On March 4, 2010, the federal finance minister, the Honourable Jim Flaherty, released the 2010 federal Budget. The Budget continues to emphasize and build on last year's economic action plan with a focus on creating jobs and growth, sustaining Canada's economic advantages and planning a return to a balanced budget. While there were no announced changes to personal or corporate income tax rates, the finance minister reiterated his commitment to carry through with previously announced corporate and personal tax reductions and to have the lowest corporate income tax rate in the G7 by 2012. The Budget was relatively light on tax changes, but still contained many proposed changes of interest to the business community, not the least of which is a commitment to close “unfair tax loopholes” and introduce a reporting regime regarding “aggressive tax planning”. The following is a summary of some of the more significant tax highlights of the Budget.
Under Canadian law, non-residents of Canada are subject to tax on gains realized on dispositions of taxable Canadian property (TCP), which includes shares of private Canadian corporations and shares of public Canadian corporations where the non-resident (alone or with non-arm's length persons) owned 25 percent or more of the issued shares of any class or series of the corporation at any time during the 60-month period preceding the sale.
Prior to the Budget, certain investors had been able to rely on treaty exemptions to avoid Canadian tax on a disposition of such shares if the shares did not derive more than 50 percent of their value from real property or resource property located in Canada. However, in the context of private corporation shares they still had to give notice of the disposition and obtain “section 116 clearance certificates” before a purchaser would release the entire proceeds of a purchase to the vendor. This process was time-consuming and could take as much as a year to obtain the release of all of the proceeds. As well, many investors did not qualify for treaty exemption and had to pay Canadian capital gains tax on these dispositions.
The Budget proposes to amend the TCP definition effective March 5, 2010, to exclude private Canadian corporation shares (and public Canadian corporation shares where the 25 percent ownership threshold has been exceeded) where no more than 50 percent of the fair market value of the shares is derived, directly or indirectly, from Canadian real estate or resource property (at the time of the sale and throughout the 60-month period preceding the sale).
This is good news in that there will no longer be a need for section 116 clearance certificates or holdbacks on dispositions of private corporation shares where the shares do not derive their primary value from Canadian real estate or resource property. Moreover, non-resident investors who are not resident in treaty jurisdictions will no longer be subject to Canadian tax on gains realized on dispositions of shares of Canadian corporations outside the resource and real estate sectors.
Although this change does not eliminate Canadian tax and the need for holdbacks and section 116 clearance certificates on dispositions of shares of private resource or real estate corporations, it may make the section 116 holdback and clearance process faster by removing other dispositions from the clearance certificate process. It should also be noted that there may be holding structures available to eliminate or reduce Canadian tax on the sale of resource and real estate businesses.
We see this change as a tangible indication of Canada's commitment to support efficient processes for the entry into and exit from the Canadian market by foreign capital, bringing Canada's domestic rules in line with many of Canada's tax treaties and the laws of Canada's major trading partners like the United States, and assisting Canadian businesses in attracting foreign capital.
Canada's tax rules relating to non-resident trusts (NRTs) and foreign investment entities (FIEs) have long been the subject of debate and consternation. The basic aim of the rules is to ensure that Canadians are prevented from using foreign intermediaries to avoid paying Canadian tax. However, the old rules were viewed by Canadian tax authorities as too weak. Accordingly, new draft rules first appeared in 1999 and were modified several times to address fundamental concerns from the tax community regarding the complexity and extremely broad scope of the rules. Ultimately, these concerns persisted and the proposed new rules have still not been enacted into law.
The Budget now proposes further significant changes to both the NRT and FIE rules. Public comments on the new proposals will be accepted before May 4, 2010.
In a nutshell, the previous proposed versions of the FIE rules have been abandoned and new rules proposed that build upon the current rules relating to “offshore investment fund property”. These new rules, which are proposed to be effective for tax years ending after March 4, 2010, will generally (a) increase the reporting requirements on beneficiaries of, and contributors to, certain foreign trusts, (b) increase the prescribed interest rate applicable to interests in offshore investment fund property, and (c) extend the limitation period within which taxpayers who are caught by these rules may be reassessed. For taxpayers who have voluntarily complied with previous proposed versions of the FIE rules, an election will be available to alleviate some of the negative consequences of the new rules.
