Federal Budget 2012 – Income Tax Measures
After much anticipation of a bold budget in its first year of majority government, the Canadian Government today tabled Budget 2012.
The Budget's main emphasis is on cutting costs, reforming Employment Insurance and increasing eligibility for Old Age Security from age 65 to 67. There are no structural changes to the personal or corporate tax systems or to the GST/HST. The Budget nonetheless contains extensive measures designed to shore up the tax base, both on the personal and corporate side, among other things. The Scientific Research & Experimental Development (SR&ED) program has undergone some significant changes, in that tax expenditures have been curtailed in favour of direct grants to steer industry to innovation and commercialization in government procurement programs.
This update summarizes the principal income tax measures and proposed changes to the Income Tax Act (the Act), contained in Budget 20121 .
A. TAX RATES
No changes are proposed to corporate and personal income tax rates. As previously announced, the Canadian federal corporate income tax rate was reduced from 16.5% in 2011 to 15% in 2012 and the small business rate will be 11%.
B. CORPORATE TAX MEASURES
Corporate Mineral Exploration and Development Tax Credit
Budget 2012 proposes to eliminate by 2016 the 10% mineral exploration and development tax credit that may be claimed for pre-production mining expenditures incurred by a corporation in respect of certain mineral resources in Canada.
The credit will be phased out separately for pre-production exploration expenditures described in paragraph (f) of the definition of "Canadian exploration expense" in section 66.1, and for pre-production development expenditures described in paragraph (g) of the definition of "Canadian exploration expense" in section 66.1.
The credit in respect of pre-production exploration expenditures will apply at the rate of 10% for expenditures incurred before 2013 and 5% for expenditures incurred in 2013. The credit will not be available for pre-production exploration expenditures incurred after 2013.
The credit in respect of pre-production development expenditures will apply at the rate of 10% for expenditures incurred before 2014, 7% for expenditures incurred in 2014, and 4% for expenditures incurred in 2015. However, as a transitional relief, the credit will apply at the rate of 10% for pre-production development expenditures incurred by a corporation under a written agreement entered into by the corporation before March 29, 2012, or as part of the development of a new mine if the construction of the mine or its engineering and design work was started before March 29, 2012. The credit will not be available for pre-production development expenditures incurred after 2015.
Atlantic Investment Tax Credit
Budget 2012 proposes to phase out the 10% Atlantic investment tax credit for qualifying acquisitions of new buildings, machinery and equipment acquired on or after March 29, 2012, for use in oil and gas and mining activities. The tax credit for assets acquired for such activities will be reduced to 5% for assets acquired in 2014 and 2015 and will be eliminated for assets acquired after 2015. Transitional relief will apply, and the credit for assets acquired after 2013 and before 2017 will remain at 10%, if the asset was acquired under a written agreement for purchase and sale entered into by a taxpayer before March 29, 2012, or as part of a project phase where construction or the engineering and design work for the phase was started before March 29, 2012.
Budget 2012 also proposes to expand the class of assets eligible for the Atlantic investment tax credit to include certain electricity generation equipment and clean energy equipment used in an eligible activity.
Tax Incentives Relating to Clean Energy Generation Equipment
Specified clean energy generation and conservation equipment is generally eligible for a 50% declining-balance capital cost allowance rate. Budget 2012 proposes to expand the class of assets that qualify for this tax incentive by including (i) waste-fuelled thermal energy equipment, regardless of whether it is used in an industrial process or a greenhouse, (ii) certain equipment that is part of a district energy system that distributes thermal energy primarily generated by waste-fuelled thermal equipment and (iii) equipment that uses the residue of plants to produce biogas or bio-oil.
This measure will apply to eligible assets acquired on or after March 29, 2012, that have not been used or acquired for use before that date.
Scientific Research and Experimental Development Program
Budget 2012 announces several major changes to the SR&ED program following the report of the Expert Review Panel on SR&ED that was presented in October 2011.
First, the general rate of 20% for the SR&ED investment tax credit applicable to qualified SR&ED expenditures is reduced from 20% to 15% in 2014. The enhanced 35% tax credit applicable to Canadian-controlled private corporations of up to $3 million of qualified expenditures will remain unchanged. The rate of 15% will apply for taxation years ending after 2013 and will apply only to that portion of the taxation year that is in 2014 when the taxation year of a taxpayer includes January 1, 2014.
