Last week, Bill Morneau tabled the Liberal government’s fourth budget, the last before the federal election slated for the fall.
What you need to know
- Improving the fairness of the tax system: The Government will allocate more resources to the Canada Revenue Agency (CRA) to crack down on tax evasion and combat tax avoidance. Budget 2019 also includes measures to close perceived tax loopholes in the Income Tax Act (Tax Act).
- Tax rates: No changes to the personal or business tax rates.
- Employee stock options: A proposed $200,000 annual cap on stock option grants that may benefit from the preferential 50% inclusion rate for employees of “large, long-established, mature firms” and corresponding changes to the deductibility rules for employers. These proposals will apply on a go-forward basis, with effect once the detailed legislative proposals are released later this year.
- Mutual fund allocations to redeemers: For taxation years commencing on or after Budget Day, a mutual fund trust will no longer be entitled to a deduction for income allocated to a redeeming unitholder that is ordinary income or capital gains that exceed the accrued gain on the unitholder’s units.
- Foreign affiliate dumping rules: The foreign affiliate dumping rules will be extended to apply to investments in foreign affiliates made by Canadian-resident corporations that are controlled by non-resident individuals and trusts.
- Cross-border securities lending arrangements: There are a number of proposed amendments to the securities lending rules, with the most notable being a new rule that will deem all dividend compensation payments made by a Canadian-resident borrower to a non-resident lender on shares, whether “fully collateralized” or not, to be dividends for purposes of the Canadian non-resident withholding tax rules. However, if the underlying shares are shares of a foreign issuer, and the borrowing is “fully collateralized,” the non-resident lender will be exempt from withholding tax on the deemed dividends.
Personal income tax measures
Employee stock options
The Tax Act currently provides that in certain circumstances, an employee will be entitled to preferential personal income tax treatment for employee stock options in the form of a stock option deduction. Where applicable, the stock option deduction results in the employee being taxed on stock option benefits at the capital gains inclusion rate of 50%. While employees are afforded this preferential tax treatment, employers are generally not entitled to a claim a deduction in respect of stock option benefits.
The Government asserts that the tax benefits of the employee stock option deduction disproportionately accrue to a small number of high-income individuals, which it believes is inconsistent with the policy behind the stock option deduction of supporting younger and growing Canadian businesses.
To address this concern, Budget 2019 announces the Government’s intention to limit the use of the current regime and move toward aligning the tax treatment of employee stock options with that of the United States. More specifically, the Government proposes a $200,000 annual cap on employee stock option grants (based on the fair market value of the underlying shares at the time of grant) that may benefit from the stock option deduction for employees of “large, long-established, mature firms.” However, for start-ups and rapidly growing Canadian businesses, employee stock option benefits will remain uncapped.
Budget 2019 does not contain specific legislative amendments to implement this measure, nor does it provide any guidance or commentary on what is meant by “large, long-established, mature firms.” It will be interesting to see how the Government defines the scope of employers to be excluded from the new rules. For example, at what threshold does an employer become “large”? Will the proposals exempt certain growing companies from the cap, regardless of size?
Budget 2019 does include three examples illustrating how these proposals could affect the stock option deduction.
An employee of a large, long-established, mature company is granted stock options to acquire 100,000 shares at a price of $50 per share (the fair market value of the shares on the date the options are granted). Since the $5 million (100,000 x $50) fair market value of the underlying shares at the time of grant exceeds the $200,000 limit, the amount of stock options that can benefit from the stock option deduction is capped. In this case, the stock option benefits associated with 4,000 of the stock options ($200,000/$50) will continue to benefit from the stock option deduction, while the stock option benefits associated with the remaining 96,000 options will be fully included in the employee’s income.
The first example also comments on the treatment of stock option benefits from the perspective of the employer and in effect provides that when the employee’s stock option benefits are subject to ordinary personal tax rates, these benefits will be deductible by the employer. In particular, the example provides that the employer will not be entitled to a deduction in respect of the 4,000 stock options subject to the preferential rates, as is the case under current rules, but the employer will be entitled to a deduction in respect of the benefits associated with the 96,000 stock options.
This signals there will also be changes to the existing rules regarding the deductibility of stock option benefits by the employer, which will promote symmetrical treatment as between the employee and employer. In the event that employees become fully taxable in respect of stock option benefits and the employer is not permitted a deduction, we would expect employers to consider alternative incentive arrangements that would provide employers with a corresponding deduction. More generally, we expect that the imposition of an annual cap on employee stock options will cause many employers to consider adjustments to their compensation policies and practices going forward, including with respect to tracking the application of the cap to stock option grants.
