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On March 29, 2012, the Federal Minister of Finance, Jim Flaherty, presented the majority government’s budget. The budget does not change corporate or personal tax rates. This Tax memo discusses the tax initiatives proposed in the budget, including SR&ED proposals.
SR&ED ITC rates are presently 35% for qualifying Canadian-controlled private corporations (CCPCs) and 20% for other corporations. The 35% rate applies on the first $3 million of qualified SR&ED expenditures incurred in a year and is refundable.
The Budget proposes that the general 20% ITC rate be reduced to 15% for taxation years ending after 2013. For a taxation year that includes January 1, 2014, the 5 % reduction in the ITC rate will be prorated accordingly.
The 35% rate for qualifying CCPCs remains unchanged. After 2013, SR&ED expenditures in excess of the $3 million expenditure limit will earn ITCs at the reduced rate of 15%.
Although a key recommendation in the Jenkins Report, there is no additional reduction in the amount of SR&ED refundability available to CCPCs, other than as a result of the changes proposed in the Budget.
Capital expenditures used all or substantially all in SR&ED are a) fully deductible in the year and b) earn ITC’s.
The budget proposes to exclude capital expenditures from being a deductible SR&ED expenditure and also from any ITC entitlement. This change also applies to exclude payments made for the use or the right to use property, which if acquired by the taxpayer would be a capital property of the taxpayer. Consequently, lease costs of equipment will no longer qualify for ITCs.
This change will apply to capital property acquired on or after January 1, 2014, and to amounts paid or payable after 2013 in respect of the use of, or the right to use, capital property.
SR&ED overhead expenditures can be claimed by using the elective proxy method or the traditional method (i.e., identifying each overhead expenditure directly related and incremental with SR&ED activities on an item-by-item basis). The proxy method allows taxpayers to claim as SR&ED overhead expenditures 65% of the total salary and wages of employees directly engaged in SR&ED.
The budget proposes to reduce the 65% proxy rate to 60% for 2013 and to 55% after 2013. The proxy rate that will apply for taxation years that include days in 2012,2013, or 2014 will be prorated based on the number of days in the taxation year that are in each of those calendar years.
This reduction will require taxpayers that typically elect to use the proxy method to consider whether the traditional method would be more beneficial.
A taxpayer who contracts SR&ED work to be undertaken on its behalf by an arm’s length party is entitled to deduct the contract payment and claim an ITC.
The budget proposes to disallow from the expenditure base for ITC purposes the “profit element” of arm’s length SR&ED contracts. Taxpayers will now be able to claim only 80% of the SR&ED contract amount paid to an arm’s length contractor.
This change will apply to expenditures incurred on or after January 1, 2013.
Furthermore, consistent with the proposed change to disallow ITCs on capital expenditures, arm’s length contract payments must also be reduced for any amount paid in respect of a capital expenditure incurred by the performer in fulfilling the contract. The performer will be required to inform the payer of these amounts.
The capital expenditures incurred by a performer in fulfilling a SR&ED contract will first reduce the contract amount before the 80% eligibility ratio is applied.
In addition, the amount that the performer is required to net against its own SR&ED qualifying expenditures as a result of the contract payment will be reduced by the amount the performer received with respect to the capital expenditure.
Contingency fee arrangements
The Jenkins Report observed that the SR&ED program is criticized for excessive complexity, which results in high compliance costs, forcing companies to retain consultants on a contingency fee arrangement and consequently diminish the benefits available under the program.
The budget proposes that “In the coming year, the Government will conduct a study, including consultations with taxpayers, to better understand why firms choose to hire consultants on a contingency-fee basis and determine what action is required.”
The budget announced new funding of $6M over two years for the Canada Revenue Agency (CRA) to implement changes to the administration of the SR&ED program. The CRA will:
Where the Canadian transfer pricing rules have applied to adjust for tax purposes amounts related to transactions between a Canadian corporation and one or more non-arm’s length non-residents (a “primary adjustment”), the related benefit to the non-residents is generally treated by the Canada Revenue Agency (“CRA”) as a deemed dividend (a “secondary adjustment”). The budget proposes to confirm this deemed dividend treatment for secondary adjustments and the related CRA administrative practice that eliminates the deemed dividend if the amount of a primary adjustment is repatriated to the Canadian corporation. No deemed dividend will arise in respect of a primary adjustment related to certain controlled foreign affiliates.
The budget proposes changes to the thin capitalization rules that limit the deductibility of interest expense of a Canadian-resident corporation that will:
For the purposes of applying the thin capitalization rules to partnerships, debts of the partnership are allocated to partners based upon their proportionate interest in the partnership. The partnership will not be denied an interest deduction, where the corporate partner exceeds the permitted debt-to-equity ratio. Instead, the corporation will have an income inclusion equal to a portion of the deductible interest of the partnership.
Disallowed interest will be treated as dividends paid at the time the interest is paid, or the end of the corporation’s taxation year if unpaid at that time, subject to an election to allocate disallowed interest to the latest interest payments made in a year. Withholding tax will be due based on these deemed payment dates.
