The federal budget tabled on March 21, 2013 ("Budget 2013") contains a number of proposed amendments to Canada’s Income Tax Act (the "Tax Act") which are primarily intended to close perceived tax loopholes and increase government revenues. This bulletin focuses on (i) synthetic dispositions; (ii) character conversion transactions; (iii) resources taxation as it affects the mining sector; (iv) loss trading; (v) leveraged life insurance arrangements; and (vi) other proposed tax measures.
Budget 2013 proposes to add the concept of a "synthetic disposition arrangement" to the Tax Act to counter the use of certain financial arrangements that would have the effect of a taxpayer having disposed of a property economically despite being considered to own the property for income tax purposes. The Department of Finance (Canada) (Finance) indicated that this legislative measure is being proposed to ensure the application of appropriate tax consequences even though such arrangements could be challenged by the Canada Revenue Agency on the basis of the Tax Act.
In general terms, a synthetic disposition arrangement in respect of a property owned by a taxpayer means one or more agreements or arrangements entered into by the taxpayer or a person or partnership that does not deal at arm’s length with the taxpayer that would have the effect of eliminating all or substantially all of the taxpayer’s risk of loss and opportunity for gain or profit in respect of the property for more than one year and do not otherwise result in a disposition of the property within one year of the time such agreements or arrangements are entered into. Finance indicated that the proposed measure could apply generally to a forward sale, a put-call collar, the issuance of certain exchangeable debt, a total return swap or a short sale. On the other hand, the proposed measure would not apply to ordinary hedging transactions, ordinary-course securities lending arrangements or ordinary commercial leasing transactions.
Where a synthetic disposition arrangement in respect of a property owned by a taxpayer is entered into, the taxpayer is generally deemed to have disposed of and reacquired the property at its fair market value. In such cases, the taxpayer will also be considered to not own the property for purposes of the holding period tests for purposes of the “stop-loss” rules and foreign tax credit rules in the Tax Act.
This proposed measure will apply to agreements and arrangements entered into on or after March 21, 2013 and will also apply to agreements and arrangements entered into before March 21, 2013 if their term is extended on or after March 21, 2013.
Character Conversion Transactions
Budget 2013 contains changes to address so-called character conversion transactions. These transactions have been used to deliver "tax efficient returns", primarily in the mutual fund industry, by converting ordinary income to a capital gain through the use of a derivative contract. Character conversions usually use a forward contract to buy or sell a forward security that is a capital property (such as a share that is a "Canadian security" on which no dividends are paid) to provide exposure to a different reference security (such as a money market instrument). The reference security is usually an investment that produces fully taxable ordinary income.
Derivative forward agreements that have a duration of greater than 180 days and provide exposure to any underlying interest other than the property that is the subject of the derivative forward agreement (or the value of the property or any income or capital gains in respect thereof) will be treated as distinct from the disposition of the capital property and taxed on income account. Income or losses can be realized under the proposed measures in Budget 2013. To prevent double tax, any such income or loss is added to or subtracted from the adjusted cost base of the forward security. Essentially, the proposed measures disaggregate the two transactions so that the holder of the forward contract is taxed on income account on the realized gain or loss on the exposure to the reference security and then is also subject to capital gains tax on the actual sale or purchase of the forward security (with an adjusted cost base adjustment to take into account the portion of any gain or loss that is duplicative).
The proposed measures will apply to derivative forward agreements entered into on or after March 21, 2013. They will also apply to existing forward agreements if the term of the agreement is extended on or after March 21, 2013.
Budget Measures Impacting the Mining Sector
Elimination of Tax Incentives
In the 2012 federal budget, corporate investment tax credits for pre-production mining expenses were phased out. Prior to that, incentives associated with the oil sands sectors were eliminated. Budget 2013 continues this trend of eliminating tax incentives in the non-renewable resource sector in two important ways:
Pre-production Mining Expenses
Budget 2013 proposes to recharacterize certain intangible expenses incurred before a mine achieves commercial production. Prior to the proposed measures, such expenses would be characterized as "Canadian exploration expense" (CEE), which can essentially be deducted on a 100% basis. As a result of the proposed measures in Budget 2013, such expenses will now be characterized as "Canadian development expense" (CDE), which can essentially only be deducted on a 30% declining balance basis. The recharacterization from CEE to CDE will be phased in over several years by providing partial CEE and CDE treatment for such expenses starting in 2015, with full CDE treatment starting in 2018. Grandfathering is provided for eligible expenses incurred before 2017 in respect of projects already under construction or where there is an existing written agreement to incur the expense.
