The federal budget tabled on February 11, 2014 (Budget 2014) contains a number of proposed amendments to Canada’s Income Tax Act (the "Tax Act") that are primarily intended to close perceived loopholes and increase government revenues. This bulletin focuses on (i) international tax measures affecting businesses, (ii) eligible capital property, (iii) resources taxation, and (iv) other proposed tax measures.
International Tax Measures Affecting Businesses
The Tax Act contains a set of rules within the foreign affiliate regime which are intended to protect the Canadian tax base from erosion through the use of foreign affiliates in low-tax jurisdictions to earn certain types of Canadian-source income as part of the affiliate’s active business. Generally, where the rules apply, the relevant income forms part of the affiliate’s foreign accrual property income (FAPI) which is taxed in Canada on an accrual basis in the hands of the Canadian taxpayer (of which the affiliate is a controlled foreign affiliate).
One rule applies to income of a foreign affiliate from the insurance or reinsurance of a risk in respect of a person resident in Canada, a property situated in Canada or a business carried on in Canada (Canadian risks). A de minimis test excludes the rule from applying where more than 90% of the gross premium revenue (net of reinsurance ceded) is in respect of the insurance of non-Canadian risks of arm’s-length persons. According to the Department of Finance (Canada) ("Finance"), some taxpayers have entered into arrangements (referred to as "insurance swaps") to circumvent this rule by transferring Canadian risks to a wholly-owned foreign affiliate, which are then exchanged with a third party for foreign risks, while at the same time maintaining the affiliate’s risk profile and economic return as if it had not entered into the exchange.
To address this concern, Budget 2014 proposes to add a provision for purposes of these rules that, if applicable, would deem the insurance of such foreign risks to be risks in respect of a person resident in Canada. Generally, the provision will apply if the affiliate enters into one or more agreements or arrangements in respect of the foreign risks, as a result of which the affiliate’s risk of loss or opportunity for gain or profit in respect of the foreign risks can reasonably be considered to be determined by reference to certain criteria in respect of risks insured by another person or partnership (referred to as the "tracked policy pool") and 10% or more of the tracked policy pool is comprised of any one or more Canadian risks. The tracking criteria are (i) the fair market value of the tracked policy pool, (ii) the revenue, income, loss or cash flow from the tracked policy pool, or (iii) any other similar criteria.
If the above conditions are satisfied in respect of a foreign affiliate of a taxpayer, any income of the affiliate from the insurance of foreign risks will be deemed to be FAPI.
This proposed measure applies to taxation years that begin on or after February 11, 2014 (Budget Day).
Offshore Regulated Banks
As stated above, the Tax Act generally requires a taxpayer to include in income its share of the FAPI of its controlled foreign affiliate, which includes income from an investment business. For these purposes, an "investment business" is generally defined to mean a business the principal purpose of which is to earn income from property. Under current rules, a business is not an investment business if, among other things, the business is carried on by the foreign affiliate as a foreign bank, a trust company, a credit union, an insurance corporation or a trader or dealer in securities or commodities, the activities of which are regulated under the laws of each country in which the business is principally carried on or another relevant foreign jurisdiction (the regulated foreign financial institution exception). This exception permits certain offshore financial services businesses to avoid being treated as investment businesses.
Finance expressed the concern that certain Canadian taxpayers that are not financial institutions have attempted to use this exception by electing to subject their foreign affiliates to regulation under foreign banking and financial laws. Finance stated that the regulated foreign financial institution exception is not intended to apply where the main purpose of a foreign affiliate is to engage in proprietary activities; rather, the exception is intended to apply where the affiliate carries on a business involving financial transactions with customers.
Budget 2014 proposes to address this concern by adding two new conditions that must be met for a foreign affiliate of a taxpayer to satisfy the regulated foreign financial institution exception.
First, the taxpayer must be (i) a Schedule I bank, a trust company, a credit union, an insurance corporation or a trader or dealer in securities or commodities resident in Canada, the business activities of which are subject by law to the supervision of a regulating authority such as the Superintendent of Financial Institutions or a similar provincial authority, (ii) a wholly-owned corporation of such a financial institution or (iii) a corporation that wholly owns such a financial institution and is subject by law to the supervision of the same regulating authority as such an institution.