Second, expenditures of a capital nature will no longer be deductible on a current basis as SR&ED expenditures and will no longer qualify for the SR&ED investment tax credit. This measure will apply to capital property acquired on or after January 1, 2014, and to amounts paid or payable in respect of the use of, or the right to use, property during any period that is after 2013. As a result of this measure, contract payments that would otherwise qualify for SR&ED tax incentives will also be excluded as qualifying expenditures to the extent that the payment is in respect of capital expenditures made in fulfillment of the contract. The performer under the contract will have to inform the payer of the amount that is incurred in respect of capital expenditures.
Third, the rate of 65% applicable to taxpayers who elect to use the proxy method for SR&ED overhead expenses will be reduced to 60% for 2013 and to 55% after 2013. The proxy rate will be pro-rated based on the number of days in the taxation year in which the particular rate applies.
Fourth, only 80% of the amount of an arm’s length SR&ED contract payment will be eligible for the SR&ED tax incentives, as opposed to the full amount thereof under the current rules. This measure will apply to expenditures incurred after 2012.
Eligible Dividends – Split-Dividend Designation and Late Designations
To minimize double taxation when corporate profits are distributed to shareholders as taxable dividends, the Act contains rules that provide shareholders who are individuals with a “dividend tax credit” that approximates the individual’s proportionate share of income tax paid at the corporate level. Shareholders are generally entitled to an enhanced dividend tax credit for dividends paid out of corporate income that is subject to the general corporate rate of tax (such as income that has not benefited from the small business deduction, for example) if the corporation provides notice in writing at the time or before the dividend is paid to each shareholder that the dividend is an “eligible dividend.” If the corporation fails to provide such notice at the time or before the dividend is paid, there is no opportunity to file a late eligible dividend designation and the dividend will not be eligible for the enhanced dividend tax credit. Further, corporations are not entitled to designate only a portion of a dividend as eligible.
Budget 2012 proposes to simplify the designation of an eligible dividend by allowing corporations to designate any portion of a taxable dividend as an eligible dividend. Although this designation is still required at the time or before the dividend is paid, Budget 2012 proposes to grant the minister discretion to accept a designation made within three years from the date the designation was required if the minister is of the opinion that providing such relief would be just and equitable in the circumstances.
This amendment will apply to taxable dividends paid on or after March 29, 2012.
C. MEASURES AFFECTING PARTNERSHIPS
Section 88 Bump
A taxable Canadian corporation (the Parent) that has acquired control of a corporation may, in certain circumstances, increase the cost of certain non-depreciable capital property acquired by the Parent on the winding-up or vertical amalgamation of the subsidiary corporation (a section 88 bump). Non-depreciable capital property may include land, shares of a corporation or an interest in a partnership.
The Department of Finance is of the view that partnerships have been used in recent years to indirectly permit a section 88 bump in respect of assets of a subsidiary corporation that would not have otherwise qualified for a section 88 bump.
Budget 2012 proposes to deny the section 88 bump in respect of a partnership interest held by a subsidiary corporation to the extent that the accrued gain in respect of the partnership interest is reasonably attributable to the amount by which the fair market value (determined without reference to liabilities) of property that would not otherwise be eligible for the bump if such property was held directly by the corporation exceeds the cost amount thereof. The measure will apply to property held directly by the partnership or indirectly through one or more partnerships and will apply to windings-up that begin or vertical amalgamations that occur on or after March 29, 2012. However, the measure will not apply to windings-up that begin or amalgamations that occur before 2013 if the Parent had acquired control, or was obligated in writing to acquire control, of the subsidiary corporation before March 29, 2012, and the Parent and the subsidiary corporation had the intention, as evidenced in writing, to amalgamate or wind-up the subsidiary corporation.
Sale of a Partnership Interest to a Tax-Exempt Taxpayer or to a Non-Resident Person
Under current rules, a taxpayer’s taxable capital gain from the disposition of a partnership interest to a person exempt from tax under section 149 is deemed to be 50% of such capital gain that is attributable to the increase in value of capital property held by the partnership (other than depreciable property) and 100% of the remaining portion of that capital gain. The rules ensure that the full increase in the value of the partnership interest that is not attributable to an increase in value of capital property of the partnership is fully taxed, as opposed to being taxed at the rate of 50%, in the hands of the taxpayer when the partnership interest is sold to a tax-exempt taxpayer. Budget 2012 proposes to extend this treatment to the sale of a partnership interest to a non-resident person, unless the partnership is carrying on business in Canada through a permanent establishment in which all the assets of the partnership are used. The rules will also be amended to clarify that they also apply to an indirect sale of a partnership interest to a tax-exempt taxpayer or to a non-resident person. The measures will apply to the disposition of a partnership interest that occurs on or after March 29, 2012. However, an exception is made for a disposition made to an arm’s length person before 2013 pursuant to a written agreement entered into before March 29, 2012.
