Highlights of Canada’s 2012 Federal Budget

By Corrado Cardarelli, Craig Maurice, Andrew Wong, Grace Pereira and Leila Ross

The federal budget tabled on March 29, 2012 (Budget 2012) contains a number of proposed amendments to Canada’s Income Tax Act (the Tax Act). This bulletin focuses on certain corporate and international taxation matters relating to (i) the use of partnerships; (ii) the thin capitalization rules; (iii) transfer pricing secondary adjustments; (iv) eligible dividends; (v) scientific research & experimental development (SR&ED); (vi) the mineral exploration tax credit for flow-through share investors; and (vii) the accelerated capital cost allowance (CCA) for clean energy generation equipment.

Tax Avoidance Through the Use of Partnerships

In a takeover transaction involving a Canadian target corporation, the target may have certain operations or redundant assets that the acquiror would like to divest to a third party or otherwise reorganize within the acquiror’s corporate structure. Section 88 of the Tax Act provides for the "bump" upon a windup into a Canadian corporate acquiror of, or an amalgamation of such acquiror with, the target to increase the cost of non-depreciable capital assets owned by the target so that the gain realized on such divestiture or reorganization may be minimized. Generally, only land, shares of a corporation or an interest in a partnership may be eligible for the bump, whereas eligible capital property, depreciable property, inventory and resource property are ineligible for the bump.

Budget 2012 notes that in recent years, partnership structures have been used with increasing frequency to circumvent the denial of the bump in respect of the target’s assets otherwise ineligible for the bump. In particular, such ineligible assets would instead be held indirectly by the target through a partnership. The target’s interest in the partnership would then be eligible for the bump upon its amalgamation with, or windup into, the acquiror, even though the entire fair market value of the partnership interest is derived from the ineligible assets.

The proposed change contained in Budget 2012 would deny a bump in respect of a partnership interest to the extent that the accrued gain from the partnership interest is reasonably attributable to the amount by which the fair market value of the ineligible assets exceeds their cost amount.

This change will apply to amalgamations that occur, and windups that begin, on or after March 29, 2012, subject to limited grandfathering regarding amalgamations and windups occurring in 2012.

On a related note, a taxpayer must currently include 100% of a capital gain in income in respect of a disposition of a partnership interest to a tax-exempt person to the extent that such gain is not attributable to non-depreciable capital property. Budget 2012 proposes to extend this treatment to a sale of a partnership interest to a non-resident person unless the partnership is carrying on business in Canada through a permanent establishment in which all assets of the partnership are used. This proposed change will apply to dispositions of interests in partnerships that occur on or after March 29, 2012, with limited grandfathering for arm’s-length dispositions made before 2013.

Thin Capitalization Rules

Debt-to-Equity Ratio

The thin capitalization rules, which are intended to protect the Canadian tax base against excessive interest deductions, currently limit a Canadian resident corporation’s ability to deduct interest expense if debts owing to certain non-residents exceed twice the amount of the corporation’s "equity" for purposes of these rules. On the recommendations of the Advisory Panel on Canada’s System of International Taxation (the Advisory Panel ), Budget 2012 proposes to reduce the debt-to-equity ratio in the thin capitalization rules from 2-to-1 to 1.5-to-1. This change will apply to corporate taxation years that begin after 2012.

Interest Expense Incurred by Partnerships

Currently, the thin capitalization rules do not address interest expense incurred by a partnership of which a Canadian resident corporation is a member. The Advisory Panel recommended that the thin capitalization rules be extended to partnerships. Budget 2012 follows the Advisory Panel’s recommendation by allocating debt obligations of a partnership to its members on the basis of their proportionate interests in the partnership. If a corporate partner’s permitted debt-to-equity ratio exceeds 1.5-to-1, the partnership’s interest deduction will not be denied; rather, an amount will be included in computing the partner’s income from a business or property, as appropriate. This proposed change will apply to debts incurred by a partnership that are outstanding during corporate taxation years beginning on or after March 29, 2012.

Disallowed Interest Deemed to Be Dividend

Budget 2012 proposes that disallowed interest will be deemed to be a dividend paid by the Canadian resident corporation to a non-resident for withholding tax purposes, subject to the corporation’s ability to allocate the disallowed interest expense to the latest interest payments made to any specified non-resident in the taxation year. If the disallowed interest has not been paid by the end of the corporation’s taxation year, it will be deemed to have been paid as a dividend at the end of that taxation year. This proposed change will apply to taxation years that end on or after March 29, 2012, subject to, in the case of taxation years which include March 29, 2012, a proration based on the number of days in the taxation year that are on or after March 29, 2012.

Loans from Foreign Affiliate

Under the existing thin capitalization rules, double taxation may result if, for instance, a Canadian resident parent corporation owns 100% of a Canadian resident subsidiary corporation that, in turn, has borrowed from its "controlled foreign affiliate." In particular, the existing thin capitalization rules may prevent the subsidiary from deducting interest on such borrowing although the same interest is subject to tax as "foreign accrual property income" (FAPI). Budget 2012 proposes to amend the thin capitalization rules so that the interest expense is excluded from their application to the extent that such interest is taxable in the corporation in respect of FAPI. This change will apply to taxation years of Canadian resident corporations that end on or after March 29, 2012.