Second, either (i) the financial institution is a bank, trust company or insurance corporation that has, or is deemed under the applicable federal statute to have, more than $2 billion of equity, or (ii) more than 50% of the taxable capital employed in Canada of the taxpayer and all related Canadian resident corporations is attributable to a business carried on in Canada, the activities of which are subject to the supervision of a regulating authority such as the Superintendent of Financial Institutions or a similar provincial authority.
The proposed amendment will apply to taxation years that begin after 2014. Finance has invited stakeholders to submit comments concerning the scope of the proposed amendment within 60 days after February 11, 2014 to ensure that the measure is appropriately targeted.
The thin capitalization rules are intended to limit interest deductions taken by Canadian resident taxpayers where debts owing by the taxpayer to certain non-resident persons exceed 1.5 times the "equity amount" of such taxpayer. Part XIII of the Tax Act imposes withholding tax on interest paid or credited by a Canadian resident taxpayer to a non-resident person with which it does not deal at arm’s length. Budget 2014 proposes to expand current anti-avoidance rules and introduce new rules to prevent the use of "back-to-back loan" arrangements in which an intermediary is placed between the Canadian taxpayer and the non-resident person to avoid the application of either or both the thin capitalization rules and Part XIII withholding tax in respect of interest.
The new rules will apply where the taxpayer has an interest-bearing obligation owing to a lender (the intermediary), and the intermediary or a person that does not deal at arm’s length with the intermediary (i) is pledged a property by a non-resident person as security in respect of the obligation, (ii) is indebted to a non-resident person under a debt for which recourse is limited to the obligation, or (iii) receives a loan from a non-resident person on condition that a loan also be made to the taxpayer.
When these conditions are met, the taxpayer will be deemed, for purposes of the thin capitalization rules, to owe an amount to the non-resident person equal to the lesser of: (a) the amount of the obligation owing to the intermediary; and (b) the fair market value of the property pledged, the amount of the limited-recourse debt or the amount of the loan received on condition, as the case may be. Furthermore, for purposes of Part XIII of the Tax Act, the taxpayer will be deemed to pay a proportionate amount of interest in respect of the deemed indebtedness to the non-resident person, with the result that such interest may be subject to Part XIII withholding tax.
According to Budget 2014, a guarantee will not in and of itself be considered to be a pledge of property as security for the purposes of the new rules. As such, a loan that is not otherwise caught by condition (ii) or (iii) above and that is guaranteed without a pledge of property as security should not be caught by these proposed measures.
The proposed thin capitalization measures apply to taxation years that begin after 2014. The proposed Part XIII measures apply to amounts paid or credited after 2014.
Consultation on Multinational Enterprise Tax Planning
In furtherance of the OECD BEPS Action Plan, Budget 2014 announces that Finance is seeking input from stakeholders on issues related to international tax planning by multinational enterprises (MNEs). Specifically, Finance is inviting input within 120 days after Budget Date on the following questions:
- What are the impacts of international tax planning by MNEs on other participants in the Canadian economy?
- Which of the international corporate income tax and sales tax issues identified in the BEPS Action Plan should be considered the highest priorities for examination and potential action by the Government?
- Are there other corporate income tax or sales tax issues related to improving international tax integrity that should be of concern to the Government?
- What considerations should guide the Government in determining the appropriate approach to take in responding to the issues identified – either in general or with respect to particular issues?
- Would concerns about maintaining Canada’s competitive tax system be alleviated by coordinated multilateral implementation of base protection measures?
Feedback on these questions will help inform Canada’s participation in international discussions, including for those relating to the OECD BEPS Action Plan.
Finance is also seeking input on effective collection of sales tax on e-commerce sales to residents of Canada by foreign vendors.
Consultation on Treaty Shopping
Budget 2013 set out Finance’s intention to call for consultations on potential measures to combat treaty shopping, a term used to describe improper use of Canada’s tax treaties. As a follow-up to Budget 2013, Finance released a consultation paper in August 2013 on which stakeholders had until December 2013 to provide comments. It is believed that Finance received eight submissions to the consultation paper from stakeholders. Budget 2014 discusses various considerations outlined in these submissions and suggests that any proposed treaty shopping measure will adopt a general and domestic-based approach.
