On February 27, 2018, the Federal Minister of Finance, Bill Morneau, presented the Liberal government’s third budget. This Tax Insights discusses the tax initiatives proposed in the budget.
Holding Passive Investments Inside a Private Corporation
In July 2017, the government released a consultation paper on tax planning strategies involving private corporations. In the paper, and in subsequent announcements in October 2017, following completion of the consultation period, the government had proposed certain changes to the taxation of passive investment income earned by private corporations. In response to feedback from many Canadians through this consultation process that the proposals could be very complex and burdensome for businesses, the budget now proposes a more targeted and simpler approach to limit perceived tax deferral advantages from holding passive investments within a private corporation. Two measures are proposed:
Limiting Access to the Small Business Tax Rate
The first measure is intended to limit the ability of businesses with significant investment income to benefit from the current small business deduction limit of $500,000. Under this proposal, if a corporation (together with any associated corporations) earns more than $50,000 of passive income in a year the amount eligible for the small business deduction will be gradually reduced. Specifically, the small business deduction limit will be reduced by $5 for every $1 of investment income over $50,000 such that it is reduced to zero at $150,000 of investment income. Taxable capital gains on the sale of active investments as well as investment income earned that is incidental to an active business will not be taken into account for this measure.
For purposes of the new reduction to the small business deduction, investment income of the associated group of companies will be measured as “adjusted aggregate investment income,” which is generally “aggregate investment income” as currently defined but modified for certain items, including to:
The new reduction, which applies to taxation years that begin after 2018, will operate in tandem with the existing business limit reduction that applies in respect of taxable capital in excess of $10 million. The reduction to a corporation’s business limit for a year will be the greater of the new reduction and the reduction under the existing provisions.
Limiting Access to Refundable Tax
The second measure is intended to limit the tax advantage that a Canadian-controlled private corporation (CCPC) can currently obtain by recovering refundable taxes on the payment of eligible dividends. The budget proposes that a CCPC will only be entitled to a refund of taxes paid on investment income by paying taxable dividends from income that has not been taxed at the general business tax rate (that is, non-eligible dividends). An eligible RDTOH (ERDTOH) account will be introduced that will track refundable Part IV taxes paid on eligible portfolio dividends. The current RDTOH account will be renamed the non-eligible RDTOH (NRDTOH) account and will track the refundable taxes incurred on investment income (including taxable capital gains) and Part IV tax on non-eligible dividends.
A refund of the NRDTOH will only be obtained on the payment of non-eligible dividends. A refund of the ERDTOH will be obtained on the payment of any taxable dividend (eligible or non-eligible), except that a non-eligible dividend must recover any NRDTOH balance first before recovering ERDTOH. Dividends received from a connected corporation will continue to generate Part IV tax to the extent of the dividend refund obtained by the payor corporation, but the Part IV tax paid will be added to the new RDTOH account of the recipient matching the RDTOH account from which the payor obtained its refund.
Coming into Force and Transition
This measure applies for taxation years that begin after 2018. As a transitional measure, a CCPC’s opening ERDTOH account will generally be the lesser of its existing RDTOH balance and 38.33% of the CCPC’s general rate income pool. Any remaining RDTOH balance for the CCPC will be added to the opening NRDTOH account. For all other corporations, the existing RDTOH balance will be added to the opening ERDTOH account.
At-Risk Rules for Tiered Partnerships
In general, the income or loss of a partnership is allocated to its partners who, in turn, are required to include (or deduct) the amount in calculating their own income. In the case of a limited partner of a partnership, any losses allocated to the partner may only be deducted to the extent the partner has invested capital that is at-risk in the partnership. Where the loss is not eligible to be deducted by the limited partner, the partner may generally carry forward the loss indefinitely, until a later year in which the partner has invested positive “ at-risk amount” in the partnership and available taxable income.