The budget proposes to introduce rules to curtail a variety of transactions involving an investment in a foreign affiliate by a Canadian subsidiary of a foreign parent corporation, referred to as foreign affiliate dumping transactions. In such cases, property transferred by the Canadian corporation in respect of the investment (other than shares of the corporation) is deemed to be a dividend to the foreign parent and no amount may be added to the paid-up capital of shares of the Canadian corporation because of the investment, including for the purposes of the thin capitalization rules,.
These measures will not apply where a “business purpose” test is met and the budget sets out factors to be considered in applying this test. Comments regarding these tests will be accepted until May 31, 2012.
These measures will apply to transactions after March 28, 2012, other than certain transactions that occur before 2013 between arm’s length persons.
The budget proposes two measures to ensure that partnerships cannot be used to circumvent the intended application of sections 88 and 100 of the Income Tax Act.
Section 88 contains rules that enable a taxable Canadian corporation (the Parent) that has acquired control of another taxable Canadian corporation (the Subsidiary) to increase the cost of certain capital assets acquired by the Parent on a vertical amalgamation with, or winding-up of, the Subsidiary (the section 88 “bump”). The budget generally denies a bump in respect of a partnership interest to the extent that the accrued gain in respect of the partnership interest is reasonably attributable to the amount by which the fair market value of “income assets” (assets that would not themselves be eligible for the bump) exceed their cost amount. This measure applies if the income assets are held directly by the partnership or indirectly through one or more other partnerships.
This measure applies to amalgamations that occur, and windings-up that begin, after March 28, 2012. An exception is available for a taxable Canadian corporation amalgamating with its subsidiary before 2013, or beginning to wind up its subsidiary before 2013, if before March 29, 2012, certain other conditions are met.
Section 100 is meant to ensure that income assets held by a partnership are fully taxable on the sale of the partnership by a taxpayer to a tax-exempt person. The budget extends the application of section 100 to the sale of a partnership interest to a non-resident person, unless the partnership uses all of its property in carrying on business through a permanent establishment in Canada. The budget also clarifies that section 100 will apply to dispositions made directly, or indirectly as part of a series of transactions, to a tax-exempt or non-resident person.
This measure applies to dispositions of interests in partnerships that occur after March 28, 2012. An exception is available for an arm’s length disposition before 2013 that the taxpayer was obligated to make pursuant to a written agreement entered into before March 29, 2012.
For dividends paid after March 28, 2012:
The budget proposes to reduce the tax compliance burden for small businesses and announces several administrative improvements by the Canada Revenue Agency (CRA):
Clean energy generation equipment (Classes 43.1 and 43.2)
The capital cost allowance (CCA) system currently provides accelerated CCA deductions for investment in specified clean energy generation and conservation equipment, and eligible equipment that generates or conserves energy.
For assets acquired after March 28, 2012, Class 43.2 is enhanced as follows:
In addition, equipment using eligible waste fuels will no longer be eligible under Class 43.1 or Class 43.2 if the applicable environmental laws and regulations of Canada or of a province, territory, municipality, or a public or regulatory body are not complied with at the time the equipment first becomes available for use.
The budget phases out the 10% corporate tax credit for pre-production mining and development expenses, as follows:
Additional transitional relief will apply at a 10% rate for pre-production development expenses incurred before 2016 in certain cases where a written agreement was entered into before March 29, 2012.
Exploration and pre-production development expenses will continue to qualify as Canadian exploration expenses.
The budget phases out the 10% Atlantic Investment Tax Credit (AITC) for certain oil and gas and mining activities, for assets acquired after March 28, 2012, from 10% if acquired before 2014, to 5% in 2014 and 2015 and nil after 2015.
Transitional relief will apply at a 10% rate for assets acquired before 2017 in cases where a written agreement was entered into before March 29, 2012.
The budget ensures that “qualified property” for the AITC includes certain electricity generation equipment and clean energy generation equipment used primarily in an eligible activity in the Atlantic region This measure applies to assets acquired after March 28, 2012, except that it does not apply to assets acquired for use primarily in oil and gas or mining activities.
The temporary hiring credit introduced in the 2011 budget will be extended for one year. As a result, up to $1,000 can be claimed against a small employer’s increase in its 2012 Employment Insurance (EI) premiums over those paid in 2011. The credit is available to employers whose total EI premiums were $10,000 or less in 2011.
The budget proposes to alleviate the tax cost to Canadian banks using excess liquidity of their foreign affiliates in their Canadian operations. Amendments are also to be developed to ensure that certain securities transactions in the course of the bank’s business of facilitating trades for arm’s length customers are not inappropriately caught by the base erosion rules.
The Investment Income Tax (IIT) levied on life insurers will be recalibrated when appropriate to neutralize impacts of proposes technical improvements to the IIT base. The government will undertake consultations on these improvements. The changes will apply to life insurance policies issued after 2013.
Under current rules, members of a partnership may designate a partner who is authorized to file an objection to the Canada Revenue Agency on behalf of all its partners. The budget proposes that a single designated partner of a partnership may also be empowered to waive, on behalf of all its partners, the three-year time limit for making a determination by the Canada Revenue Agency. This measure will apply on royal assent to the enacting legislation.