Examples 2 and 3
The second and third examples illustrate situations where the cap will not apply. In the second example, an employee of the same large, long-established, mature company as in example 1 is granted stock options to acquire 3,000 shares at a price of $50 per share. In this scenario, the employee will not be affected by the cap since the fair market value of the underlying shares at the time of grant ($50 x 3,000 = $150,000) is less than the $200,000 limit.
In contrast, in the third example, an employee of a start-up company is granted stock options to acquire 100,000 shares at a price of $1 per share. Since the employee received the options from a start-up, all of the stock option benefits associated with the options will continue to benefit from the stock option deduction. This would be the case even if the price of the shares increased to $6 per share at the time of exercise and resulted in a stock option benefit of $500,000 (($6 x 100,000) - ($1 x 100,000)), being an amount in excess of the cap.
Budget 2019 states that further details of this measure will be released before summer 2019 and that any amendments would be enacted on a go-forward basis and would not apply to employee stock options granted prior to the announcement of legislative proposals to implement any new regime. On that basis, it appears that any stock options granted prior to the announcement of specific legislative proposals to implement the new regime will not be subject to the cap.
Mutual fund allocations to redeemers
New proposed rules will impact the allocation of ordinary income and capital gains by mutual fund trusts to unitholders whose units are redeemed (redeemers). The changes will be effective for taxation years of mutual fund trusts that commence on or after Budget Day.
By way of background, a mutual fund trust is a vehicle that allows numerous investors to invest collectively in the vehicle through their ownership of interests or units in the mutual fund trust. A mutual fund trust is generally not subject to an entity level tax, provided the trust has redeemed a sufficient number of units and/or distributed sufficient amounts to its unitholders during the year based on the income (including taxable capital gains) of the trust for the year. If this is done, the mutual fund trust is entitled to claim a deduction equal to the amounts that are distributed (or made payable) to its unitholders and the amounts distributed (or made payable) are subject to tax in the hands of the unitholders. One of the definitional requirements of the most prevalent kind of mutual fund trust in use is that the units of the mutual fund trust must be redeemable on demand by unitholders.
These basic rules work well when distributions are made, and current ordinary income and capital gains are allocated, by a mutual fund trust to its unitholders on a proportionate basis. Difficulties can be caused by redeemers for various reasons, including if the mutual fund trust realizes ordinary income or capital gains on property disposed of to fund the redemption of units, the issue being whether it is fair for the trust to allocate these amounts to all unitholders, thereby subjecting unitholders (including the redeemer) to tax on these amounts. The “capital gains refund” rule for mutual fund trusts was designed to provide some relief in that it permits the trust to apply this refund against the tax the trust would otherwise be subject to if it decides not to allocate capital gains to unitholders, opting instead to have these amounts taxed at the trust level. While the capital gains refund mechanism is useful in these circumstances, it was found to be a fairly blunt tool so that other practices were found to deal with these circumstances.
For example, many mutual fund trusts have adopted the practice of allocating ordinary income or capital gains to redeeming unitholders to achieve fairness among unitholders generally, as well as among unitholders that redeem mid-year as compared to those that remain unitholders at the trust’s year-end. This allocation practice effectively results in: (i) treating the proceeds of redemption received by the redeemer as being in part a distribution of ordinary income or capital gains to the redeemer and subject to tax as such to the redeemer, rather than being taxable at the trust level, and (ii) the proceeds of redemption being reduced by the allocated ordinary income and capital gains for purposes of calculating the gain or loss realized by the redeemer on the disposition of its units. In the past, various provisions of the Tax Act were amended in a way that recognized this practice.
In Budget 2019, the Government raises two concerns with the practice of allocating ordinary income and capital gains to redeeming unitholders, since not only does this ensure that the mutual fund trust will not be subject to tax on these amounts, but it also has the following favourable impact on the remaining unitholders:
- Character conversion: The allocation methodology can permit the mutual fund trust to convert a return on an investment that would have the character of ordinary income into capital gains for the remaining unitholders. This character conversion is possible when a mutual fund trust allocates ordinary income to a redeemer that holds its units on income account and the remaining unitholders hold their units as capital property.
