Canada: 2017 Federal Budget – Business Income Tax Measures

The Budget makes no changes to corporate tax rates. In addition, no changes are made to eligibility for the small business rate.

Tax Planning Using Private Corporations

The government's review of federal tax expenditures highlighted issues in respect of tax planning strategies available to owners of private corporations. The government feels that these strategies can result in high-income individuals gaining unfair tax advantages not available to other Canadians. As the Budget papers indicate, measures have been put in place over the years to limit the scope of certain of these arrangements. However, the government is of the opinion that such measures have not always been as effective as desired. Accordingly, the government is further reviewing the use of private corporation tax planning strategies that may reduce the personal tax of high-income earners in a manner considered inappropriate. In particular, the government has identified the following strategies for review:

  • Income sprinkling — causing income that would be taxable to an individual at a high rate to be realized by, and therefore taxed in the hands of, a family member subject to a lower marginal tax rate, commonly achieved through dividends or capital gains
  • Holding of portfolio investments — corporate tax rates on ordinary business income are generally much lower than personal rates; retaining income in a private corporation can therefore facilitate accumulation of a larger pool of funds for investment
  • Conversion of regular income into capital gains — causing income that would normally be paid to the shareholder as salary or dividend to be converted to capital gains, taxed at a significantly lower tax rate. As part of its review of this area, the government will also examine current legislation that may have inappropriate tax consequences in connection with genuine business transactions between family members, including inter-generational transfers of family businesses. In the coming months, a paper will be released that will review these issues in detail and provide proposed policy responses.

Billed-Basis Accounting

Members of designated professions (accountants, dentists, lawyers, medical doctors, veterinarians and chiropractors) may elect to exclude the value of their work in progress (WIP) in computing their income. Where this election is made, a tax deferral is achieved as the costs associated with the WIP are deducted as incurred whereas the revenue is recognized only when the WIP is actually billed to clients.

The Budget proposes to eliminate the WIP exclusion over a two-year period, effective for taxation years beginning after March 21, 2017. For the first affected taxation year, WIP will be valued at 50 per cent of the lesser of its cost and fair market value and must be recognized for tax purposes and not excluded from income. For subsequent years, WIP, valued at the lesser of its cost and fair market value, must be recognized for tax purposes and cannot be excluded from income.

These provisions will require a determination of the cost of the WIP, which may not be readily available.

Meaning of Factual Control

There are two main definitions of control for tax purposes — de jure or legal control and de facto or factual control. Some provisions rely on de jure control whereas others rely on de facto control.

De facto control is broader than legal control and takes into account influence, that, if exercised, would result in control in fact of a corporation. It is particularly relevant for purposes of determining whether or not corporations are associated and therefore required to share the annual $500,000 small business deduction limit and certain other limits.

Recent jurisprudence essentially restricted control in fact to circumstances where the potential controller has an enforceable right to change the board of directors or its powers or can exercise influence over shareholders who have the right and ability to make such changes. The Budget proposes to effectively override the case law. For taxation years beginning after March 21, 2017, all factors relevant in the particular situation, not just those that meet the criteria set out in the recent jurisprudence, shall be included in assessing whether or not de facto control is present.

Distribution of T4 Information Slips

Effective for 2017, employers will not be required to obtain express consent from employees to electronically distribute T4s (Statement of Remuneration Paid). Privacy policy safeguards specified by the Minister of National Revenue will be required to be in place before an employer can electronically distribute T4s without employee consent.

Timing of Recognition of Gains and Losses on Derivatives

Derivatives are sophisticated financial instruments whose value is derived from the value of an underlying security. The Budget proposes two measures that clarify the timing of the recognition of gains and losses from derivatives held on income account.

In the past, there was uncertainty as to whether taxpayers could mark to market their derivatives held on income account under the general principles of profit computation. A recent Federal Court of Appeal decision allowed the use of the mark-to-market method for a taxpayer which was not a financial institution on the basis that it provided an accurate picture of the taxpayer's income.

To provide certainty regarding the choice of using the mark-to-market method, the Budget proposes an elective mark-to-market regime for derivatives held on income account so that taxpayers will be allowed to mark to market all of their eligible derivatives for taxation years beginning after March 21, 2017. Once made, the election will remain effective for all subsequent years unless revoked with the consent of the Minister of National Revenue.

A straddle transaction is one in which a taxpayer concurrently enters into two or more positions, often derivative positions, that are expected to generate equal and offsetting gains and losses on account of income. In order to obtain a tax deferral, the position with the accrued loss would be disposed of in one taxation year to realize the loss and the offsetting position with the accrued gain would be disposed of to realize the gain in the following taxation year. In addition, the taxpayer could attempt to indefinitely defer the recognition of the gain by entering into successive straddle transactions.

