The federal budget (Budget 2017) tabled on March 22, 2017 (Budget Day) contains a number of proposed amendments to Canada’s Income Tax Act (the Tax Act). This bulletin focuses on (i) business income tax measures, (ii) international tax measures, (iii) avoidance rules for registered plans, (iv) tax planning using private corporations and (v) the status of outstanding tax measures.
Business Income Tax Measures
Timing and Recognition of Gains and Losses on Derivatives
In computing profit from gains and losses on derivatives held on income account for purposes of the Tax Act, taxpayers (other than financial institutions subject to the mark-to-market rules) generally use general profit computation principals. One such method used by taxpayers is the realization method whereby gains and losses on derivatives held on income account are only included in the calculation of income for tax purposes upon realization of such gains or losses. Budget 2017 proposes two measures that specifically address the timing of the recognition of gains and losses on derivatives held on income account.
1. Elective use of mark-to-market method
Financial institutions are required to mark-to-market certain types of derivatives, thus having to recognize both unrealized gains and losses in computing their income. Currently, there is no such requirement for other taxpayers. However, the Federal Court of Appeal recently held that a non-financial institution taxpayer was allowed to use the mark-to-market method under general profit computation principals for purposes of calculating its income.
Budget 2017 proposes to allow taxpayers to elect to mark-to-market all derivatives it holds that are eligible derivatives. Once made, such election will remain effective going forward and revocation will be granted only upon consent of the Minister of National Revenue (the Minister). Upon making this election, the taxpayer will be required to include in computing income the increase or decrease in the value of the taxpayer’s eligible derivatives on an annual basis.
This election will be available for taxation years that begin on or after Budget Day.
2. Straddle transactions
Canada’s Department of Finance (Finance), has identified certain straddle transactions which allow taxpayers using the realization method to selectively realize gains and losses from derivatives (and other positions) held on income account. Finance describes the basic straddle transaction as one where a taxpayer enters into two or more derivative positions concurrently that are expected to generate equal and offsetting gains and losses. Prior to its taxation year end (Year 1), the taxpayer disposes of the positions that result in the realization of an accrued loss. The taxpayer then disposes of the offsetting position to realize an accrued gain early in the following taxation year (Year 2). The result is that the taxpayer can claim the loss in Year 1 while deferring the recognition of the offsetting gain to Year 2. Finance notes that this and other straddle transactions raise tax base and fairness concerns.
Budget 2017 proposes to implement a specific anti-avoidance rule to address the concerns raised by straddle transactions. This anti-avoidance measure will be in the form of a stop-loss rule which will defer the loss realization on a disposition to the extent that there is an unrealized gain on an offsetting position. Generally, such offsetting gain would not be realized until disposition provided it is not subject to mark-to-market income computation method.
This proposed stop-loss rule will apply in respect of a "position" which will generally be defined to include an interest in actively traded personal property (e.g., commodities), derivatives and certain debt obligations, and a related offsetting position will generally be one that "has 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 position". There will be exceptions to this stop-loss rule including that it will not apply: to a position held by a financial institution subject to the mark-to-market rules or by a mutual fund trust or mutual fund corporation; to a position that is part of certain ordinary course hedging transactions; if the offsetting gain position is held throughout a specified period starting on the date of the disposition of the related loss position; or to a position that is part of a series of transactions where none of the main purposes is the avoidance or deferral of tax.
This stop-loss measure will apply to any loss realized on a position entered into on or after Budget Day.