- Deferral: The allocation methodology can also result in a deferral of tax for the remaining unitholders when capital gains allocated to a redeemer exceed the accrued gain on the redeemer’s units in the trust. In this scenario, the redeemer will be subject to the following tax consequences: (i) the proceeds of redemption will be reduced by the capital gain allocated to the redeemer, so the redeemer will realize a gain on the disposition of its units equal to the actual accrued gain, (ii) the capital gain allocated to the redeemer effectively gives rise to a capital loss on the redemption that offsets the capital gain allocated, so the redeemer is indifferent to this “excess” allocation. The Government states that it views this as an inappropriate deferral of tax for the remaining unitholders who will still realize a gain on their units, but not until they redeem their units.
Budget 2019 proposes to address these concerns by denying a deduction to the mutual fund trust of the amount of any ordinary income allocated to a redeemer, as well as any capital gains allocated to a redeemer, if the amount allocated exceeds the accrued capital gain on the redeemer’s units, as determined by formula.
These rules will create challenges for mutual fund trust managers. Many mutual fund trusts have changed their declarations of trusts to require the treatment resulting from the practice with respect to allocations to redeemers. Those declarations of trust will need to be reviewed in light of the proposals. Regarding income allocations, Budget 2019 describes the problem as one in which there are over allocations to unitholders holding their units on income account and there is no acknowledgement of the investor unfairness that arises for mid-year redeemers: if a redeemer receives a pro-rata share of income, there is no “character conversion” (which Budget 2019 is seeking to avoid) but an equalization of income effect between holders. Regarding capital gain allocations, as a practical matter, it will be difficult for managers to determine if there will be “excess” accrued gains allocated as per the formula, given that managers have limited access to the cost base and accrued gain information of units held by unitholders. Further, there is no safe harbor under this rule for a manager having used reasonable efforts to determine these amounts and the impact of reassessments creates a potential risk and cost to future unitholders.
It is expected that the mutual fund industry will want to seek additional clarity about the rules and perhaps seek amendments to make them more practical. It is also expected that managers will seek to administer the rules for all future affected years so that their mutual fund trusts will not be subject to any income inclusion.
Other personal income tax measures
- Canada training credit: To address barriers to professional development for working Canadians, Budget 2019 proposes to introduce a new refundable Canada Training Credit to help cover up to half of eligible tuition and fees associated with training. Individuals who are a resident in Canada and meet certain age and income requirements will be able to accumulate $250 each year in a notional account which can be accessed for this purpose, with credits available to be claimed starting in the 2020 taxation year.
- Amendments to the home buyers’ plan (HBP): Budget 2019 proposes to increase the HBP withdrawal limit for first-time home buyers to $35,000, from $25,000. This increase will apply to the 2019 and subsequent calendar years in respect of withdrawals made after Budget Day. Budget 2019 also proposes to extend access to the HBP to help Canadians maintain homeownership after the breakdown of their marriage or common law partnership. This measure will apply to HBP withdrawals made after 2019.
- Change in use rules for multi-unit residential properties: To better harmonize the treatment of multi-unit residential properties with that of single-unit residential properties, Budget 2019 proposes that if an owner of a multi-unit residential property changes the use of part of that property from income-producing to personal use (or vice versa), the owner can elect for the resulting deemed disposition under current rules not to apply. This measure will apply to changes in the use of property that occur on or after Budget Day.
- Permitting additional types of annuities under registered plans: To give Canadians more flexibility in managing their retirement savings, Budget 2019 proposes a number of changes relating to registered plans, including allowing funds from certain registered plans to be used to purchase advanced life deferred annuities and variable payment life annuities. These changes are generally effective in the 2020 taxation year.
- Registered Disability Savings Plans (RDSPs) and cessation of eligibility for the Disability Tax Credit (DTC): Budget 2019 proposes to: (i) remove the time limitation on the period that a RDSP can remain open after a beneficiary becomes ineligible for the DTC; and (ii) eliminate the requirement for medical certification stating that the beneficiary is likely to become eligible for the DTC in the future in order for the plan to remain open. This measure will apply after 2020. An RDSP issuer will not, however, be required to close an RDSP on or after Budget Day and before 2021 solely because the RDSP beneficiary is no longer eligible for the DTC.
- Kinship care providers: Budget 2019 proposes that for the 2009 and subsequent taxation years, provisions in the Tax Act relating to the Canada Workers Benefit tax credit and kinship care programs are clarified in a manner that is advantageous to taxpayers.
- Donations of cultural property: To address the concerns raised by a recent court decision, Budget 2019 proposes to amend the Tax Act and the Cultural Property Export and Import Act to remove the requirement that property be of “national importance” in order to qualify for the enhanced tax incentives for donations of cultural property. This measure will apply to donations made on or after Budget Day.
- Medical cannabis expense tax credit: Budget 2019 proposes to update the provisions of the Tax Act relating to the Medical Expense Tax Credit for medical cannabis expenditures occurring on or after October 17, 2018.
