxation year after February 25, 2008.
Provincial Component of Specified Investment Flow-Through (SIFT) Tax
The non-portfolio earnings of SIFT partnerships and trusts are subject to a special tax that was introduced as part of the October 31, 2006 announcement concerning the taxation of income trusts. This tax has both a federal component which is equal to the federal corporate rate and a fixed provincial component which is currently 13%.
Beginning in 2009, the Budget proposes refining the provincial component by having it more closely relate to the provincial corporate tax rates applicable to a corporation doing business where the SIFT carries out its activities. The allocation to be used in arriving at the provincial component will be determined using a formula based on the general corporate provincial income allocation mechanism contained in the Act.
Mineral Exploration Tax Credit
The temporary mineral exploration tax credit, the availability of which was extended in the 2007 federal budget, will be extended again. Thus, a 15% tax credit will be available for qualifying expenditures renounced under flow-through share agreements entered into by March 31, 2009. This is expected to result in a fiscal cost of C$120-million over the next two fiscal years.
Compliance-Related Issues
The Budget proposes replacing the 10% fixed penalty for late remittances of source deductions with a graduated penalty starting at 3%. The government is also proposing to relax some of the rules that required certain large remitters to remit source deductions to a financial institution rather than to the Canada Revenue Agency (CRA) directly. Finally, the Budget includes a proposal to provide CRA with greater latitude to share a taxpayer's business number and business number information with certain federal and provincial government departments.
Previously Announced Measures
The Budget announced the government's plan to proceed with a number of previously announced tax measures, including proposals affecting the taxation of foreign affiliates released on February 27, 2004 and promised modifications to the rules applicable to SIFTs released on December 20, 2007. Curiously missing from this list was the controversial "reasonable expectation of profit" loss limitation proposal which the Department of Finance has apparently been reworking for some time.
Personal Tax Measures
Tax-Free Savings Account (TFSA)
In the 2006 election campaign, one of the more significant campaign promises made by the Conservatives was to introduce a mechanism through which people would be able to defer capital gains taxes, provided that the proceeds giving rise to such capital gains were reinvested within a certain time period. As predicted by many in the tax community, the actual creation of such a capital gains deferral mechanism has proven to be a challenge. Although the TFSA is touted as fulfilling this election promise, it is actually a very different and more limited approach. The TFSA is more restricted than a general deferral mechanism since only the limited contributions made to the TFSA and related earnings will be eligible for this tax-free treatment. Furthermore, all income, rather than just capital gains, earned within the TFSA will be free from tax.
Under the proposal, Canadian-resident individuals 18 or older will be entitled to contribute up to C$5,000 per year to a TFSA with the contribution limit being indexed to inflation. Income and gains within the TFSA will not be subject to income tax. Contributions will not be deductible to the individual, but unused contribution room may be carried forward without limitation. Spousal contributions will be permitted and income earned or gains realized in a spouse's TFSA will not be subject to the existing attribution rules.
Withdrawals made from the TFSA will not be subject to tax and the amount withdrawn will be added to the individual's contribution room. Furthermore, withdrawals from a TFSA will not be taken into account in determining an individual's eligibility for government means-tested benefits such as Old Age Security and the Guaranteed Income Supplement. Interest on money borrowed to invest in a TFSA will not be deductible. The types of investments permitted to be held in these accounts will be limited to those that may be held in RRSPs and other registered plans. This may attract criticism from those who were hoping for a capital gains deferral mechanism that would apply to real estate, such as cottage properties.
The TFSA is intended to complement RRSPs and allow individuals to make withdrawals from their TFSAs for significant expenditures while retaining the ability to re-contribute those amounts at some point in the future. The Budget documents state that the expected fiscal cost of the TFSA proposal will be C$50-million in its first year.
Dividend Tax Credit
The Budget proposes reducing the attractiveness of the higher gross-up and tax credit mechanism available in respect of "eligible dividends" received from Canadian corporations by Canadian-resident individuals. The Budget documents state that these adjustments are appropriate given the previously announced reduction in corporate tax rates.
Donations of Exchangeable Securities
In 2006, measures were introduced to eliminate capital gains taxes on donations of qualifying publicly traded securities. Many Canadian residents hold exchangeable shares with significant unrealized capital gains. Such shares may have been issued on a tax-free rollover basis and may be exchangeable for publicly traded shares of a foreign company. In some cases, such exchangeable shares are not publicly listed and, hence, would not be eligible for the favourable treatment available for donations of publicly traded securities. Although the shares for which the exchangeable shares could be exchanged might be so eligible, a holder could only acquire those shares by disposing of the exchangeable shares through a taxable disposition. The Budget proposes exempting the capital gain that would arise on qualifying transactions where the shares received on an exchange for exchangeable shares are donated to a charity within 30 days of the exchange.
Private Foundations: Excess Corporate Holdings
The 2007 federal budget introduced a regime that limited a private foundation's ability to hold certain unlisted and publicly listed shares beyond certain ownership thresholds. Essentially, where the foundation and certain "relevant persons" (generally, persons who do not deal at arm's length with the foundation) own, on a consolidated basis, more than 20% of a class of shares, the foundation may be subject to certain divestment rules. This regime also includes certain reporting obligations. Recognizing that unlisted shares may be difficult to sell, the Budget proposes an exemption from the divestment requirement in respect of certain unlisted shares held on March 18, 2007. This exemption will not, however, apply in certain cases where the foundation owns, indirectly as a result of owning the unlisted shares and through a corporation controlled by the foundation and/or certain "relevant persons", an interest in listed shares of another corporation. The Budget also proposes introducing rules that would require that certain "substituted shares" be taken into consideration when applying these rules. The Budget documents also note that anti-avoidance rules are to be introduced dealing with arrangements designed to avoid the reporting or divestment obligations under this regime through the use of trusts. These rules will apply for taxation years of foundations beginning on or after February 26, 2008.
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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