The budget proposes to address a recent Federal Court of Appeal ruling that held that the “at-risk rules” did not generally apply to a partnership that is itself a limited partner in another partnership. The at-risk rules will be expanded to ensure that losses allocated to a limited partner that is an “upper tier” partnership in excess of its at-risk amount in the “lower tier” partnership will be denied and will not be available for carry-forward to future taxation years. Instead, the losses will not reduce the adjusted cost base of the partnership interest in the lower tier partnership, such that these losses will now effectively result in a lower capital gain or higher capital loss on the ultimate disposition of the partnership interest.
The above measures will apply to taxation years that end on or after February 27, 2018, including in respect of losses incurred in taxation years that end prior to February 27, 2018. In particular, losses that were allocated to a limited partner, that is itself a partnership, for a taxation year that ended prior to February 27, 2018, will not be allowed to be carried forward to a taxation year that ends on or after February 27, 2018.
Tax Support for Clean Energy
Class 43.2 provides accelerated capital cost allowance for investments in specified clean energy generation and conservation equipment. The budget extends eligibility for Class 43.2 by five years, so that it is available for property acquired before 2025.
Artificial Losses Using Equity-Based Financial Arrangements
The budget proposes to expand the existing synthetic equity arrangement and securities lending arrangement (SLA) rules to prevent taxpayers from realizing artificial tax losses through the use of equity-based financial arrangements to circumvent these rules. The budget proposes:
The first measure is to apply for dividends that are paid or become payable on or after February 27, 2018. The second and third measures apply to dividend compensation payments made on or after February 27, 2018 unless the securities lending or repurchase arrangement was in place before February 27, 2018, in which case the measures will apply for dividend compensation payments made after September 2018.
Stop-Loss Rule on Share Repurchase Transactions
The 2011 budget introduced dividend stop-loss rules applicable to financial institutions that held shares as mark-to-market property. The rules apply where a financial institution is deemed to have received a dividend on a share repurchase to deny the loss to the extent the original cost of the shares exceeded its paid-up capital. The institution could continue to claim a loss to the extent of the mark-to-market income previously recognized on the share on the premise that the institution paid tax on the income. In most cases, the repurchased shares were fully hedged and mark-to-market income realized on the share would be fully offset by the hedge.
The budget proposes to reduce the tax-loss otherwise realized on the share repurchase by the dividend deemed to have been received on the repurchase when the dividend is eligible for the intercorporate dividend deduction.
Health and Welfare Trusts
The budget proposes to apply only one set of rules to health and welfare trusts (the tax treatment for which are set out in published Canada Revenue Agency (CRA) administrative positions) and employee life and health trusts (for which rules are set out in the Income Tax Act (ITA)). After the end of 2020, the CRA will no longer apply their administrative positions with respect to health and welfare trusts. Transitional rules will be added to facilitate the conversion of existing health and welfare trusts to employee life and health trusts. Trusts that do not convert (or wind up) to employee life and health trusts will be subject to the normal income tax rules for trusts. Health and welfare trusts established after February 27, 2018 will no longer be subject to the CRA’s administrative positions. Stakeholders are invited to submit comments on transitional issues by June 29, 2018. Draft legislation will follow.
U.S. tax reform
The budget does not specifically address U.S. tax reform. The budget states that “[o]ver the coming months, the Department of Finance Canada will conduct detailed analysis of the U.S. federal tax reforms to assess any potential impacts on Canada.”
Cross-Border Surplus Stripping using Partnerships and Trusts
The existing cross-border surplus stripping rules seek to prevent a non-resident shareholder from entering into transactions to extract free of tax a Canadian corporation’s surplus in excess of the paid-up capital (PUC) of its shares or to artificially increase such PUC.
The current rules do not expressly address certain internal reorganizations that involve situations where a non-resident disposes of an interest in a partnership that owns a Canadian subject corporation to a Canadian purchaser corporation nor do they deal with similar planning involving trusts. A corresponding corporate immigration rule may be ineffective in similar circumstances.
The budget proposes to amend these provisions to add comprehensive “look-through” rules for partnerships and trusts, to ensure that the rules cannot be avoided inappropriately. These rules will allocate the assets, liabilities and transactions of a partnership or trust to its members or beneficiaries, as the case may be based on the relative fair market value of their interest.