- Contributions to a specified multi-employer plan for older members: Budget 2019 proposes rules to streamline the treatment of elderly members of specified multi-employer plans with other defined benefit registered pension plans. This measure will apply in respect of contributions made pursuant to collective bargaining agreements entered into after 2019, in relation to contributions made after the date the agreement is entered into.
- Pensionable service under an Individual Pension Plan (IPP): To prevent what has been labelled as “inappropriate planning,” Budget 2019 proposes to prohibit IPPs from providing retirement benefits in respect of past years of employment that were pensionable service under a defined benefit plan of an employer, other than the IPP’s participating employer (or its predecessor employer). This measure applies to pensionable service credited under an IPP on or after Budget Day.
- Carrying on business in a Tax-Free Savings Account (TFSA): Under current rules, the trustee of a TFSA is jointly and severally liable with the TFSA for tax on income from a business carried on by the TFSA. In recognition of the fact that the holder of the TFSA will be in the best position to assess whether the TFSA is carrying on business, Budget 2019 proposes to extend this liability to the TFSA holder, effective for 2019 and subsequent taxation years.
- Electronic Delivery of Requirements for Information: Budget 2019 proposes to allow the CRA to send requirements for information electronically to banks and credit unions once the bank or credit union has notified CRA that it consents to this method of service. This measure will apply as of January 1, 2020.
Business income tax measures
Character conversion transactions
In 2013, the Government introduced the “derivative forward agreement” (DFA) rules to address certain transactions, referred to as “character conversion transactions”, under which certain taxpayers entered into derivative contracts for the sale or purchase of “Canadian securities” that effectively enabled the conversion of ordinary income into capital gains.
In general, for a purchase agreement to constitute a DFA, the difference between the fair market value of the property delivered on settlement of the agreement and the amount paid for the property must be attributable, in whole or in part, to an underlying interest (subject to certain exclusions). One excluded underlying interest is where this difference is attributable to the economic performance of the property that is the subject of the agreement—for example, to revenue, income or cashflow in respect of the property, or changes in the fair market value of the property over the term of the agreement. The Government asserts that this exception, referred to as the “commercial transaction exception,” is intended to ensure that certain transactions (like M&A transactions) are excluded from the application of the DFA rules.
The Government has now become concerned about a form of character conversion transaction it believes constitutes a “misuse” of the commercial transaction exception. Under this transaction, a mutual fund enters into a forward purchase agreement to acquire units of a second mutual fund at a specified future date for a purchase price equal to the value of the units on the date the agreement is entered into. The second fund earns ordinary income from its investment holdings. When the agreement is settled, the first fund acquires units of the second fund and treats the cost of the units as being equal to the purchase price under the agreement. The first fund, which has made an election to treat its “Canadian securities” as capital property, then redeems or sells the units of the second fund and treats the gain as a capital gain. The agreement is not considered a DFA because it fits within the language of the commercial transaction exception, but the transaction has been structured to effectively “convert” ordinary income from investments into a capital gain.
To address the Government’s concern, Budget 2019 proposes a specific limitation to the commercial transaction exception. Under the proposed amendment, the exception will not be available in respect of a purchase agreement if it can reasonably be considered that one of the main purposes of the series of transactions is for all or any portion of the capital gain on the disposition of a “Canadian security” to be attributable to amounts paid or payable on the security during the term of the purchase agreement as ordinary income (specifically interest, dividends, or income of a trust other than income paid out of the trust’s taxable capital gains).
This measure will generally apply to transactions entered into on or after Budget Day. In addition, detailed transitional rules will apply after December 2019 to transactions that were entered into before Budget Day including those that extended or renewed the terms of the agreement on or after Budget Day.
Qualified Canadian journalism organizations
Budget 2019 proposes to introduce three measures aimed at supporting Canadian journalism. A qualifying organization must be designated as a “qualified Canadian journalism organization” (QCJO), requiring it to meet certain criteria in the Tax Act, including designation by an administrative body in a process to be based on the recommendations of an independent panel set up for that purpose.
A QCJO will be required to be organized as a corporation, partnership or trust. To qualify as a QCJO a corporation must be incorporated and resident in Canada. In addition, its chairperson (or other presiding officer) and at least 75% of its directors must be Canadian citizens. In general, for a trust or partnership to qualify, corporations that are QCJOs along with Canadian citizens must own at least 75% of the interests in the trust or partnership. Certain other conditions must also be met, including with respect to its Canadian operations, journalism activities, number of employees and separation from government.
