Canadas 2021 budget addresses international tax issues: PwC

In brief

The Deputy Prime Minister and Minister of Finance, Chrystia Freeland, presented the Canadian Government’s budget on April 19. The budget includes several international tax proposals, in which the budget:

enhances Canada’s mandatory reportable transaction disclosure rules, subject to public consultation,
provides further details of a proposed digital services tax, to be effective January 1, 2022,
limits the deductibility of interest by corporations, trusts, and partnerships to a percentage of tax-basis EBITDA, and
introduces rules to address hybrid mismatch arrangements.

The budget does not contain any proposed changes to the corporate tax rates in Canada. The timeline for draft legislation and proposed effective dates are described below.

The takeaway: With this proposed budget, Canada is aligning with actions proposed by the OECD, the European Union, and many jurisdictions. Given the global momentum for such provisions, MNCs should understand how the proposals might impact their operations. In addition, MNCs should consider providing feedback on such impact as requested within the proposals.

Mandatory disclosure rules

The government is consulting on proposals to enhance Canada’s mandatory disclosure rules to address:

changes to the Income Tax Act's (ITA’s) existing reportable transaction rules
a new requirement to report ‘notifiable transactions’
a new requirement for specified corporations to report uncertain tax treatments, and
related rules providing for, in certain circumstances, extension of the applicable reassessment period and the introduction of penalties.

To the extent the proposed measure applies to tax years, the amendments resulting from this consultation will apply to tax years beginning after 2021. To the extent the proposed measure applies to transactions, the amendments will apply to transactions entered into on or after January 1, 2022. Comments and feedback on the proposals should be directed to the Department of Finance by September 3, 2021.

Reportable transactions

Current ITA rules require reporting a transaction if it is considered an ‘avoidance transaction,’ as defined by the general anti-avoidance rule, and it meets at least two of three defined hallmarks. The reporting must be made on or before June 30 of the calendar year following the calendar year in which it first becomes a reportable transaction.

To improve the rules’ effectiveness and align them with international best practices, the budget proposes that only one of the three hallmarks need be present for a transaction to be reportable. It also proposes that a transaction would be considered an avoidance transaction if it can reasonably be concluded that one of the main purposes of entering into it is to obtain a tax benefit.

The budget proposes that a taxpayer report the transaction to the Canada Revenue Agency (CRA) within 45 days of the earlier of the day that a taxpayer, or another person who entered into the transaction for the benefit of the taxpayer, (1) becomes contractually obligated to enter into the transaction or (2) enters into the transaction.

Reporting of such schemes by a promoter or adviser, with the same time limits, also would be required. An exception may be available for advisers to the extent that the solicitor-client privilege applies.

Penalties for failure to report are proposed for both taxpayers and promoters or advisers.

Notifiable transactions

To provide the CRA with further information related to tax avoidance transactions (including a series of transactions) and other transactions on a timely basis, the budget proposes a category of specific transactions known as ‘notifiable transactions.’ The Minister of National Revenue, with the concurrence of the Minister of Finance, would have the authority to designate a transaction as a notifiable transaction.

Notifiable transactions would include both transactions that the CRA has found to be abusive and transactions identified as transactions of interest. The description of a notifiable transaction would set out fact patterns or outcomes in sufficient detail to assist taxpayer compliance with the disclosure rule. The consultation would include sample descriptions.

A taxpayer, or a person who enters into a transaction for the benefit of a taxpayer, entering into a notifiable transaction (or a transaction or series of transactions that is substantially similar to a notifiable transaction) would be required to report the transaction or series to the CRA within 45 days of the earlier of the day the taxpayer or person (1) becomes contractually obligated to enter into the transaction or (2) enters into the transaction.

The budget also requires reporting of such schemes by a promoter or adviser, with the same time limits. An exception may be available for advisers to the extent that solicitor-client privilege applies.

This disclosure would not change the tax treatment of the transaction, but is intended to provide information to the CRA.

This proposal is in response to a recent decision of the Tax Court of Canada (Paletta v. the Queen).

Penalties for failure to report are proposed for both taxpayers and promoters or advisers.

Uncertain tax treatments

Currently, there is no requirement to disclose uncertain tax treatments. The budget proposes requiring specified corporate taxpayers to report particular uncertain tax treatments to the CRA when the following conditions are met:

the corporation files a Canadian income tax return
the corporation has at least $50 million in assets at the end of the year
the corporation, or a related corporation, has audited financial statements prepared in accordance with IFRS or other country-specific GAAP relevant for domestic public companies, and
there is an uncertain tax position related to the corporation’s Canadian income tax reflected in the audited financial statements.