The new NRT rules seek to simplify and narrow the previous proposals. Unlike the FIE proposals, the new NRT rules essentially maintain the structure of most recent draft proposals, however they introduce or broaden the exemptions applicable to a number of non-offensive scenarios, including bona fide commercial trusts, tax-exempt entities and transactions involving Canadian financial institutions. The NRT proposals also contemplate extending the limitation period for reassessing taxpayers holding interests in NRTs by three years. These new proposals are intended to apply beginning in 2007, with a potential elective relief available to taxpayers who relied upon the previous legislative proposals.
These objectives are laudable since the prior drafts of both the FIE and NRT legislation were overbroad and virtually unworkable in many contexts. However, as always, we will await the newest iteration of the draft legislation governing both proposals before declaring any type of victory in the long-running saga on foreign investment entities and non-resident trusts.
According to the Budget, some Canadian corporations have engaged in “foreign tax credit generator” schemes designed to avoid tax in respect of interest income on indirect loans to foreign corporations earned via a partnership or a foreign affiliate. To address such plans, the Budget proposes to deny foreign tax credit claims and deductions for foreign accrual tax and underlying foreign tax where the tax law of the foreign jurisdiction considers the Canadian corporation to have a lesser direct or indirect interest in the foreign corporation or entity than the Canadian corporation is considered to have for Canadian tax purposes.
Canadian corporations earning income subject to foreign taxes via a partnership or a foreign affiliate will need to carefully consider the potential application of these new rules, particularly where shares of a foreign affiliate or entity are subject to a “repo” transaction or where an entity may be treated as a “hybrid” or “fiscally transparent” under foreign tax law.
These new measures will take effect for foreign taxes incurred in respect of taxation years that end after March 4, 2010 (and could therefore include foreign taxes paid prior to the Budget announcement). The Department of Finance is encouraging interested stakeholders to submit comments on the proposals before May 4, 2010.
In anticipation of fundamental changes to the taxation of Canadian income trusts and partnerships coming in 2011, many such trusts and partnerships (SIFTs) have been converting to corporate form. A number of these conversion transactions have been structured in a manner that allows the converted SIFT to utilize the tax losses of a pre-existing loss company or “Lossco”. In essence, this type of planning involves a “reverse takeover” transaction whereby new shares of the Lossco are issued in exchange for interests in the trust or partnership being converted. The transaction did not result in an acquisition of control of the Lossco (thereby avoiding a “streaming” or “successoring” of the Lossco's tax losses). This was possible because the rules that prevented this result where two corporations were being combined in a reverse takeover scenario did not apply where a trust or partnership was being combined with a corporation.
The Budget proposes to amend the corporate “acquisition of control” rules so that SIFT conversions are now caught. The amendment is effective for transactions undertaken after 4:00 pm EST on March 4, 2010. Pre-Budget transactions are grandfathered, as are transactions that the parties are obligated to complete pursuant to an agreement in writing entered into before this time (unless the agreement contains a change of tax law “out”). This change was not entirely unexpected as it had been commented upon in the news media and was alluded to by the minister of finance in a recent public statement.
A beneficial change announced in the Budget in the context of SIFT conversions is that the acquisition of control rules are to be amended to ensure that they do not apply where the SIFT trust is wound up and distributes the shares of a corporation it holds. Under this change, where the sole beneficiary of a SIFT trust following a conversion is a corporation, the wind-up of the trust will not trigger an acquisition of control of corporations held below the trust.
The Budget proposes three significant changes to the way in which both employees and employers are taxed in respect of stock options.
First, the Budget eliminates the deferral that was introduced in the 2000 Federal Budget that permitted employees of public corporations to elect to defer the income inclusion associated with the exercise of a stock option until the year in which the underlying shares are sold. A similar deferral in the context of employee stock options issued by Canadian-controlled private corporations (CCPC) will remain available.