Clean Energy Generation Equipment: Geothermal Energy
Under the current capital cost allowance (CCA) rules, specified clean energy generation and conservation equipment is eligible for accelerated CCA treatment by way of inclusion in Class 43.1 or Class 43.2. Under the current CCA rules, equipment that uses geothermal energy is currently eligible for inclusion in Class 43.2 (which provides for a CCA rate of 50%) only if it is primarily used for the purposes of generating electricity; however, equipment that is used primarily for heating purposes does not qualify and is generally included in Class 1 (which is eligible for a CCA rate of 4%). The current regime also allows for:
- costs of drilling and completing exploratory wells to be fully deducted in the year incurred as Canadian renewable and conservation expenses when it is reasonable to expect at least 50% of the capital cost of the property will be used in an electricity generation project included in Class 43.1 or Class 43.2; and
- costs of drilling and completing geothermal production well for an electricity generation project that qualifies for Class 43.2 to be included in that class. Where such costs are not related to electrical energy generation (and are, for example, related to supplying heat) they may be included in Class 1 (CCA rate of 4%), Class 14.1 (CCA rate of 5%), Class 17 (CCA rate of 8%) or treated as a current expense.
Under the current regime, certain equipment that is part of a district energy system is eligible for inclusion in Class 43.1 or Class 43.2. Geothermal energy is not currently eligible as a thermal energy source for use in a district energy system.
Budget 2017 proposes several changes to this regime. The first proposed change is that geothermal energy equipment eligible for inclusion in Class 43.1 and Class 43.2 will be expanded to include geothermal equipment that is used primarily for the purpose of generating heat or a combination of heat and electricity. Certain eligible costs will include the cost of completing a geothermal well and the cost of electricity transmission equipment related to systems that produce electricity. The second proposed change is that geothermal heating will be made an eligible thermal energy source for use in a district energy system. The final proposed change is that for both electricity and heating projects, expenses incurred for the purpose of determining the extent and quality of geothermal drilling will qualify as a Canadian renewable and conservation expense.
These proposed changes will apply in respect of property acquired for use on or after Budget Day that has not been used or acquired for use before Budget Day.
Tax Measures Impacting the Petroleum Sector
Budget 2017 contains two measures directed at the petroleum sector. The first proposal recharacterizes the tax treatment of expenses relating to the preparation and drilling of discovery wells (being exploratory wells that identify a previously unknown petroleum reservoir). Currently such expenses are treated as Canadian exploration expense (CEE) which can generally be deducted up to 100% in the year incurred. The proposal would recharacterize these expenses as Canadian development expense (CDE) which can only be deducted on a 30% declining balance basis. The proposal is stated to come into force for expenses incurred in 2019 and thereafter, except for expenses incurs prior to 2021 that the taxpayer has committed in writing (prior to Budget Date) to expend.
The second proposal would eliminate an incentive within the flow-through share rules which allows small corporations to incur up to $1 million of certain types of CDE, and to renounce those expenditures to subscribers of the flow-through shares as CEE. This measure is stated to be applicable to expenses incurred after 2018, with the exception of any commitments under a flow-through share agreement entered into prior to Budget Date.
While the Budget espouses the commitment of the Canadian government to its Federal Sustainable Development Program and its ongoing environmental stewardship, the absence of any similar changes to the mining sector (which continues to enjoy preferential tax treatment to the petroleum sector) is likely to be perceived by those in the petroleum sector as a continued targeting of that sector by the current government. In particular, the Budget’s pronouncement that these changes could influence investment decisions in a way that could reduce environment impacts (i.e., that the changes may result in fewer wells being drilled) may be the most blatant example to date of the current government’s desire to discourage further petroleum exploration activities in Canada.
Mineral Exploration Tax Credit for Flow-Through Share Investors
Budget 2017 has offered what has become the traditional one-year extension to the investment tax credit regime for flow-through shares in the mining sector. Consequently, eligible expenses will continue to qualify for a 15% mineral exploration tax credit for flow-through share agreements entered into on or before March 31, 2018.
Meaning of Factual Control
Various rules in the Tax Act refer to control of a corporation. These rules recognize two forms of control: de jure control (or legal control) and de facto control (or factual control). Legal control generally means the right to elect the majority of the board of directors of the corporation. On the other hand, factual control is intended to be broader than legal control and may exist even without the ownership of shares. The concept of factual control is relevant in the determination of whether a corporation is a “Canadian-controlled private corporation” (CCPC) and whether corporations are considered to be associated for purposes of the Tax Act. These rules are important for determining a corporation’s eligibility for refundable investment tax credits as well as a corporation’s small business deduction limit.