The corporation would be required to provide the quantum of taxes at issue, a concise description of the relevant facts, the tax treatment taken (including the relevant sections of the ITA), and whether the uncertainty relates to a permanent or temporary tax difference. The budget proposes that taxpayers report the disclosures by the same due date as the Canadian’s corporate tax return.

Penalties of $2,000 per week up to a maximum of $100,000 are proposed for failure to timely report each particular uncertain tax treatment.

Reassessment period

To support the new mandatory disclosure rules, the budget proposes that the normal reassessment period would not commence with respect to a transaction until the taxpayer has complied with the applicable reporting requirement. If a taxpayer does not comply with respect to a transaction, a reassessment with respect to that transaction would not become statute-barred.

Digital services tax

As previously announced in the November 2020 Fall Economic Statement, the budget proposes to implement a digital services tax (DST) effective January 1, 2022. The DST is a 3% non-income tax introduced as a temporary tax until an acceptable multilateral approach is agreed and implemented by the OECD members and G20 countries. The DST targets large global businesses earning revenue from certain digital services reliant on the engagement, data, and content contributions of Canadian users. The revenue subject to DST is grouped into four categories: revenues earned from online marketplaces, social media, online advertising, and user data (‘in-scope revenue’).

The DST would apply in a particular calendar year to an entity that meets, or is a member of a business group that meets, the following thresholds:

global revenue from all sources of €750 million or more in the previous calendar year (the same threshold used for country-by country reporting under an OECD standard), and
in-scope revenue associated with Canadian users of more than C$20 million in the particular calendar year.

In-scope revenue in excess of C$20 million earned from or associated with Canadian users would be subject to DST.

The budget proposes to permit one entity in a group to file a DST return on a calendar-year basis and pay the DST liability on behalf of the group. To facilitate enforcement, each entity in a group would be jointly and severally liable for DST payable by any of the group members. The DST would be deductible in computing taxable income for Canadian income tax purposes based on general principles, but it would not be eligible for a credit against Canadian income tax payable.

The government plans to engage with provinces and territories to discuss the DST implications and has requested feedback by June 18, 2021 from stakeholders on the proposed approach to implementing the DST. The draft legislation for a new statute implementing the DST will be released for public comment during the summer.

Base erosion and profit shifting (BEPS)

The government reiterated its commitment to safeguarding Canada’s tax system and combatting BEPS. The budget builds on the government’s prior efforts to address BEPS by introducing two new measures:

interest limitation rules consistent with the recommendations in the Action 4 report of the BEPS Action Plan, and
rules to address hybrid mismatch arrangements consistent with the recommendations in the Action 2 report of the BEPS Action Plan.

Interest deductibility limits

The budget proposes a new rule that would limit the net interest expense that a corporation may deduct in computing its taxable income to no more than a fixed ratio of its ‘tax EBITDA’ (this is the corporation’s taxable income before taking into account interest expense, interest income, income tax, and deductions for depreciation and amortization, where each of these items is as determined for tax purposes). The new rule also would apply to trusts, partnerships and Canadian branches of non-resident taxpayers.

The fixed ratio for the interest limitation would apply to existing as well as new borrowings and would be phased in as follows:

fixed ratio of 40% for tax years beginning on or after January 1, 2023, but before January 1, 2024 (the transition year)
fixed ratio of 30% for tax years beginning on or after January 1, 2024.

A ‘group ratio’ rule would allow a taxpayer to deduct interest in excess of the fixed ratio, where the taxpayer can demonstrate that the ratio of net-third party interest to book EBITDA of its consolidated group is higher than the fixed ratio; in this case, the interest limitation would be based on the higher group ratio.

Detailed legislative proposals are expected to be released for comment in the summer. The budget provides the following details with respect to the computation of tax EBITDA:

Tax EBITDA will exclude, among other things, dividends to the extent they qualify for the inter-corporate dividend deduction or the deduction for certain dividends received from foreign affiliates..
Interest expense and interest income would include not only amounts that are legally interest, but also certain payments that are economically equivalent to interest, and other financing-related expenses and income.
Interest expense would exclude interest that is not deductible under existing income tax rules, including the thin capitalization rules (which would continue to apply).
Interest expense and interest income related to debts owing between Canadian members of a corporate group would generally be excluded.
Interest denied under the new interest limitation could be carried forward for up to 20 years or back for up to three years (including carry back to years before the introduction of the new rule, with some restrictions).