This measure will apply to transactions that occur on or after February 27, 2018.
Investment Business Definition
Income of a foreign affiliate from an investment business is generally included in its foreign accrual property income (FAPI). However, an investment business does not include a business carried on by a foreign affiliate if certain conditions are satisfied. One of these conditions in general terms is that the affiliate employs more than five full-time employees or the equivalent (the six employee test) in the active conduct of its business.
The budget proposes to introduce a rule for purposes of the investment business definition so that, where pursuant to a contractual or other arrangement the income attributable to specific activities carried out by a foreign affiliate accrues to a specific Canadian taxpayer under a tracking arrangement, those activities carried out to earn such income will be deemed to be a separate business carried on by the affiliate. Each such “deemed separate business” of the affiliate will therefore need to satisfy each relevant condition in the investment business definition, including the six employee test, in order for the affiliate’s income to be excluded from FAPI.
This measure will apply to taxation years of a taxpayer’s foreign affiliate that begin on or after February 27, 2018.
Controlled Foreign Affiliate Status
The FAPI of a foreign affiliate of a taxpayer is included in the taxpayer’s income on an accrual basis only where the affiliate is a controlled foreign affiliate of the taxpayer.
The budget proposes to deem a foreign affiliate of a taxpayer to be a controlled foreign affiliate of the taxpayer if FAPI attributable to specific activities of the foreign affiliate accrues to the benefit of the taxpayer under a tracking arrangement.
This measure will apply to taxation years of a taxpayer’s foreign affiliate that begin on or after February 27, 2018.
Trading and Dealing in Indebtedness
Where the principal purpose of a business carried on by a foreign affiliate of a taxpayer is to derive income from trading and dealing in indebtedness, the income from that business is generally treated as FAPI of that affiliate. Similar rules apply to ensure that income from an investment business is generally included in a foreign affiliate’s FAPI. Both sets of rules contain exceptions in respect of certain regulated financial institutions.
A condition under the investment business rules requires a taxpayer to satisfy certain minimum capital requirements in order to qualify for the regulated foreign financial institution exception. To ensure consistency with the investment business rules, the budget proposes to add a similar minimum capital requirement to the trading or dealing in indebtedness rules.
This measure will apply to taxation years of a taxpayer’s foreign affiliate that begin on or after February 27, 2018.
The budget proposes to extend the reassessment period for a taxpayer by three years in respect of income arising in connection with a foreign affiliate of the taxpayer.
This measure will apply to taxation years of a taxpayer that begin on or after February 27, 2018.
The budget proposes to bring the information return filing-due date in respect of a taxpayer’s foreign affiliates in line with the taxpayer’s income tax return filing-due date by requiring the information returns to be filed within six months after the end of the taxation year.
This measure will apply to taxation years of a taxpayer that begin after 2019.
Reassessment Period – Requirements for Information and Compliance Orders
The budget proposes to add a “stop the clock” rule that extends the reassessment period of a taxpayer where a requirement for information (excluding foreign-based information, for which an existing “stop-the-clock” rule already applies) or compliance order is being contested in court. The reassessment period is extended by the amount of time during which the requirement or compliance order is being contested. The existing “stop the clock” rule for foreign-based information will continue to apply.
Reassessment Period – Non-Resident Non-Arm’s Length Persons
The budget proposes to extend the reassessment period of a taxpayer by three years to the extent the reassessment relates to a loss carry back previously claimed, where a reassessment is made to the loss as a consequence of a transaction involving a taxpayer and a non-resident person with whom the taxpayer does not deal at arm’s length. This measure will apply in respect of taxation years in which a carried back loss is claimed, where that loss arises in a taxation year ending after February 26, 2018.
Sharing Information for Criminal Matters
To facilitate the sharing of information related to tax offences under Canada’s tax treaties, tax information exchange agreements and the Convention on Mutual Administrative Assistance in Tax Matters, the budget proposes to allow the legal tools available under the Mutual Legal Assistance in Criminal Matters Act to be used by the CRA.