The budget reaffirms the government’s commitment to continue to explore whether new rules for the taxation of corporate group could improve the functioning of the corporate tax system.
The age eligibility for Old Age Security and the Guaranteed Income Supplement will increase from 65 to 67, starting April 2023, with full implementation by January 2029. This change will not affect individuals who are 54 or older on March 31, 2012.
Commencing 2013, the Overseas Employment Tax Credit (OETC) will be phased out over four years. During the phase-out period the factor (currently 80%) applied to an employee’s qualifying foreign employment income in determining the OETC will be reduced to 60% for 2013, 40% for 2014, 20% for 2015 and nil for 2016 and thereafter.
These phase out rules will not apply to qualifying foreign employment income earned by an employee in connection with a project or activity to which the employee’s employer had committed in writing before March 29, 2012. In this circumstance the factor will remain 80% until 2016 and subsequent years when it will be nil.
The list of expenses eligible for this credit will include blood coagulation monitors for use by individuals who require anti-coagulation therapy, for expenses incurred after 2011.
The budget proposes several changes to the rules governing Registered Disability Savings Plans (RDSPs):
Employer contributions to a group sickness or accident insurance plan will be included in an employee’s income for the year in which the contributions are made, to the extent the contributions are not in respect of a wage-loss replacement benefit payable on a periodic basis. This measure will generally apply in respect of employer contributions made after March 28, 2012 relating to coverage after 2012.
The Canada Revenue Agency has identified several arrangements that seek to take advantage of various features of the Retirement Compensation Arrangement (RCA) rules to obtain unintended tax benefits. To prevent the use of similar schemes in the future, the budget proposes new prohibited investment and advantage rules that will impose significant tax penalties where an RCA engages in non-arm’s length transactions.
The new rules will be closely based on existing rules for Tax-Free Savings Accounts, Registered Retirement Savings Plans and Registered Retirement Income Funds. They will apply to:
In addition, the budget proposes a new restriction on RCA tax refunds in certain cases when RCA property has lost value. This measure will apply in respect of RCA tax on RCA contributions made after March 28, 2012.
To ensure that Employees Profit Sharing Plans (EPSPs) are used for their intended purposes, the budget introduces a special tax payable by specified employees (generally an employee who has a significant interest in, or does not deal at arm’s length with, the employer).
The tax will be payable on the portion of an employer’s EPSP contribution, allocated by the trustee to a specified employee, that exceeds 20% of the employee’s salary received in the year from the employer. The tax rate will equal the top combined marginal rate of the province in which the employee resides (except for Quebec residents, for which the tax rate will equal the top federal marginal tax rate).
This measure will generally apply to EPSP contributions made after March 28, 2012.
The mineral exploration tax credit is extended by one year to flow-through share agreements entered into before April 1, 2013.
The budget proposes technical improvements to update and simplify the test that determines whether a life insurance policy is an exempt policy. The government will undertake consultations on these improvements. The changes will apply to life insurance policies issued after 2013.
Commencing 2013, the income tax exemption for the Governor General will end.
Generally for supplies made after March 29, 2012, the budget proposes to improve the application of the Goods and Services Tax/Harmonized Sales Tax (GST/HST) to:
Charity and qualifying non-profit literacy organizations prescribed by regulation will be allowed to claim a rebate of the GST (and the federal portion of the HST) they pay to acquire printed books to be given away. This measure will apply to acquisitions and importations of printed books in respect of which tax has become payable after March 29, 2012.
GST/HST streamlined accounting thresholds
To simplify GST/HST compliance for small businesses and public service bodies the budget doubles the existing streamlined accounting thresholds. This measure will generally apply to GST/HST reporting periods of a person beginning after 2012.
Foreign-based rental vehicles temporarily imported by Canadian residents will be provided:
In addition, the Green Levy and the automobile air conditioner tax will not apply to foreign-based rental vehicles temporarily imported by Canadian residents.
These changes will apply to foreign-based rental vehicles temporarily imported by Canadian residents after May 31, 2012.
On February 17, 2012, the Minister of Natural Resources announced that Canada will changes the vehicle fuel consumption testing requirements to better align with those in the United States. To ensure this change does not affect the application of the Green Levy, the Excise Tax Act will be amended to ensure that the weighted average fuel consumption rate for purposes of the Green Levy continues to be determined by reference to the current test method.
The necessary legislative amendments will apply on royal assent to the enacting legislation.
The budget proposes to modify the rules whereby gifts can be made to foreign charities. The Minister of Finance and the Minister of Revenue will have the discretionary power to grant qualified donee status to foreign charities.
The budget proposes:
For goods imported after March 29, 2012, the budget eliminates the 5% Most-Favoured-Nation (MFN) rate of duty on certain imported oils used as production inputs in gas and oil refining as well as electricity production.
The travellers’ exemptions will increase for
Canadian residents returning to Canada after May 31, 2012. For those out of the country:
The budget confirms that the government will proceed with the following previously announced measures:
The government also reaffirms the government’s commitment to move ahead with technical amendments to improve the operation of the tax system.
Of further interest