By Carole Chouinard , firstname.lastname@example.org
The following proposed measures introduced in the February 28, 2000 budget will be of interest to high tech companies and their employees and shareholders:
Capital Gains Inclusion Rate
Effective February 28, 2000, only 2/3 of capital gains will be taxable. Currently, 3/4 of capital gains are taxable. As a result of this change, capital gains will be taxed at about the same rate as dividends. This measure may be of benefit to the high technology sector by making the acquisition of shares in such companies and therefore, access to capital, more appealing from a tax perspective.
Employee Stock Options
When a stock option is granted, i.e., the stock option agreement is entered into, there are no tax consequences to the employee. Instead, the employee has a taxable employment benefit when the employee exercises the options and acquires shares, subject to the comments below regarding shares of a Canadian-controlled private corporation ("CCPC"). When an option is exercised, the employee is deemed to receive a taxable benefit equal to the value of the shares at the time of their acquisition less the price paid to the corporation for the shares, the "option price". The timing of the employment benefit inclusion depends on the type of corporation issuing the shares:
1. For public corporations, the employee must include the taxable benefit in income on the exercise of the option.
2. For CCPCs, the employment benefit arises only when the shares are sold or exchanged, provided that the employer and the employee are dealing at arm's length. If the employer and employee are not dealing at arm's length, the income inclusion arises at the time of exercise, as it does for public corporations.
In addition, partial relief may be available to the employee to offset the taxable employment benefit if certain conditions are met. The relief is in the form of a deduction from taxable income equal to 25% of the amount included in employment income. The stock option deduction reduces the tax rate on benefits from employee stock options to the same level as the tax rate on capital gains. For CCPCs, the 25% deduction is available if the shares acquired are held for at least two years. For public corporations, the conditions that must be met to obtain the 25% deduction are as follows:
a. the employer company and the employee must be dealing at arm's length immediately after the stock option agreement is made;
b. the share must be a prescribed share (basically an ordinary common share.); and
c. the "option price" must not be less than the fair market value of the share at the time the agreement was made.
In the case of a CCPC, if the shares are not held for two years, the deduction may still be available if the conditions required for public corporations are met.
On the future sale of the shares, the employee will realize a capital gain or loss equal to the difference between the sale price and the adjusted cost base ("ACB") of the shares. The ACB of shares acquired on the exercise of stock options equals the shares’ fair market value at the time of exercise.
In the case of employee stock options granted by public corporations, the current practice of taxing benefits when employees exercise their options often forces employees to sell the shares immediately to pay the income tax which the taxable benefit generates. The budget proposes to change the rules with respect to the timing of the employment benefit inclusion where options are granted by a public corporation to require inclusion of the benefit in income only when the employee sells the shares.
Accordingly, employees of public corporations who exercise their options will no longer have to pay tax on a benefit which, at the time of exercise, has not materialized as cash. The proposed change to the timing of the taxation of the employment benefit will be subject to a $100,000 annual limit on the value of the options (i.e., the fair market value of the underlying share) that will be eligible for deferral and will be effective for options exercised after February 27, 2000.
In addition, consistent with the reduction in the inclusion rate for capital gains, the budget further proposes that the deduction currently available for employee stock options be increased from 25% to 33.3%.
From the employer’s perspective, the budget proposals provide that the deferral of the taxation of the employment benefit arising from the exercise of an employee option will be available only if the employer has an arrangement in place to ensure that it can monitor compliance with the $100,000 limit and that the related employment benefit and stock option deduction can be reported on an information slip in the year the shares are disposed of.
Capital Gains Rollovers for Small Business Investors
Currently, investors disposing of existing business investments to reinvest in other businesses must pay tax on the capital gains realized on the previous investment. This may limit access to capital for small businesses. Therefore, the budget proposes that individuals be able to defer the tax on accrued capital gains from eligible small business investments, to the extent that proceeds from the sale of such investments are reinvested in another eligible small business investment by the earlier of 120 days after disposition or 60 days after the end of the calendar year. The rollover treatment will be available for investments not exceeding $500,000 and only to the extent that the investment is held for more than six months from the time of acquisition. An eligible small business investment will be defined as newly issued common shares of a small business corporation with assets not exceeding $2.5 million before the investment is made and not exceeding $10 million after the investment. This tax deferral will be available for dispositions of shares after February 27, 2000. This measure may improve access to capital for small businesses with high growth potential.
Scientific Research and Experimental Development
Both the federal and provincial governments provide tax and non-tax assistance to taxpayers to support scientific research and experimental development. The federal government provides assistance in the form of investment tax credits, which are computed based on the cost of an expenditure, net of any government assistance that the taxpayer has received or is entitled to received. However, not all types of government assistance are treated equally for income tax purposes. In an effort to reduce disparities in the characterization of what constitutes government assistance for purposes of claiming investment tax credits, the budget proposes to treat provincial deductions for scientific research and experimental development that exceed the actual amount of an expenditure as government assistance. This should result in SR&ED deductions and credits having comparable value.
GST - Export-Related Measures
Under the GST system, where an exporter purchases or imports goods, processes them and exports the finished product, the exporter must pay tax on its purchases and importations, which it subsequently recovers through the input tax credit mechanism. This process involves a financing cost, since, unlike most other businesses, exporters do not obtain a cash-flow benefit from collecting GST on their sales. However, in certain cases, the cash-flow cost may be significant in relation to the level of value added to the goods by the business. The budget proposes to address cash-flow issues relating to these activities by introducing a new export distribution centre program that will permit businesses that export substantially all of their outputs, or operate export distribution operations for other businesses, to acquire or import most goods without the payment of GST. The program will be targeted at businesses that acquire or import goods on which they provide limited or no processing before export and whose export revenue accounts for at least 90% of their total revenue generated from activities in Canada. Qualifying businesses will be able to use a certificate to acquire or import on a tax-free basis, inventory or parts or components to be used in processing, and to import goods in respect of which processing, storage or distribution services will be performed. The proposed program will come into force on January 1, 2001.
In addition, the budget proposes to introduce measures to broaden the rules that provide for tax-free importation of goods for warranty repair, enhance the drop-shipment rules and expand the Exporters of Processing Services Program. As regards goods imported into Canada for warranty repair, currently, such goods are not subject to GST provided they are exported after the service is performed. However, where the imported good is replaced rather than repaired, relief from tax on importation does not apply. The budget proposes to extend the relieving rules to cover situations where a replacement good is provided under warranty and is exported in place of the original imported defective good.
With respect to drop shipments, the purpose of the drop shipment rules under the GST system is to allow an unregistered non-resident person to acquire goods and services in respect of goods in Canada, without paying the GST, where the goods are bound for export and remain in the possession of registered Canadian service providers before being exported. At present, the service of storing goods is not covered by these rules. The budget proposes to include storage services among the services that can be provided tax-free under these rules.
The Exporters of Processing Services Program allows the tax-free importation of goods by a Canadian processor for the purpose of processing the goods in Canada and subsequent export if, throughout the time the goods remain in Canada, they are not the property of the processor or a non-resident person to whom the processor is closely related. However, the program does not apply where a Canadian processor only provides storage or distribution services. The budget proposes to expand the program to allow storage and distribution activities.
Carole Chouinard, an Associate in the Ottawa office, practises in the area of taxation law with emphasis on personal and corporate taxation, charitable organizations and other non-taxable entities. She can be reached by telephone at (613) 7868668 and by e-mail at email@example.com.
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