The budget also proposes to enable the sharing of tax information with Canadian mutual legal assistance partners in respect of acts that, if committed in Canada, would constitute terrorism, organized crime, money laundering, criminal proceeds or designated substance offenses.
The proposals will also enable confidential information under Part IX of the Excise Tax Act and the Excise Tax Act, 2001 to be disclosed to Canadian police officers in respect of those offences where such disclosure is currently permitted under the ITA
International Tax Avoidance – Base Erosion and Profit Shifting (BEPS)
The government confirms its commitment to safeguard Canada’s tax system and continues to be an active participant in the Organisation for Economic Co-operation and Development/Group of 20 (OECD/G20) project to address both the inappropriate shifting of profit offshore and other international planning to avoid tax by corporations and some wealthy individuals, known as the BEPS initiative. The government continues to work with its international partners to improve international dispute resolution, and to ensure a coherent and consistent response to fight cross-border tax avoidance.
Reporting Requirements for Trusts
The budget proposes new reporting requirements, and related penalties for non-compliance, effective for the 2021 and subsequent taxation years that will require a trust to report the identity of all trustees, beneficiaries and settlors of the trust, as well as the identity of each person who has the ability to exert control over trustee decisions regarding appointment of income or capital of the trust (e.g., a protector). This will create a T3 “Trust Income Tax and Information Return” filing obligation for certain trusts where a filing requirement currently does not exist. The new reporting requirements will apply to certain trusts resident in Canada and non-resident trusts that are currently required to file a T3 return.
Exceptions to the filing requirement include:
Penalties for failure to file the T3 return including the beneficial ownership schedule will be $25 per day with a minimum penalty of $100 and a maximum penalty of $2,500. Gross negligence penalties of up to 5% of the maximum fair market value of the property held in the trust in the year may also apply.
Mineral Exploration Tax Credit for Flow-Through Share Investors
The budget proposes to extend eligibility for the mineral exploration tax credit for an additional year, to flow-through share agreements entered into before April 1, 2019.
Canada Workers Benefit
The Working Income Tax Benefit, a refundable tax credit, will be renamed the Canada Workers Benefit, and will be enhanced starting in 2019 (indexed thereafter). A Canada Workers Benefit disability supplement will also be enhanced. Starting with 2019, the CRA will determine if an individual is eligible to receive the benefit and assess the return as if the benefit had been claimed, even if it had not claimed on filing. For eligible couples who do not make a claim, the CRA will designate which individual receives the benefit.
Medical Expense Tax Credit – Eligible Expenditures
The medical expense tax credit will be expanded to include eligible expenses incurred after 2017, in respect of an animal specially trained to perform tasks for a patient with a severe mental impairment, to help the patient cope with their impairment (e.g. a psychiatric service dog trained to assist with post-traumatic stress disorder). Expenses will not be eligible if they relate to an animal that provides only comfort or emotional support.
Registered Disability Savings Plan – Qualifying Plan Holders
When an adult individual lacks the capacity to enter into a contract, the ITA requires that the plan holder of an individual’s Registered Disability Savings Plan (RDSP) be the individual’s legal representative, as recognized under provincial or territorial law. Since the appointment of a legal representative can take a long time, a temporary federal measure allows a qualifying family member to be the plan holder of an individual’s RDSP, if the adult individual does not have a legal representative. The budget extends this temporary measure by five years, to the end of 2023. A qualifying family member who becomes a plan holder before the end of 2023 can remain the plan holder after 2023.
Deductibility of Employee Contributions to the Enhanced Portion of the Quebec Pension Plan
The Government of Quebec recently announced that the Quebec Pension Plan (QPP) would be enhanced in a manner similar to the enhancement of the Canada Pension Plan (CPP) that was announced in 2016. To provide consistent treatment of CPP and QPP contributions, the budget proposes to amend the ITA to provide a deduction for employee contributions to the enhanced portion of the QPP. This measure will apply to the 2019 and subsequent taxation years.