- Qualified donee and tax-exempt status: A QCJO that is a corporation or a trust may register under a new category of tax-exempt entity and be a “qualified donee” provided it meets additional criteria in the Tax Act, including in particular, having purposes that exclusively relate to journalism and ensuring no part of its income is payable to, or otherwise available for the personal benefit of, any shareholder, member, director, trustee, settlor or like individual. In addition, a QCJO must not be controlled (including as a factual matter) by a person or by a group of persons that do not deal with each other at arm’s length. A QCJO that meets these stringent requirements will qualify as a “registered journalism organization” and be tax exempt and may both issue tax receipts to provide the charitable donation tax credit (for individual) or deduction (for corporate) for donors and receive funds from Canadian registered charities. A further requirement is that the QCJO must not in any year receive gifts from one source that represent 20% or more of its total revenues (including donations), except in certain limited circumstances. This measure will apply as of January 1, 2020.
- Refundable labour tax credit: A qualifying QCJO is eligible for a 25% refundable tax credit on salary and wages paid to eligible newsroom employees. This will be subject to a cap on labour costs of $55,000 per eligible newsroom employee per year, for a maximum credit of $13,750 per eligible employee per year. To qualify for the credit, the QCJO must be primarily engaged in producing original written news content and a number of other conditions must be met. This measure will apply to salary or wages earned in respect of a period on or after January 1, 2019.
- Personal tax credit for digital subscriptions: An individual may claim a non-refundable tax credit of 15% on amounts paid to a QCJO for eligible digital news subscriptions, up to a maximum tax credit of $75 annually. Eligible digital subscriptions are those that provide access to the digital content of QCJOs primarily engaged in producing original written news content. Certain other conditions must be met. The credit will be available in respect of eligible amounts paid after 2019 and before 2025.
Scientific research and experimental development program
The Tax Act provides tax incentives for qualifying Scientific Research and Experimental Development (SR&ED) expenditures. Under the federal SR&ED program, qualifying expenditures are fully deductible in the year incurred and are also eligible for an investment tax credit. The rate and level of refundability of the tax credit depends on the characteristics of the company that incurred the expenditures.
Under the existing rules, Canadian-controlled private corporations (CCPCs) are eligible for a fully refundable enhanced tax credit at a rate of 35% for up to $3 million of qualifying SR&ED expenditures annually. This expenditure limit is progressively reduced based on the CCPC’s taxable income and taxable capital employed in Canada for its previous taxation year (applied on an associated group basis).
Budget 2019 proposes to eliminate the use of taxable income as a factor to determine a CCPC’s annual expenditure limit for purposes of the fully refundable enhanced SR&ED tax credit. As a result of this measure, CCPCs with taxable capital employed in Canada of up to $10 million will benefit from full access to the fully refundable enhanced SR&ED tax credit regardless of their taxable income. This measure applies to taxation years that end on or after Budget Day.
Other business income tax measures
- Business investment in zero-emission vehicles: Budget 2019 proposes to introduce a temporary enhanced first-year capital cost allowance rate of 100% for eligible zero-emission vehicles acquired on or after Budget Day and that become available for use before 2028 (subject to a phase out for vehicles that become available for use after 2023).
- Small business deduction for farming and fishing: Budget 2019 proposes to eliminate the requirement that income of a CCPC from sales of farming products or fishing catches be from sales to a farming or fishing cooperative corporation to qualify for the small business deduction. This measure will apply to taxation years that begin after March 21, 2016.
- Canadian film or video production tax credit for Canadian-Belgium co-productions: Budget 2019 proposes to extend the Canadian film or video production tax credit to joint projects of producers from Canada and Belgium. This measure will apply as of March 12, 2018.
International tax measures
Foreign affiliate dumping rules
In 2012, the Government adopted the foreign affiliate dumping (FAD) rules to counter certain types of “foreign affiliate” dumping transactions to ensure that cross-border investments were not used as a tool to erode the corporate tax base or strip surplus from Canada free of non-resident withholding tax. By way of example, one type of foreign affiliate dumping transaction identified was where a Canadian subsidiary used borrowed money to purchase shares of a foreign affiliate from its foreign parent corporation. Under the Canadian foreign affiliate rules, most dividends received by the Canadian subsidiary from the foreign affiliate would be received tax-free, whereas interest on the borrowed money would be deductible.