To further advance the discussion, Budget 2014 introduces four main elements of a proposed rule to address treaty shopping:
- Main purpose provision: subject to the relieving provision, a treaty benefit would not be provided to a person if one of the main purposes for undertaking a transaction that results in the benefit was for the person to obtain the benefit.
- Conduit presumption: in the absence of proof to the contrary, the presumption is that one of the main purposes for undertaking a transaction that results in a benefit under a tax treaty was for a person to obtain the benefit if the relevant income is primarily used to transfer an amount to another person that would not have been entitled to an equivalent or more favourable benefit had the other person received the relevant income directly.
- Safe harbour presumption: subject to the conduit presumption, it would be presumed in the absence of proof to the contrary, that none of the main purposes for undertaking a transaction was for a person to obtain a benefit under a tax treaty in respect of relevant income if:
- the person or a related person carries on an active business in the treaty jurisdiction that is substantial compared to the Canadian activity giving rise to the relevant income;
- the person is not controlled in fact by another person that would not have been entitled to an equivalent or more favourable benefit had the other person received the relevant income directly; or
- the person is a corporation or a trust the shares or units of which are regularly traded on a recognized stock exchange.
- Relieving provision: if the main purpose provision applies in respect of a benefit under a tax treaty, the benefit is to be provided, in whole or in part, to the extent that it is reasonable having regard to all the circumstances.
Budget 2014 provides five examples intended to illustrate how the proposed rule would apply. Three of these examples appear to resemble the facts in the Velcro, Prévost Car, and MIL Investments cases, all of which the taxpayers won. Not surprisingly, the proposed rule would deny treaty benefits to the income at issue in those examples.
If adopted, the rule may be included in the Income Tax Conventions Interpretation Act which would apply to all Canadian tax treaties, to taxation years commencing after the enactment of the rule into Canadian law. Finance is inviting comments, including those in relation to potential transitional relief, from interested parties within 60 days after Budget Day. Budget 2014 indicates that the recommendations from the OECD BEPS project which is expected to be released in September 2014, will be relevant in developing a Canadian approach to address treaty shopping. Accordingly, the enactment of such a rule may not occur until then at the earliest.
Eligible Capital Property
The eligible capital property (ECP) regime governs the treatment of eligible capital expenditures and eligible capital receipts. Generally, 75% of the amount of an eligible capital expenditure is added to the cumulative eligible capital (CEC) pool in respect of the business and is deductible, on a declining-balance basis, at 7% annually. Similarly, 75% of an eligible capital receipt is first applied to reduce the CEC pool and then results in the recapture of any CEC previously deducted. Any excess receipt beyond this recapture is included in the income of the business at the rate of 50%.
In response to stakeholder sentiment that the ECP regime has become unnecessarily complicated, Budget 2014 announces a public consultation on a proposal to repeal the ECP regime and replace it with a new class of property to which the CCA rules would apply. The new CCA class would be available to businesses, and taxpayers would transfer their existing CEC pools to this new CCA class. Expenditures that currently get added to the CEC pool at a 75% inclusion rate would be included in the new CCA class at 100%. To compensate for this increased expenditure recognition, the new CCA class would have a 5% annual depreciation rate. Transitional rules are proposed such that for the first ten years, the depreciation rate for the new CCA class would be 7% in respect of expenditures incurred before the implementation of these proposed rules.
Special proposed rules would apply to goodwill and eligible capital expenditures and receipts that do not relate to a specific property of the business. Without these special rules, these amounts would not otherwise be relevant in the adjustments to the balance of the new CCA class.
The timing and details of this proposed change are not outlined in Budget 2014; Finance has indicated that these will be determined following the public consultation.
Budget 2014 has provided yet another extension to the investment tax credit regime for flow-through shares in respect of certain grassroots mining expenses, commonly referred to as the mineral exploration tax credit. As has been the case in prior years, the extension is limited to one year, thus only providing tax credits for qualifying flow-through share offerings through to the end of March, 2015. While there is nothing to suggest that this tax credit is under particular scrutiny, the continued approach of one-year extensions suggests that the government will continue to monitor the costs and benefits of the mineral exploration tax credit regime without assurance of further renewal.