In addition to a less attractive deduction profile, the recharacterization of these expenses from CEE to CDE may affect the ability of issuers to raise capital using flow-through shares because the flow-through share market generally insists on receiving CEE deductions.
As noted in Budget 2013, these proposed measures attempt to further align the mining and petroleum sectors, because these types of pre-production expenses would generally be CDE for participants in the petroleum sector under the existing rules in the Tax Act.
Phase-Out of Accelerated Capital Cost Allowance
Under existing rules in the Tax Act, an accelerated Capital Cost Allowance regime is available for certain mining facilities built to service a new mine as well as certain expansion projects for an existing mine. For eligible tangible property, the taxpayer is entitled to claim the base Capital Cost Allowance (generally 25% on a declining balance, subject to the available-for-use rules), plus an amount equal to the income from the particular mine or mines for which the facility was built or expanded. Essentially, this permits the taxpayer to fully deduct these capital costs prior to being taxed on the income from the particular mine or mines. Similar to the way the accelerated Capital Cost Allowance was previously eliminated for the oil sands sector, the proposed measures in Budget 2013 phase-out the accelerated Capital Cost Allowance regime over the next few years. The phase-out will begin in 2017, when only a portion of the additional Capital Cost Allowance can be claimed, and will be completed by 2021, at which point no additional allowance will be provided. Grandfathering is available for eligible tangible property acquired before 2018 in respect of projects already under construction or where there is an existing written agreement to acquire the property.
Extension of Mineral Exploration Tax Credit
Budget 2013 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 March2014. It will be interesting to see if Finance will continue to extend this program in the future given that mineral exploration tax credit stands as one of the only remaining incentives applicable to the mining sector that is not available in the petroleum sector. In light of the continued alignment of the tax deductions in the mining and petroleum sectors made in Budget 2013 and other recent budgets, the junior mining sector may be somewhat concerned that this longstanding incentive scheme could be subject to scrutiny in the near future.
The Tax Act contains a number of provisions that in general terms restrict the ability of taxpayers to engage in loss trading transactions with arm’s length entities. A typical loss trading transaction involves a taxpayer acquiring an arm’s length entity that has unused losses (a Loss Entity). The taxpayer then transfers income-producing assets to the Loss Entity or causes the Loss Entity to be merged with a profitable entity in order to utilize the Loss Entity’s unused losses to shelter income from tax.
Corporate Loss Trading
The existing rules in the Tax Act restrict the ability of a corporation to use certain tax attributes (such as losses) when control of the corporation has been acquired (Attribute Trading Rules). A limited exception is provided for non-capital losses from a business where the corporation continues to carry on the business following the acquisition of control (the Business Loss Exception).
"Control" for these purposes means the ability to elect a majority of the board of directors of the corporation. Therefore, under existing rules, where the majority of the shares of a corporation have been acquired by a person, but these shares are non-voting shares, the person is not considered to have acquired control for purposes of the Attribute Trading Rules.
Budget 2013 proposes to introduce an anti-avoidance rule to prevent taxpayers from engaging in transactions designed to circumvent the existing Attribute Trading Rules. The proposed measure generally deems a person or group of persons to have acquired control of a corporation for purposes of the Attribute Trading Rules if (i) the shares of the corporation held by the person or group increases from less than or equal to 75% of the fair market value of all the shares of the corporation to greater than 75% of the fair market value of all the shares of the corporation, (ii) the person or group does not otherwise control the corporation, and (iii) it is reasonable to conclude that one of the main reasons that the person or group does not control the corporation is to avoid the application of one or more of the Attribute Trading Rules. Further anti-avoidance rules are proposed to ensure this proposed measure is not circumvented.
The proposed measure is deemed to be effective on March 21, 2013, with limited exceptions for certain transactions pursuant to an agreement in writing entered into before March 21, 2013.
Trust Loss Trading
In general, the Tax Act does not currently contain similar Attribute Trading Rules for trusts.