The FAD rules currently apply when, among other things, a corporation resident in Canada (CRIC) makes an “investment” in a foreign affiliate of the CRIC and the CRIC is or becomes controlled by a non-resident corporation (parent). In the event that no single non-resident corporation controls the CRIC, but a related group of non-resident corporations is in a position to control, the non-resident corporate member of this related group with the greatest direct equity percentage in the CRIC will generally be deemed to control the CRIC and be the parent for purposes of the FAD rules. There are limited exceptions to the FAD rules, and if these rules apply, the consequences vary depending on the type of consideration given by the CRIC for making the investment in the foreign affiliate. When shares are issued by the CRIC as consideration, the paid-up capital on these shares will be suppressed, and when the CRIC provides non-share consideration, the CRIC will generally be deemed to pay a dividend to the parent, and this dividend will be subject to Canadian non-resident withholding tax under Part XIII of the Tax Act (subject to treaty relief).
The Government notes that while the current FAD rules apply only where the CRIC is controlled by a non-resident corporation, or a related group of non-resident corporations, similar policy concerns arise where a CRIC is controlled by a non-resident individual or trust and the CRIC makes an investment in a foreign affiliate.
To address these concerns, effective for transactions or events occurring on or after Budget Day, Budget 2019 proposes to extend the application of the FAD rules to situations where a CRIC is controlled by either a single non-resident person or a group of non-arm’s length non-resident persons. A “person” includes an individual, a trust or a corporation and a group can include any combination of these persons.
For purposes of the Tax Act: (i) related persons will be deemed not to deal at arm’s length; (ii) a taxpayer and certain personal trusts will be deemed not to deal at arm’s length if the taxpayer, or any non-arm’s length person, would be beneficially interested in the trust, as determined under enumerated rules for this purpose; and (iii) in any other case, it is a question of fact of whether two persons are dealing at arm’s length.
While the Tax Act contains detailed rules to determine if two or more persons are “related,” these rules generally focus on the related status of corporations, as well as individuals, in relation to other persons, as opposed to trusts. To ensure that a non-resident trust will be considered to be related to another non-resident person in circumstances similar to where a non-resident corporation would be so related, Budget 2019 proposes to add an extended meaning of “related” that applies to trusts. Under this new rule, it is assumed that:
- each trust is a corporation having a capital stock of 100 voting common shares;
- each beneficiary under a trust owns a portion of the 100 voting common shares equal to their proportionate interest in the trust, measured by the relative fair market value of their interest in the trust; and
- if a beneficiary has a discretionary interest in a trust, the fair market value of that beneficiary’s interest is equal to the total fair market value of all the beneficiaries’ interests under the trust.
The Government states that this new rule is being introduced to ensure that non-resident trusts will be related to another non-resident person, thereby ensuring a non-resident trust will be subject to the “deemed non-arm’s length” rule. Notably, however, the draft legislation provides that this new rule also applies generally for the FAD rules and in determining whether any person is controlled by another person or group of persons. As a result, it appears that if a trust (whether resident or non-resident) has a non-resident discretionary beneficiary, the non-resident beneficiary will be assumed to own 100% of the voting shares of the assumed corporation for the purposes of applying the FAD rules.
These proposals cast a wide net in terms of structures that may now be subject to the FAD rules, including, in particular, owner-manager structures with family trusts having remote non-resident beneficiaries. In addition, by also introducing a “non-arm’s length” test, determining whether these rules apply will be fraught with uncertainty, given that this concept applies to related parties as well as persons who factually do not deal with each other at arm’s length. Arguably, the FAD rules now extend beyond their initial stated target, which was understood to be multinational corporations.
Cross-border share lending arrangements
Budget 2019 proposes three changes to rules for securities lending arrangements (SLA) in the cross-border context where a Canadian resident borrows a publicly-listed share from a non-resident person. All of these changes relate to the application of Canadian non-resident withholding tax rules in Part XIII of the Tax Act to compensation payments made by Canadian-resident borrowers to non-resident lenders, with the first two changes dealing with SLAs of Canadian shares, and the last dealing with SLAs of foreign shares.
Under the existing SLA rules, for purposes of the Canadian non-resident withholding tax rules in Part XIII of the Tax Act, the character of a compensation payment for a dividend on such shares made by a Canadian-resident borrower to a non-resident lender under a qualifying SLA depends on the level and type of collateral provided by the borrower. A dividend compensation payment is deemed to be interest paid by the borrower to the lender unless the SLA is “fully collateralized,” in which case the dividend compensation payment is treated as a dividend. In this regard, an SLA will be regarded as fully collateralized where, throughout the term of the SLA, the borrower provides collateral to the lender consisting of cash and/or government debt having a value of 95% or more of the lent shares and the borrower enjoys the economic benefits from the collateral.