In addition, a taxpayer (other than a bank or life insurance company) that is part of a group and that has excess capacity to deduct interest under the new rule generally could transfer this unused capacity to other Canadian group members.

Exemptions from the new rule would be available for:

Canadian-controlled private corporations that, together with any associated corporations, have taxable capital employed in Canada of less than $15 million, and
groups of corporations and trusts whose aggregate net interest expense among their Canadian members is $250,000 or less.

Hybrid mismatch arrangements

Hybrid mismatch arrangements are cross-border transactions that are characterized differently under the tax laws of different countries. For example, certain financial instruments may be treated as debt in one country and equity in another country. Hybrid mismatches also can involve certain entities that are treated as separate taxpayers in one country, but are treated as fiscally transparent in another country.

The Action 2 report of the BEPS Action Plan recommended that countries adopt detailed rules to eliminate the tax benefits arising from hybrid mismatch arrangements. The budget proposes to implement rules that are intended to be consistent with the recommendations of this Action 2 report (with modifications for the Canadian income tax context).

The budget does not include detailed rules, but describes the proposed rules in general terms:

A payment by a Canadian resident under a hybrid mismatch arrangement would not be deductible in Canada to the extent that it produces a deduction in another country or is not included in the ordinary income of a nonresident recipient.
A payment by a nonresident under a hybrid mismatch arrangement cannot generate a deduction for a Canadian resident to the extent the payment is deductible in another country.
A payment made by a non-resident to a Canadian resident under a hybrid mismatch arrangement would be included in ordinary income of the Canadian recipient to the extent the payment is deductible in another country (if the payment is a dividend from a foreign affiliate, no offsetting deduction would be available under the normal rules for foreign affiliate dividends).

Other measures outlined in the Action 2 report also would be adopted to the extent they are considered relevant and appropriate in the Canadian tax context. These could include measures addressing the following:

Imported mismatches - this generally refers to arrangements in which a payment is deductible by an entity in one country and included in the ordinary income of an entity in a second country, but that income inclusion is offset by a deduction under a hybrid mismatch arrangement with an entity in a third country.
Branch mismatches - these are mismatches resulting from differences in the tax laws of different countries involving the allocation of income or expenditures to a branch.
Reverse hybrids - these are entities that are treated as fiscally transparent in the country where they are formed, but are treated as separate taxpayers in an investor’s country; the Action 2 report included rules for payments to reverse hybrids.

The proposed rules would apply only to arrangements between related parties, and to certain arrangements between unrelated parties that are structured to produce a hybrid mismatch. Ordering rules would coordinate the application of the proposed rules with the hybrid rules of other countries.

The proposed rules will be implemented in two packages of proposed legislation, each of which will be released for stakeholder comment:

The first package will be released later in 2021, and will deal with ‘deduction/non-inclusion’ mismatches resulting from financial instruments (generally speaking, arrangements in which a payment under a financial instrument is deductible by the payer and is not included in the ordinary income of the recipient). These rules would apply as of July 1, 2022.
The second package will be released after 2021, and will deal with hybrid mismatch arrangements that are not addressed by the first package. These rules would apply no earlier than 2023.

Transfer pricing

The government is concerned that perceived shortcomings in the current transfer pricing rules could encourage the inappropriate shifting of corporate income out of Canada. To address this concern, the budget announces the government’s intention to consult on Canada’s transfer pricing rules with a view to protecting the integrity of the tax system, while preserving Canada’s attractiveness as a destination for new investment and business activity.

Observation: The government’s concerns appear to be based on the Federal Court of Appeal’s decision in Her Majesty The Queen v Cameco Corporation, which interpreted the transfer pricing recharacterization rule, but the consultation is not limited to matters relevant to that decision. For a discussion of the Tax Court of Canada decision in that case, see the our Tax Insight “Cameco decision addresses transfer pricing recharacterization rules in Canada.”

Other Measures

The government also announced that it will take further steps to strengthen and modernize Canada’s general anti-avoidance rule, as previously announced in the 2020 Fall Economic Statement.

Timing

The budget proposes significant new measures but does not provide details or draft legislation for most of the new proposals. The timeline for the draft legislation and effective dates of these new measures are summarized below:

Canada’s 2021 budget addresses mandatory disclosure, DST, interest limitation, and hybrid mismatches

In brief