Budget 2013 proposes to extend the Attribute Trading Rules to trusts, including the limited Business Loss Exception. The proposed measures will apply to restrict the use of a trust’s unused losses (and certain other tax attributes) if the trust is subject to a "loss restriction event". For these purposes, a trust will be subject to a loss restriction event if, on or after March 21, 2013 and after the time that the trust was created, a person becomes a "majority-interest beneficiary" or a group of persons becomes a "majority-interest group of beneficiaries" of the trust. The existing concepts of "majority-interest beneficiary" and "majority-interest group of beneficiaries" will apply for these purposes, with appropriate modifications. A "person" includes a partnership for these purposes. Essentially, under the proposed measures, a trust will be subject to a loss restriction event if a person or group of persons acquires greater than 50% of the fair market value of all the beneficial interests in the income or capital, respectively, of the trust.
Existing deeming rules that apply in the context of an acquisition of control of a corporation will be extended to apply in determining whether or not a trust is subject to a loss restriction event. As a result, it is expected that many typical transactions or events involving changes in the beneficiaries of a personal trust (such as a change in the beneficiaries resulting from the death of a beneficiary) will not result in a personal trust being subject to a loss restriction event.
Finance has invited interested stakeholders to submit comments within 180 days after March 21, 2013 as to whether there should be additional exceptions from the proposed measures for personal trusts.
The proposed measures apply to transactions that occur on or after March 21, 2013, with limited exceptions for certain transactions pursuant to an agreement in writing entered into before March 21, 2013.
Leveraged Life Insurance Arrangements
Budget 2013 contains changes to address two so-called leveraged life insurance arrangements: leveraged insured annuities (LIAs) and "10/8 Arrangements". These transactions have been used by closely held private companies to obtain life insurance for key owners and investors on a tax-advantaged basis compared with other similar arrangements. Finance announced it would monitor developments in this area and would evaluate further action if new structures or transactions emerge.
An LIA policy is a life annuity policy that has been assigned to a lender. LIAs have been offered as an investment product and were marketed and sold as such. Investors earned some of the return from the insurance product tax-free while obtaining an interest deduction for borrowings made to invest in the policy. In addition, for private corporations and their owners, the insurance proceeds could be used to return proceeds tax-free and avoid realizing capital gains on the death of the owners.
Under these proposed measures, the unintended tax benefits will be eliminated for LIA Policies for taxation years that end on or after March 21, 2013. The proposed measures will not apply to LIAs for which all borrowings were entered into before this date. Income accruing on an LIA will be subject to annual accrual taxation and no deduction will be allowed for any portion of any premium paid. Perhaps most importantly, the policy will not give rise to an increase in the capital dividend account in respect of the death benefit from the policy.
So-called 10/8 Arrangements also involved borrowing to purchase a life insurance policy and then borrowing against the policy to make an investment that produces income in circumstances in which no investing and borrowing would ordinarily have been made except for the tax benefits. Investors generally paid deductible interest of, say, 10% to purchase a policy that earned 8% that was not included in income because it was earned on a tax-exempt policy. In addition, for private corporations and their owners, the insurance proceeds could be used to return proceeds tax free and avoid realizing capital gains on the death of the owners.
The unintended tax benefits will be eliminated for 10/8 Arrangements for taxation years that end on or after March 21, 2013. The proposed measures will apply if a life insurance policy, or an investment account under the policy, is assigned as security on a borrowing, and either the interest rate payable on an investment account under the policy is determined by reference to the interest rate payable on the borrowing or the maximum value of an investment account under the policy is determined by reference to the amount of the borrowing. The proposed measures will deny (i) the deductibility of interest paid or payable on the borrowing that relates to a period after 2013; (ii) the deductibility of a premium that is paid or payable under the policy that relates to a period after 2013; and (iii) the increase in the capital dividend account by the amount of the death benefit that becomes payable after 2013 under the policy and that is associated with the borrowing.
These proposed measures contain transitional rules to facilitate the unwinding of these arrangements if the withdrawal is made on or after March 21, 2013 and before January 1, 2014.
Finance also announced that 10/8 Arrangements are being challenged under existing provisions of the Tax Act.
Certain Other Proposed Tax Measures
Lifetime Capital Gains Exemption
Budget 2013 proposes to increase the lifetime capital gains exemption by $50,000, so that it will apply to $800,000 of capital gains realized by an individual on qualified property, effective for the 2014 taxation year. The exemption will also be indexed to inflation, with the first adjustment to occur for the 2015 taxation year.