The Government asserts that, with respect to Canadian shares, certain non-residents have used the SLA rules as a means to avoid Part XIII withholding tax on dividend compensation payments made by Canadian-resident borrowers, either by not meeting the fully collateralized test (in which case the compensation payment is deemed to be interest) or by entering into a securities loan that does not meet the definition of SLA.
In this context, the first change in Budget 2019 is to amend the SLA rules to ensure that dividend compensation payments on shares made by a resident of Canada to a non-resident lender are always treated as a dividend for Canadian withholding tax purposes; that is, regardless of the level of collateralization. This treatment will apply not only to qualifying SLAs, but also to specified SLAs as defined in the Tax Act, which are securities loans that are substantially similar to SLAs.
Budget 2019 also proposes to introduce amendments that will ensure that the same withholding tax rate under a tax treaty applies to the dividend compensation payment to the non-resident lender as to a dividend that would have been paid to the non-resident had it continued to hold the Canadian share.
The two proposed amendments described above will generally apply to dividend compensation payments that are made on or after Budget Day, other than amounts paid or credited as dividend compensation payments on or after Budget Day and before October 2019 pursuant to a written arrangement entered into before Budget Day.
The final SLA proposal in Budget 2019 relates to the characterization rules for purposes of Part XIII withholding tax that apply to compensation payments by Canadian-resident borrowers on foreign shares. Under the current rules, when a non-resident lends a foreign share to a resident of Canada pursuant to a fully-collateralized SLA, a compensation payment is treated as a dividend paid by the Canadian borrower to the non-resident, which the Government states may produce an inappropriate result from a Canadian withholding tax perspective.
To address this inappropriate result, Budget 2019 proposes to amend an existing exemption from Canadian withholding tax on compensation payments on foreign shares that are treated as dividends. In particular, the proposal will provide that compensation payments on foreign shares made by a Canadian-resident borrower to a non-resident under an SLA or a specified SLA, which under the new rules will be treated as a dividend, will be exempt from Canadian withholding tax if the arrangement is fully collateralized. While the amendment is relieving in nature, it is not clear why it is only being extended to compensation payments by Canadian-resident borrowers on fully collateralized securities loans of foreign shares, as opposed compensation payments on all securities loans of foreign shares whether fully collateralized or not. This proposed measure applies to dividend compensation payments that are made on or after Budget Day.
Transfer pricing measures
Budget 2019 notes that in the tax context, “transfer pricing” refers to the prices, and other terms and conditions, used in cross-border transactions between non-arm’s length persons. Like other members of the Organisation for Economic Co-operation and Development (OECD), Canada has adopted the “arm’s length principle” in the transfer pricing rules in the Tax Act and these rules can be used by the CRA to adjust the quantum or nature of amounts related to cross-border transactions involving non-resident persons to reflect arm’s length principles.
Budget 2019 proposes two measures concerning the relationship between the transfer pricing rules and other provisions of the Tax Act, the first relating to the priority of application of the transfer pricing rules and the second harmonizing, and broadening, the “transactions” subject to the extended three-year reassessment period.
Order of application
The transfer pricing rules currently provide that: (i) these rules take priority over the general “reasonability” rules in section 67 and 68, as well as subsection 69(1) and (1.2), and (ii) these rules do not apply to loans made by a Canadian-resident corporation to a controlled foreign affiliate, or to guarantee fees payable to the Canadian-resident corporation in respect of loans to a controlled foreign affiliate, where the affiliate uses the funds in its active business.
Budget 2019 proposes to amend the Tax Act, effective for taxation years beginning on or after Budget Day, to clarify that adjustments pursuant to the transfer pricing rules shall be made before any other provision of the Tax Act is applied. The Government notes that this change may have various implications, including with respect to the application of penalties under the transfer pricing rules. The current narrower priority rule regarding the general “reasonability” rules will be repealed, although the exceptions to the transfer pricing rules for loans and guarantee fees regarding controlled foreign affiliates will continue to apply.
Broader definition of “transaction” for extended reassessment period
The CRA is generally subject to a limitation period of three years (or four years in the case of a mutual fund trust or a corporation that is not a CCPC) from its initial assessment of a taxpayer’s taxation year to reassess a taxpayer in respect of that year. In a cross-border context, there is an extended three-year reassessment period that applies where a reassessment is made as a consequence of a transaction involving a taxpayer and a non-arm’s length person that is a non-resident of Canada. The Government states that this extended reassessment period is intended to apply in the transfer pricing context.
