2012 Federal Budget

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Continued tightening

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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.

Business tax measures | Personal tax measures | Other tax measures

Business tax measures

General SR&ED Investment Tax Credit (ITC) rate reduced

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.

SR&ED capital expenditures eliminated

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.

Overhead proxy rate reduced

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.

SR&ED contract payments reduced

 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.”

Enhancing predictability

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:

  • conduct a pilot project to determine feasibility of a formal pre-approval process;
  • enhance the existing online self-assessment  eligibility tool;
  • work collaboratively with industry representatives to address emerging issues;
  • make more frequent and effective use of “tax alerts”; and
  • improve the Notice of Objection process to allow for a second review of scientific eligibility determinations.

Transfer pricing – Secondary adjustments

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.

Thin capitalization rules

The budget proposes changes to the thin capitalization rules that limit the deductibility of interest expense of a Canadian-resident corporation that will:

  • for years beginning after 2012, reduce the debt-to-equity ratio from 2-to-1 to 1.5-to-1;
  • for years that begin after March 28, 2012, extend the thin capitalization rules to apply to debts of a partnership in which a Canadian-resident corporation is a member;
  • for years that end after March 28, 2012, treat disallowed interest as dividends for Part XIII withholding tax purposes; and
  • prevent double taxation in circumstances where a controlled foreign affiliate of a Canadian-resident corporation lends funds to the corporation and the interest is included in the foreign accrual property income of the affiliate.

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.

Foreign affiliate dumping

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.

Tax avoidance through the use of partnerships

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.

Eligible dividend designations

For dividends paid after March 28, 2012:

  • a corporation can designate, at the time it pays a taxable dividend, any portion of the dividend to be an eligible dividend; and
  • the Minister of National Revenue will be allowed to accept late designations of eligible dividends that are made within three years after the day the designation was first required to be made.

Tax compliance burden

The budget proposes to reduce the tax compliance burden for small businesses and announces several administrative improvements by the Canada Revenue Agency (CRA):

  • Written responses to business enquiries – Starting April 16, 2012, businesses will be able to submit questions and receive answers to specific enquiries electronically using the CRA’s My Business Account portal.
  • CRA’s My Business Account Portal – Starting April 16, 2012, business owners can input address changes online and balances such as non-capital loss and refundable dividend tax on hand from the last five tax-year ends will be automatically displayed.
  • Business section on the CRA’s website – Modifications are intended to provide a “one-stop shop” for businesses and a clear path to available electronic services with a new task-based page.
  • Penalties – The CRA has a new administrative policy intended to ensure that penalties for late-filed information returns are charged in a fair and reasonable manner.
  • Tax fairness – Revised pages on the CRA website are intended to make information on complaints and disputes easier to see. Information on recourse mechanisms to notices of assessment and reassessment will be added. The CRA is also updating publications related to tax fairness and developing new content and new types of content on this topic.

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:

  • the restriction that heat energy generated from waste-fuel thermal energy equipment must be used in an industrial process or a greenhouse has been removed;
  • district energy system equipment is expanded to include those that distribute thermal energy primarily generated by waste-fuelled thermal energy equipment; and
  •  the list of eligible waste used in waste-fuelled thermal energy equipment or a cogeneration system is expanded to include the residue of plants.

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.

Corporate Mineral Exploration and Development Tax Credit

The budget phases out the 10% corporate tax credit for pre-production mining and development expenses, as follows:

  • 10% for mining exploration expenses incurred in 2012, 5% in 2013 and nil after 2013; and
  •  10% for development expenses incurred before 2014, 7% in 2014, 4% in 2015 and nil after 2015.

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.

Atlantic Investment Tax Credit

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.

Hiring credit for small business

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.

Base erosion rules – Canadian banks

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.

Life insurers

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.

Partnership waivers

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.

Taxation of corporate groups

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.

Personal tax measures

Old age security eligibility

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.

Overseas Employment Tax Credit

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.

Medical Expense Tax Credit

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.

Registered Disability Savings Plans

The budget proposes several changes to the rules governing Registered Disability Savings Plans (RDSPs):

  • Plan holders – Certain family members will be allowed to temporarily become the plan holder of the RDSP for an individual who might not be able to enter into a contract. This measure will apply from the date of royal assent until the end of 2016.
  • Government repayments – For RDSP withdrawals made after 2013, the 10-year repayment rule for government repayments will be replaced with a proportional repayment rule.
  • Withdrawals – Changes to the rules governing maximum and minimum withdrawals, intended to provide greater flexibility, will apply after 2013.
  • Registered Education Savings Plan (RESP) investment income – After 2013, investment income earned in an RESP can be transferred tax free to an RDSP if the plans share a common beneficiary and certain other conditions are met.
  • Termination of an RDSP – In certain cases, the period for which an RDSP may remain open when a beneficiary becomes ineligible for the Disability Tax Credit is extended.
  • Administrative changes – Measures are intended to reduce the administrative burden when an RDSP is transferred from one issuer to another.