Thin Capitalization Rules
The thin capitalization rules, which are intended to protect the Canadian tax base against excessive interest deductions, currently apply to Canadian-resident corporations and partnerships of which a Canadian-resident corporation is a member. Budget 2013 proposes to extend the application of these rules to trusts resident in Canada and to non-resident corporations and trusts that carry on business in Canada. The proposed measures will apply to taxation years that begin after 2013 and will apply to both existing and new borrowings.
For a Canadian-resident corporation, the thin capitalization rules restrict the ability to deduct interest expense if debts owing to certain non-residents (specified non-residents) exceed 1.5 times the amount of the corporation’s "equity" for purposes of these rules. Amendments will be made with respect to the tested specified non-resident, and to the calculation of equity in extending the application of the rules to trusts resident in Canada. Trust beneficiaries will be the tested specified non-resident in place of shareholders, and the "equity" of a trust will generally be defined to include contributions to the trust by a specified non-resident beneficiary plus the tax-paid earnings of the trust, less certain distributions of the trust to specified non-resident beneficiaries. A trust will be entitled to designate interest rendered non-deductible by application of the rules as a payment of income of the trust to a non-resident beneficiary. The proposed measures will also extend the application of the rules to partnerships of which a trust resident in Canada is a partner.
Non-Resident Corporations and Trusts
Certain modifications will also be made to extend the thin capitalization rules to non-resident corporations and trusts that carry on a business in Canada. A loan used in the Canadian business of a non-resident corporation or trust will be "outstanding debts to specified non-residents" if it is payable to a non-resident person who was not dealing at arm’s length with the non-resident corporation or trust. In addition, a debt-to-asset ratio of 3-to-5 will be used in place of, but is conceptually parallel to, the 1.5-to-1 debt-to-equity ratio. The proposed measures will also extend the application of the rules to partnerships in which a non-resident corporation or trust is a member.
Clean Energy Generation Equipment: Accelerated Capital Cost Allowance
Class 43.2 of Schedule II of the Income Tax Regulations, which includes certain clean energy generation equipment, is entitled to an accelerated Capital Cost Allowance rate of 50% per year on a declining balance basis. The 2012 federal budget expanded Class 43.2 to provide an incentive for investment in certain low or no-emission energy generation equipment. Citing a desire to reduce air pollutants and improve water quality, and in support of Canada’s targets in the Canadian Federal Sustainable Development Strategy, Budget 2013 proposes to again expand this Class 43.2. Specifically, it proposes to expand the type of biogas production equipment eligible for inclusion by providing that more types of eligible organic waste (such as pulp and paper waste and wastewater, beverage industry waste and wastewater and separated organics from municipal waste) can be used in qualifying biogas production equipment. Budget 2013 also proposes to expand the types of eligible cleaning and upgrading equipment used to treat gases from waste under Class 43.2 by removing various existing restrictions such that all types of cleaning and upgrading equipment that can be used to treat eligible gases from waste will now be included in the class.
These proposed measures will apply in respect of property acquired on or after March 21, 2013 that has not been used or acquired for use before that day.
Manufacturing and Processing Machinery and Equipment: Accelerated Capital Cost Allowance
Budget 2013 proposes to extend to the end of 2015 the support for investment in eligible machinery and equipment for the manufacturing and processing sector that was previously due to expire at the end of this year. This support applies to assets acquired before the end of 2015 that are primarily for use in Canada for the manufacturing or processing of goods for sale or lease. Such machinery and equipment that would otherwise be included in Class 43, thereby qualifying for a 30 % declining balance Capital Cost Allowance rate, will instead be included in Class 29, receiving a 50 % Capital Cost Allowance straight-line rate.
Conclusion of Study Regarding Taxation of Corporate Groups
The 2010 federal budget announced, and the 2012 federal budget reaffirmed, Finance’s interest in exploring whether new rules for the taxation of corporate groups, such as the introduction of a formal system of loss transfers or consolidated reporting, could improve the overall function of the corporate tax system. However, Budget 2013 notes that after extensive public consultations on the issue and taking into account feedback from provincial and territorial officials, a consensus could not be reached regarding how a corporate group taxation system could be introduced that both improves the tax system and addresses the concerns of the business community, provinces and territories. Finance has determined that implementing a system of group taxation is not a current priority, and that it will not be going forward with any further study in this area.
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