Retroactive Eligibility of Foreign-Born Status Indians
Beginning in July 2016, foreign-born status Indians residing legally in Canada who are neither Canadian citizens nor permanent residents could receive the Canada Child Benefit (CCB) where all other eligibility requirements were met. Such individuals were not eligible for predecessor programs to the CCB. The budget proposes that such individuals be made retroactively eligible from January 1, 2005 to June 30, 2016 for the predecessor programs to the CCB.
Provincial/Territorial Access to Taxpayer Information
The budget proposes to allow the government to share taxpayer information related to the CCB, as of July 1, 2018, with provinces and territories, solely for the purpose of administering social assistance payment regimes.
Charities – Miscellaneous Technical Issues
Municipalities as Eligible Donees
If a charity loses its registered status, a 100% revocation tax on the net value of the charity’s assets can be imposed. The charity can reduce this tax by making qualifying expenditures, including gifts to “eligible donees” (generally, an arm’s length charity in good standing). In some cases, a charity may not be able to locate an eligible donee. The budget proposes to amend the ITA to allow transfers of property to municipalities made after February 26, 2018 to be qualifying expenditures for the purposes of the revocation tax, subject to case-by-case approval by the Minister of Revenue.
Universities Outside Canada
Since 2011, certain categories of “qualified donees” for donation tax credits, including universities outside Canada, have been required to register with the CRA. As of February 27, 2018, to eliminate the need for duplicate lists, the budget proposes to remove the requirement that universities outside Canada be prescribed in the Income Tax Regulations.
GST/HST and Investment Limited Partnerships
The budget confirms the government’s intention to proceed with the September 8, 2017 GST/HST draft legislative and regulatory proposals relating to investment limited partnerships, with the following changes:
Consultations on the GST/HST Holding Corporation Rules
A GST/HST rule, commonly referred to as the “holding corporation rule”, generally allows a parent corporation to claim input tax credits to recover GST/HST paid on expenses that relate to another corporation. The rule provides that, if a parent corporation resident in Canada incurs expenses that can reasonably relate to shares or indebtedness of a commercial operating corporation and the parent corporation is related to the commercial operating corporation, the expenses are generally deemed to have been incurred to relate to commercial activities of the parent corporation.
The government intends to consult on this rule, particularly with respect to the limitation of the rule to corporations and the required degree of relationship between the parent corporation and the commercial operating corporation. The government also intends to clarify which expenses of the parent corporation that relate to shares or indebtedness of a related commercial operating corporation qualify for input tax credits under the rule. Consultation documents and draft legislative proposals will be released for public comment in the near future.
As of February 28, 2018, tobacco excise duty rates on cigarettes and other tobacco products will increase, and these rates will be adjusted by inflation annually (instead of every five years) starting April 1, 2019.
In addition, inventories of cigarettes held by manufacturers, importers, wholesalers and retailers at the end of February 27, 2018, will be subject to an inventory tax of $0.011468 per cigarette (subject to certain exemptions). Taxpayers will have until April 30, 2018 to file returns and pay the inventory tax.
The budget proposes a new federal excise duty framework for cannabis products, which will be effective when non-medicinal cannabis becomes available for legal sale. The duty will generally apply to all products available for legal purchase. Cannabis cultivators and manufacturers will be required to obtain a cannabis licence from the CRA. Excise duties will be imposed on federally-licenced producers at the higher of a flat rate applied on the quantity of cannabis contained in a final product and a percentage of the dutiable amount of the product as sold by the producer. In addition, the GST/HST basic groceries rules will be amended to ensure that any sales of cannabis products that would otherwise be considered as basic groceries are subject to the GST/HST in the same way as sales of other types of cannabis products.
The budget confirms that the government will proceed with the following previously announced measures, as modified to take into account consultations and deliberations since their announcement or release:
The budget also reaffirms the government’s commitment to move forward as required with technical amendments to improve the certainty of the tax system.