The Budget proposes to introduce a specific anti-avoidance "stop-loss" rule, which will effectively defer the realization of any loss on the disposition of a position to the extent of any unrealized gain inherent in an offsetting position. This proposal will apply to any loss realized on a position entered into after March 21, 2017.

Investment Fund Mergers

Mutual Funds

Mutual funds can be structured as either corporations or trusts. The Income Tax Act (ITA) currently contains provisions that facilitate the merger of mutual funds on a tax-deferred basis. Two mutual fund trusts can be merged into one or a mutual fund corporation can be merged into a mutual fund trust. The current rules do not provide for the reorganization of a mutual fund corporation into multiple mutual fund trusts.

"Switch mutual fund corporations" are structured with multiple classes of shares that are each traced to a pool or fund of assets of the corporation. Investors switch underlying funds by exchanging one class of shares for another. The benefits of such structures were eliminated in the 2016 Budget by deeming the share exchanges to be fair market value dispositions.

The Budget proposes to allow the tax-deferred restructuring of a switch corporation into multiple mutual fund trusts. In order to qualify, in respect of each class of shares of the switch corporation, all or substantially all (generally interpreted as 90 per cent or more) of the assets allocable to that class must be transferred to a mutual fund trust and the shareholders of that class must become unit holders of the trust. This measure will be applicable to qualifying reorganizations occurring on or after March 22, 2017.

Segregated Funds

Segregated funds are life insurance policies that have many of the characteristics of mutual fund trusts. Unlike mutual fund trusts, segregated funds cannot currently merge on a tax-deferred basis.

The Budget proposes to allow tax-deferred mergers of segregated funds under rules similar to those for mutual fund trusts. The Budget also proposes that non-capital losses in segregated funds arising in taxation years beginning after 2017 will be able to be carried over to apply against income of other years under the normal rules (back 3 years and forward 20 years). Loss application will be restricted after a segregated fund merger.

To give the life insurance industry the opportunity to comment on the proposed new rules, the merger rules will be applicable for mergers carried out after 2017.

Clean Energy Generation Equipment

Capital cost allowance (CCA) classes 43.1 and 43.2 provide for accelerated CCA on clean energy generation equipment. The Budget expands the assets qualifying for these classes to include geothermal energy equipment used primarily for the purpose of generating heat or a combination of heat and electricity and certain equipment in district energy systems that use geothermal heating as an energy source.

Canadian renewable and conservation expenses may be deducted in the year incurred, carried forward indefinitely for use in future years or transferred to investors through a flow-through share mechanism. The Budget proposes to include expenses incurred to determine the quality and extent of geothermal resources and the cost of geothermal drilling for electricity and heating projects in this category.

The measures are applicable for new property acquired for use and expenses incurred after March 21, 2017.

Resource Measures

Expenditures in respect of drilling or completing a discovery well, including building access roads to or preparing the site for such wells, are currently classified as Canadian exploration expense (CEE, fully deductible in the year incurred). The Budget proposes to classify these expenditures as Canadian development expense (CDE, deductible on a 30 per cent declining-balance basis).

This measure will apply to expenses incurred after 2018, including those incurred in 2019 that could have been deemed incurred in 2018 under the "look-back" rule. Expenses incurred before 2021 pursuant to a written commitment to incur the expenses entered into before March 22, 2017, will still qualify as CEE.
Eligible small oil and gas corporations will no longer be able to treat their first $1 million of CDE as CEE. This measure will apply to expenses incurred after 2018, including those incurred in 2019 that could have been deemed incurred in 2018 under the "look-back" rule. Expenses incurred after 2018 and before April 2019 that are renounced to investors under a flow-through share agreement entered into after 2016 and before March 22, 2017, will be exempt from the new rules.

Child Care Space Investment Tax Credit

The Budget eliminates the investment tax credit for child care space expenditures incurred after March 21, 2017. Expenditures incurred before 2020 pursuant to written agreements entered into before March 22, 2017 will still be eligible for the investment tax credit.

Farming and Fishing Property Insurers

The Budget eliminates the tax exemption for farming and fishing property insurers. This exemption is based on the proportion of their gross premium income earned from insuring such property. This measure is effective for taxation years beginning after 2018.

Consultation on Cash Purchase Tickets

The Budget institutes a consultation on the tax deferral available in respect of deferred cash purchase tickets for deliveries of listed grains by farmers. Interested parties should submit their comments to the government by May 24, 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.

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