The transfer pricing rules contain an expanded definition of “transaction” that explicitly includes “an arrangement or event.” However, this expanded definition does not apply to the extended reassessment period for non-arm’s length transactions. Budget 2019 proposes to use the expanded definition of transaction for purposes of the extended reassessment period, to ensure that the same definition of “transaction” applies to both sets of rules where appropriate.
This measure will apply to taxation years for which the normal reassessment period ends on or after Budget Day. Therefore, it can apply to transactions that have already occurred, in years that have already been assessed by the CRA.
Combatting aggressive international tax avoidance
Budget 2019 provides an update on Canada’s involvement in the Base Erosion and Profit Shifting (BEPS) initiative spearheaded by the OECD and the G20. In particular, the Government indicates the first exchanges of country-by-country reports between the CRA and other tax authorities with whom Canada has entered into exchange agreements took place in 2018. Canada is participating in an OECD review of the standard for these reports, which is scheduled to be completed in 2020.
In addition, the Government confirms it is taking the necessary steps to enact the OECD’s Multilateral Instrument into Canadian law and to ratify it to bring it into force. The Multilateral Instrument will implement in Canada certain tax treaty measures stemming from the BEPS project, including measures to address perceived tax-treaty abuses such as “treaty shopping,” and will impact the vast majority of Canada’s existing treaties.
Sales and excise tax measures
The goods and services tax/harmonized sales tax (GST/HST) legislation provides relief from the GST/HST for certain health care services and products generally by exempting services provided by health care professionals (such as doctors, dentists and physiotherapists) from the GST/HST, and zero-rating prescription drugs, certain biologicals and certain specially designed medical devices.
Budget 2019 proposes to extend this relief to: (i) supplies and importations of human ova and importations of human in vitro embryos, (ii) foot care devices supplied on the order of a podiatrist or chiropodist, and (iii) multidisciplinary health care services supplied by a team of health professionals in certain circumstances. These measures will be effective for supplies and importations made after Budget Day.
Budget 2019 also proposes to amend the GST/HST legislation to ensure the treatment of expenses incurred in respect of eligible zero-emission passenger vehicles under the GST/HST aligns with the proposed income tax treatment of these vehicles. This measure will apply to acquisitions of eligible zero-emission vehicles on or after Budget Day.
The sale of cannabis for non-medical purposes became legal in Canada on October 17, 2018. Currently, five classes of cannabis products may be sold: (i) fresh cannabis; (ii) dried cannabis; (iii) cannabis oil; (iv) cannabis plant seeds; and (v) cannabis plants. In December 2018, the Government released for consultation draft regulations governing the production and sale of three new classes of cannabis products, being edible cannabis, cannabis extracts and cannabis topicals.
Budget 2019 proposes that edible cannabis, cannabis extracts (including cannabis oil) and cannabis topicals will be subject to a flat-rate excise duty imposed on cannabis licensees based on the quantity of total tetrahydrocannabinol (THC) in the final product. The duty will be imposed at the time of packaging and will generally be payable when the product is delivered to a wholesaler, retailer or provincial consumer. The combined federal-provincial-territorial duty in respect of these products is proposed to be $0.01 per milligram of total THC (plus a sales tax adjustment in certain provinces and territories).
This proposed measure will become effective on May 1, 2019, except that cannabis oil products packaged for final retail sale before May 1, 2019 will be subject to the currently applicable duty rate no matter the date of final delivery to a purchaser.
Status of outstanding tax measures
Budget 2019 confirms the Government intends to proceed with the following previously announced tax changes.
- Income tax measures announced on November 21, 2018, which include the Accelerated Investment Incentive.
- Regulatory proposals on the taxation of cannabis released on September 17, 2018.
- The remaining legislative and regulatory GST/HST proposals released on July 27, 2018.
- Budget 2018 measures proposing enhanced reporting requirements for certain trusts.
- Budget 2018 measures facilitating the conversion of Health and Welfare Trusts to Employee Life and Health Trusts.
- GST/HST measures confirmed in Budget 2016 that relate to the joint venture election.
- Measures announced in Budget 2016 that address information reporting requirements for certain dispositions of an interest in a life insurance policy.
Intergenerational business transfers
In 2017, the Government released a number of measures relating to the taxation of private corporations. During the consultation period for these proposals, the Government heard concerns from business owners about efficiencies relating to the transfer of businesses to the next generation and announced that it would reach out to business owners to develop proposals to better accommodate intergenerational transfers of businesses. In Budget 2019, the Government affirmed its commitment to develop these proposals.
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