Group sickness or accident insurance plans

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.

Retirement Compensation Arrangements

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:

  • investments acquired, or that become prohibited after March 28, 2012; and
  • advantages extended, received or receivable after March 28, 2012 (including advantages related to property acquired or transactions occurring previously, subject to transitional rules).

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.

Employees Profit Sharing Plans

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.

Mineral exploration tax credit

The mineral exploration tax credit is extended by one year to flow-through share agreements entered into before April 1, 2013.

Life insurance policy exemption test

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.

Governor General’s salary

Commencing 2013, the income tax exemption for the Governor General will end.

Sales and excise tax measures

Health measures

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:

  • Pharmacists’ services – Services rendered by pharmacists for non-dispensing health care services will be GST/HST exempt. In addition, the GST/HST exemption for diagnostic services will be extended to those ordered by pharmacists if certain conditions are met.
  • Corrective eyewear – Corrective eyeglasses or contact lenses supplied by opticians will be zero-rated if certain conditions are met.
  • Medical and assistive devices – The budget proposes to zero-rate blood coagulation monitoring or metering devices (and associated test strips and reagents), and medical and  assistive devices supplied on the written order of a medical practitioner, registered nurse, occupational therapist or physiotherapist (if these supplies currently qualify for zero-rating only if supplied on the order of a medical practitioner).
  • Drugs – Isosorbide-5-mononitrate will be added to the list of zero-rated non-prescription drugs.

GST rebate for books

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

Foreign-based rental vehicles temporarily imported by Canadian residents will be provided:

  • a full GST/HST exemption if the Canadian resident was outside Canada at least 48 hours; and
  • a partial GST/HST exemption in other cases.

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.

Fuel-inefficient vehicles

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.

Other tax measures

Gifts to Foreign Charities

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.

Charities – Enhancing Transparency

The budget proposes:

  • to apply sanctions to charities with respect to political activities such as suspending tax receipting privileges;
  • when it is reasonable to consider that a purpose of a gift was to support political activities, it will be deemed to be an expenditure on political activities; and
  • to modify the tax shelter rules to encourage tax shelter reporting by modifying and introducing new penalties.

Most-Favoured-Nation (MFN) rate

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.

Travellers’ exemptions

The travellers’ exemptions will increase for
Canadian residents returning to Canada after May 31, 2012. For those out of the country:

  • from 24 to 48 hours – the exemption increases from $50 to $200; and
  • 48 hours or more – the exemption will be $800. This new threshold replaces the current 48-hour and 7-day exemptions

Previously announced measures

The budget confirms that the government will proceed with the following previously announced measures:

  • legislative proposals released on July 16, 2010, relating to income tax technical and bijuralism amendments;
  • the March 4, 2010 budget measures, some of which were included in legislative proposals released on August 27, 2010;
  • legislative proposals released on November 5, 2010, relating to income tax technical amendments;
  • legislative proposals released on December 16, 2010, relating to Real Estate Investment Trusts;
  • GST/HST changes released on January 28, 2011, relating to financial institutions;
  • legislative proposals released on March 16, 2011, in draft form relating to the deductibility of contingent amounts, withholding tax on interest paid to non-residents and the tax treatment of certain life insurance corporation reserves;
  • measures announced on July 20, 2011, relating to specified investment flow-through entities, real estate investment trusts and publicly traded corporations;
  • legislative proposals released on August 19, 2011, relating to foreign affiliates;
  • legislative proposals released on October 31, 2011, relating to income and sales and excise tax technical amendments;
  • measures announced on November 10, 2011 to improve the caseload management of the Tax Court of Canada;
  • income and GST/HST amendments to accommodate the introduction of Pooled Registered Pension Plans (including legislative proposals released on December 14, 2011);
  • automobile expense amounts for 2012 announced on December 29, 2011; and
  • measures announced on February 17, 2012, relating to transitional rules for the elimination of the HST in British Columbia.

The government also reaffirms the government’s commitment to move ahead with technical amendments to improve the operation of the tax system.