The existence of factual control is a question of fact that is dependent on the relevant facts and circumstances of each particular situation. Recent case law held that for a factor to be a relevant consideration in the determination of factual control, it must include a “legally enforceable right and ability to effect a change to the board of directors or its powers, or to exercise influence over the shareholder or shareholders who have that right and ability.”
Budget 2017 proposes to amend the Tax Act to clarify that all factors that are relevant in the circumstances should be taken into consideration in the determination of factual control and that the determination should not be limited to the requirements set out above. This measure will apply in respect of tax years that begin on or after Budget Day.
Investment Fund Mergers
There are rules in the Tax Act that allow for tax-deferred reorganizations of investment funds in certain limited circumstances. Budget 2017 proposes to extend this ability to reorganize investment funds on a tax-deferred basis to several additional situations.
1. Merger of switch corporations into mutual fund trusts
Mutual funds are structured as "mutual fund trusts" or "mutual fund corporations" under the Tax Act. A "mutual fund trust" can have only one investment mandate whereas each class of shares of a mutual fund corporation can have a separate investment mandate which tracks a separate pool of investments (commonly referred to as a "switch corporation"). Under the Tax Act, two mutual fund trusts can be merged on a tax-deferred basis. Similarly, a mutual fund corporation can be converted or merged into a mutual fund trust on a tax-deferred basis.
Budget 2017 proposes to extend these rules to allow a switch corporation to reorganize into multiple mutual fund trusts on a tax-deferred basis. For a switch corporation to qualify for this tax-deferred exchange, (i) all or substantially all (generally 90% or more) of the property of the switch corporation must be transferred to one or more mutual fund trusts, (ii) no shareholder of the switch corporation receives any consideration other than units of one or more mutual fund trusts, (iii) in respect of each class of shares of the switch corporation, all or substantially all of the assets allocable to that class must be transferred to a mutual fund trust and the shareholders of that class must become unitholders of that mutual fund trust, and (iv) the switch corporation and the mutual fund trust(s) must file a joint election in prescribed form.
This measure will apply to qualifying reorganizations that occur on or after Budget Day.
2. Segregated fund mergers
The Tax Act does not contain rules that allow for a tax-deferred merger of segregated funds. Budget 2017 recognizes that segregated funds share many of the same qualities of mutual fund trusts and should be provided with consistent treatment. Therefore, Budget 2017 proposes to allow segregated funds to merge on a tax-deferred basis in a manner that is intended to be parallel to rules available for mutual fund trusts.
Furthermore, Budget 2017 proposes to allow segregated funds to carry over non-capital losses to be applied in computing taxable income for years that begin after 2017. The losses eligible for carryover must arise in taxation years beginning after 2017, will be subject to the ordinary limitations set out in the Tax Act for carryback and carryforward of non-capital losses and the use of such losses will be restricted following a merger of segregated funds.
The life insurance industry is invited to comment on the proposals. The measures will apply to segregated fund mergers implemented after 2017 and to losses arising in tax years beginning after 2017.
International Tax Measures: Foreign Branches of Life Insurers
Ordinarily, a Canadian-resident person is subject to tax in Canada on its worldwide income from all sources. There is an exception provided in the Tax Act for corporations resident in Canada that carry on a life insurance business both in Canada and outside Canada (through a foreign branch). This exception provides that the life insurer is subject to tax in Canada in respect of its income from its insurance business carried on in Canada but not outside Canada. This rule is parallel to the treatment afforded to foreign affiliates of Canadian resident corporations since the foreign business income of such affiliates is generally not subject to tax in Canada (and usually exempt from tax when repatriated to Canada).