Other Proposed Tax Measures
Graduated Rate Taxation of Trusts and Estates
In Budget 2013, Finance announced its intention to consult on possible measures to increase the tax rate applicable to income earned in testamentary trusts and grandfathered inter vivos trusts. On June 3, 2013, Finance released its consultation paper containing possible measures, including the proposal to tax all estates at the top marginal rate after the first 36 months of administration, which it considered a reasonable period of administration. Despite receiving numerous submissions arguing strongly against such measures—including the lengthy submission written by the Joint Committee on Taxation of the CBA and the CPA of Canada, dated December 2, 2013—Budget 2014 includes measures that will proceed with these consultation paper proposals (except with respect to testamentary trusts with beneficiaries eligible for the Federal Disability Tax Credit as discussed further below).
The measures contained in Budget 2014 also include the repeal of other preferential provisions of the Tax Act applicable to testamentary trusts (other than estates for their first 36 months), including the elimination of, among other things, (i) the exemption from the tax instalment rules, (ii) the exemption from the calendar taxation year requirement, (iii) the $40,000 exemption in the computation of alternative minimum tax, (iv) the exemption from Part XII.2 tax, and (v) the ability to make investment tax credits available to the trust’s beneficiaries, each of which was also proposed as part of the consultation paper.
In response to certain submissions made during the consultation paper process, Budget 2014 states that graduated rates will continue to apply in respect of testamentary trusts that have beneficiaries who are eligible for the federal Disability Tax Credit.
These proposed measures will generally apply to the 2016 and subsequent taxation years.
Under existing rules in the Tax Act (NRT Rules), a non-resident trust may be deemed to be resident in Canada for certain purposes if there is a "resident contributor" to the trust or a "resident beneficiary" under the trust. Generally, a trust is exempt from the NRT Rules where the Canadian contributor to the trust is an individual (other than a trust) who has not been resident in Canada for a period of (or periods totaling) more than 60 months (the 60-month exemption). Non-resident trusts that qualify for this exemption are commonly known as immigration trusts. The 60-month exemption allows a non-resident individual who becomes a Canadian resident to obtain indirect tax benefits as a result of the non-imposition of Canadian tax on the foreign-source income of the immigration trust for up to five years.
Budget 2014 proposes to eliminate the 60-month exemption. Finance indicated that this measure is being proposed out of tax fairness, tax integrity and tax neutrality concerns. Similar benefits are not available to Canadian residents who earn foreign-source income directly or through a Canadian resident trust.
This proposed measure generally applies for taxation years that end on or after Budget Day.
Tax Incentives for Clean Energy Generation
Class 43.2 of Schedule II to the Income Tax Regulations provides an accelerated CCA rate of 50% on a declining-balance basis for certain clean energy generation and energy conservation equipment. The accelerated CCA provides a financial incentive to encourage investment in clean energy generation. Currently, gasification equipment used in an eligible cogeneration facility (producing electricity and heat) or an eligible waste-fuelled thermal energy facility (producing heat) is eligible for inclusion in Class 43.2.
Budget 2014 proposes to expand eligibility to include property used to gasify eligible waste fuel for other applications such as to sell the resulting "producer gas" for domestic or commercial use. Budget 2014 also proposes to expand Class 43.2 to include water-current energy equipment. Water-current energy equipment converts kinetic energy of flowing water, such as in a river, into electrical energy without the use of physical barriers or flow diversion.
Accelerated CCA will only be available if at the time the property first becomes available for use, all applicable Canadian environmental laws, by-laws and regulations have been met. This requirement will also extend to wave and tidal energy equipment which is currently eligible for inclusion in Classes 43.1 and 43.2.
The purpose of the proposed changes is to encourage investment in technologies that can contribute to a reduction in emissions of greenhouse gases and air pollutants in furtherance of Canada’s targets set out in the Federal Sustainable Development Strategy. Finance has indicated that these measures may also aid in the diversification of Canada’s energy supply.
These measures will apply to property acquired on or after Budget Day that has not been used or acquired for use before that date.
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