As a partial relieving measure, the Budget proposes to allow those employees who have filed deferral elections to ensure that the tax liability on the deferred stock option benefit does not exceed the proceeds from the disposition of the shares in circumstances where the shares have declined in value from the date of exercise, taking into account tax relief from capital losses on the shares against capital gains from other sources. However, employees who have exercised CCPC options will continue to suffer negative tax consequences where the shares decline in value from the date of exercise.
Second, employers will no longer be able to “cash out” option holders under the preferential stock option rules and get a corresponding deduction at the same time. Under existing rules, an employee stock option arrangement could generally be structured to permit the employee to receive cash rather than shares at the time of exercise and still qualify for the 50-percent employee stock option deduction, while the employer would achieve a deduction for the payment (employers cannot claim a deduction when stock option shares are issued).
After March 4, 2010, an employee will no longer be eligible for the 50-percent stock option deduction in respect of cash payments (i.e., they have to actually acquire the shares) unless the employer makes an election not to deduct any amount paid to the employee in respect of the stock option cash out. It appears that the election only applies to the specific grant of options covered by the election (rather than on a global basis to all grants). It is not clear from the Budget materials whether the proposed amendment and the ability to make the election applies to options granted after the Budget date, or to options disposed of after Budget date, which may be a significant issue for many option plans.
Third, the Budget proposes to clarify the existing rules to require an employer (other than a CCPC) to remit to the Canada Revenue Agency (CRA) the appropriate withholding in respect of employee stock option benefits on the same basis as if the benefit had been paid in cash as a bonus (taking into account the benefit of the 50-percent employee stock option deduction to the extent it is available). Under the existing rules, it was unclear to what extent the employer had to remit in the case of an employee who was compensated primarily by way of stock option benefits, and the CRA had a favourable administrative position that effectively did not require withholding in certain circumstances where it would cause undue hardship to the employee. This amendment is to apply to securities acquired by employees after 2010, and will not apply to stock options granted prior to 2011 pursuant to a written agreement entered into before 4:00 pm EST on March 4, 2010, where the agreement included restrictions on the employee's ability to dispose of the underlying securities.
The change to require source deductions in respect of non-CCPC stock options may cause problems where stock option benefits constitute a significant component of an employee's overall compensation. Employees and employers may need to look for ways to effectively fund the withholding out of cash other than out of salary payable to the employee, perhaps placing more reliance on so-called “cashless” exercise plans where the options are exercised through an administrative agent and the shares are immediately sold, with the exercise price and the source deductions funded out of the sales proceeds.
A long-standing complaint about the Canadian tax system is the absence of a statutory mechanism for transferring losses among members of a corporate group. While intra-group loss utilization may still be possible and has generally been found to be acceptable in tax policy terms, it can be cumbersome and complex.
The Budget proposes to explore whether new rules for the taxation of corporate groups (including the introduction of a formal system of loss transfers or consolidated reporting) would improve the effectiveness of Canada's tax laws. This is a welcome development, though it is clearly at an early stage and any real changes are not likely to appear before 2011 at the earliest.
The current general anti-avoidance rule (GAAR) in Canada's income tax legislation serves as a rule of last resort to combat abusive tax planning. However, unlike some jurisdictions (including the United States and, most recently, the province of Québec), the GAAR does not contain any mandatory reporting requirements for transactions that may be viewed as aggressive by the CRA.
The Budget proposes to have a public consultation on proposals to require the reporting of certain “tax avoidance transactions”. In particular, it proposes a new regime whereby taxpayers would have to report a transaction to the CRA if it contained certain “hallmarks” of tax avoidance schemes, including (a) the entitlement of a promoter or tax advisor to fees contingent on the success of a particular tax plan, and (b) a transaction which is subject to confidentiality restrictions. If a taxpayer fails to report such a transaction on a timely basis, the tax benefit could be denied or subject to penalties.