The Tax Act, however, contains rules within the foreign affiliate regime that deem the foreign affiliate's income 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) to be included in the affiliate's foreign accrual property income (FAPI) which, in the case where the foreign affiliate is a controlled foreign affiliate, is taxed in Canada on an accrual basis in the hands of the Canadian corporation. Budget 2017 proposes an analogous rule for Canadian-resident insurers with foreign branches to ensure that such insurers are subject to tax in Canada on their income from the insurance of Canadian risks. The intention is to prevent such corporations from shifting income from the insurance of Canadian risks to low or no tax jurisdictions. The rule generally provides that, where more than 10% of the gross premium income of the foreign branch income from the insurance of risks (net of reinsurance) is in respect of Canadian risks, the insurance of Canadian risks by the foreign branch is considered to be included in the Canadian corporation’s life insurance business carried on in Canada and the related policies are considered life insurance policies in Canada.
Furthermore, Budget 2017 proposed to extend certain anti-avoidance rules that were previously introduced into the FAPI regime to foreign branches of life insurers. The previously announced measures were intended to address so-called "insurance swaps" and ceding of Canadian risks.
Finally, a further anti-avoidance measure is proposed to apply to both foreign branches of and foreign affiliates of Canadian life insurance corporations. In particular, if a Canadian resident life insurer has, through its foreign branch, insured foreign risks and it can be reasonably concluded that the foreign risks were insured as part of a transaction or series of transactions one of the purposes of which was to avoid the application of any of the proposed rules set out above, the Canadian insurer will be treated as if such risks were Canadian risks. A parallel rule is proposed for foreign affiliates of Canadian resident corporations.
This proposed measure will apply to taxation years that begin on or after Budget Day.
Anti-Avoidance Rules for Registered Plans
The Tax Act provides for certain beneficial tax treatment in relation to various registered plans: Registered Education Savings Plans (RESPs), Registered Disability Savings Plans (RDSPs), Tax-Free Savings Accounts (TFSAs), Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs). For TFSAs, RRSPs and RRIFs, there are a number of anti-avoidance rules including:
- the advantage rules;
- the prohibited investment rules; and
- the non-qualified investment rules.
Budget 2017 proposes to extend these anti-avoidance measures to apply to RESPs and RDSPs. These measures will generally apply to investments acquired after Budget Day and to transactions occurring after Budget Day (such transactions will include investment income generated after Budget Day where the investment was acquired prior to the implementation of the proposed changes).
Tax Planning Using Private Corporations
Budget 2017 noted a number of issues regarding tax planning strategies using private corporations, which can result in high-income individuals gaining unfair tax advantages. These strategies include:
- Sprinkling income using private corporations, which can shift income from an individual facing a high personal income tax rate to family members who are subject to lower personal tax rates (or who may not be taxable at all).
- Holding a passive investment portfolio inside a private corporation, which may be financially advantageous for owners of private corporations compared to otherwise similar investors.
- Converting a private corporation’s regular income into capital gains, which can reduce income taxes by taking advantage of the lower tax rates on capital gains.
Budget 2017 confirmed that the government is planning to review the use of these tax planning strategies involving private corporations by high-income earners and will release a paper on the matter in the coming months that will include proposed responses to these issues.
Status of Outstanding Tax Measures
Budget 2017 confirms the government’s intention to proceed with certain tax and related measures (as modified to take into account consultations and deliberations since their announcement or release):
- measures announced to improve fairness in relation to the capital gains exemption on the sale of a principal residence (announced October 3, 2016);
- the measures announced in Budget 2016 on information-reporting requirements for certain dispositions of an interest in a life insurance policy;
- proposals relating to income tax technical amendments (released on September 16, 2016);
- proposals relating to the Goods and Services Tax/Harmonized Sales Tax (released on July 22, 2016); and
- measures confirmed in Budget 2016 relating to the Goods and Services Tax/Harmonized Sales Tax joint venture election.
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