Transfer Pricing Secondary Adjustments

Under Canada’s transfer pricing rules, if a transfer pricing income adjustment or a transfer pricing capital adjustment (a "primary adjustment") has been made, the related benefit conferred on the non-resident is generally treated by the Canada Revenue Agency (CRA) as a deemed dividend (a "secondary adjustment") subject to Part XIII withholding tax. The Transfer Pricing Subcommittee of the Advisory Panel had questioned the legislative basis for such treatment and recommended legislating such authority in the transfer pricing rules. Budget 2012 follows such recommendation and proposes to amend the transfer pricing rules to confirm that for purposes of Part XIII, secondary adjustments with respect to benefits conferred on a non-resident will be treated as a dividend that is deemed to have been paid by the particular Canadian corporation and received by the particular non-resident at the end of that taxation year, regardless of whether the non-resident is a shareholder of the Canadian corporation.

Consistent with CRA administrative practice, Budget 2012 also proposes amendments to the transfer pricing rules that eliminate the deemed dividend if the amount of the primary adjustment is repatriated to the Canadian corporation. Certain controlled foreign affiliates will be exempted from such deemed dividend treatment on the basis that the benefit conferred on the non-resident is more akin to a capital contribution than to a dividend. These proposals will apply to transactions (including transactions that are part of a series of transactions) that occur on or after March 29, 2012.

Eligible Dividends: Split Dividend Designation and Late Designation

The provisions of the Tax Act integrate the corporate and personal income tax systems by, among other things, providing individuals receiving dividends from a Canadian corporation with the dividend tax credit (DTC). An individual who receives an eligible dividend, which is paid out of such corporation’s income that was taxed at the general corporate rate, qualifies for an enhanced DTC. An individual who receives a non-eligible dividend, which is paid out of a corporation’s income that was taxed at a lower rate than the general corporate rate, qualifies for a regular (non-enhanced) DTC.

Currently, a corporation paying an eligible dividend is required to designate the entire dividend as an eligible dividend; if some portion of the dividend was intended to be a non-eligible dividend, the corporation must pay two separate dividends: an eligible dividend and a non-eligible dividend. Budget 2012 contains proposals aimed at relieving the administrative burden on Canadian corporations paying a dividend by allowing any portion of the dividend to be designated as an eligible dividend. The eligible portion will qualify for the enhanced DTC and the remainder will qualify for the regular DTC. This measure will apply to taxable dividends paid on or after March 29, 2012.

Under the current provisions of the Tax Act, if a corporation fails to make an eligible dividend designation at the time of paying the dividend, it cannot file a late designation. Budget 2012 proposes to change this by granting the Minister of National Revenue the discretion, where it is just and equitable, to accept a late designation, as long as it is made within three years from the day on which the designation was first required to be made. This measure will apply to taxable dividends paid on or after March 29, 2012.

Scientific Research & Experimental Development

Budget 2012 proposes certain reductions of the tax incentives currently provided under, and certain administrative changes with respect to, the SR&ED program. The general tax credit rate on qualified expenditures will be reduced from 20% to 15% effective January 1, 2014. Capital expenditures for property acquired after 2013 will no longer be eligible for the SR&ED expenditure deduction and the corresponding investment tax credits. To enhance the SR&ED program’s predictability, the CRA will conduct a pilot program to determine the feasibility of a formal preapproval process.

Mineral Exploration Tax Credit for Flow-Through Shares

To encourage investment in grassroots mineral exploration in Canada, the October 18, 2000 Federal Budget Update introduced a "temporary" investment tax credit for relatively small-scale mining exploration activities in Canada. More specifically, the investment tax credit was layered onto the flow-through share program by providing investors in flow-through shares with a 15% investment tax credit on certain Canadian exploration expenses renounced to investors under the flow-through share agreements.

Although introduced as a temporary measure, the mineral exploration tax credit has since been extended on a yearly basis 11 times. Budget 2012 proposes to extend this tax credit for another year. Consequently, flow-through share agreements entered into before April 2013 will be eligible for the investment tax credit for qualifying expenditures incurred (or deemed to be incurred) before 2014. While one might question the "temporary" nature of this incentive, and the legislative nuisance of annual extensions, the extension is certainly welcome news to issuers of flow-through shares in the mining sector.

Clean Energy Generation Equipment: Accelerated Capital Cost Allowance

Certain clean energy generation equipment is included in Class 43.2 of Schedule II to the Income Tax Regulations, and is entitled to an accelerated CCA rate of 50% per year on a declining balance basis. The prior two federal budgets expanded the types of equipment that would qualify for Class 43.2 treatment. Citing a desire to reduce greenhouse gas emissions and air pollutants and to diversify Canada’s energy supply, Budget 2012 proposes an incentive for investment in environmentally beneficial equipment (low-emission or no-emission energy generation equipment) via a further expansion of Class 43.2 to include waste-fuelled thermal energy equipment, equipment of a district energy system that uses thermal energy provided primarily by eligible waste-fuelled thermal energy equipment, and equipment that uses the residue of plants to generate electricity and heat.

These measures will apply to new assets acquired on or after March 29, 2012 that have not been used or acquired for use before that date. To ensure environmental responsibility for those who benefit from this accelerated CCA treatment, Budget 2012 also proposes that equipment using eligible waste-fuels only be eligible if applicable environmental laws and regulations are complied with at the time the equipment first became available for use.

To discuss these issues, please contact the author(s).

This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

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