Budget 2012 proposes to allow a single partner of a partnership that has been designated by all the partners of the partnership to file a notice of objection to a determination of any income, loss, deduction or other amount in respect of the partnership made by the Canada Revenue Agency and to waive, on behalf of its partners, the three-year limitation period that applies for such determination or redetermination.
D. INTERNATIONAL TAXATION
When Canadian tax authorities adjust intra-group transfer prices because the price exceeds an arm’s length amount, they normally also treat the excess transfer price as a dividend subject to withholding tax. However, technical issues sometimes arise for these “secondary adjustments” if the non-resident involved in the transaction is not a shareholder of the Canadian corporation. Budget 2012 proposes that, for transactions that occur on or after March 29, 2012, the excess transfer price will be deemed to be a dividend paid proportionately to the non-resident participants in the transaction, regardless of whether they are shareholders of the Canadian corporation. Non-resident withholding tax would then apply to the deemed dividends.
While not specifically addressed in Budget 2012, the proposed “deemed dividend” rule should ensure that the rates of withholding tax imposed in a secondary adjustment would be reduced under applicable tax treaties.
Budget 2012 also proposes to confirm legislatively the current administrative policy of allowing a non-resident of Canada to avoid withholding tax by repatriating the excessive portion of the transfer price to the Canadian corporation that was subject to the primary transfer pricing adjustment.
Thin Capitalization Rules
Currently, the thin capitalization rules limit the amount of interest expense a Canadian corporation is entitled to deduct on debts owing to specified non-residents where the amount of the debt exceeds a 2:1 debt-to-equity ratio. Budget 2012 contains several important measures that impact the thin capitalization rules.
Budget 2012 proposes to reduce the debt-to-equity ratio in the thin capitalization rules to 1.5:1 for all corporate taxation years that begin after 2012. This measure, which follows a recommendation made by the Advisory Panel on Canada's System of International Taxation, is intended to bring Canada's debt-to-equity ratio in line with actual industry ratios in the Canadian economy and with global standards.
Application to Partnerships
The thin capitalization rules do not currently apply to debts owing by partnerships. Budget 2012 proposes to extend the application of the thin capitalization rules to debts owed by partnerships of which a Canadian resident corporation is a partner. For the purpose of determining the corporate partner's debt-to-equity ratio, Budget 2012 proposes that the debts of the partnership be allocated to its partners based on each partner’s proportionate interest in the partnership. In the event the allocation of the partnership debts results in these rules being applicable, the corporate partner will be required to include in income an amount equal to the amount of interest on the portion of the allocated partnership debt that exceeds the permitted debt-to-equity ratio. The partnership's interest deduction will not be restricted. This measure will apply in respect of debts of a partnership that are outstanding during corporate taxation years that begin on or after March 29, 2012.
Under current legislation, interest expense that is disallowed under the thin capitalization rules is still considered interest for purposes of Canadian non-resident withholding tax. Budget 2012 proposes that any interest expense that is disallowed as a result of the application of the thin capitalization rules will be recharacterized as a dividend for non-resident withholding tax purposes. This measure will also apply to any amount that is required to be included in computing the income of a corporate partner in respect of disallowed interest expense associated with partnership debts.
Budget 2012 also contains proposals for the allocation of the disallowed interest expense of a corporation among specified non-residents, in proportion to the debt (including debts owing by a partnership of which the corporation is a member) owing in the taxation year to each specified non-resident. The corporation may also allocate the disallowed interest expense to the latest interest payments made to any particular specified non-resident in the taxation year. Where the interest expense has not been paid by the end of the taxation year, the disallowed interest expense will be deemed to have been paid as a dividend to that specified non-resident at the end of the taxation year. In such circumstances, the corporation will be required to remit non-resident withholding tax in respect of the deemed dividend.
This measure will apply to taxation years that end on or after March 29, 2012, and will apply pro-rata for taxation years that include March 29, 2012, based on the number of days in the taxation year that are on after March 29, 2012.
Foreign Affiliate Loans
In certain cases, Canada’s thin capitalization rules can apply to deny an interest deduction on loans made to a Canadian corporation from a "controlled foreign affiliate" of that corporation. The interest income earned by the controlled foreign affiliate may also be taxed in the hands of the Canadian corporation under Canada’s "foreign accrual property income" (FAPI) regime. In order to avoid this double taxation, Budget 2012 proposes that the thin capitalization rules will exclude the interest expense of a Canadian-resident corporation to the extent that the interest expense is taxable to the corporation in respect of the FAPI of a controlled foreign affiliate of the corporation. This measure will apply to taxation years of a Canadian-resident corporation that end on or after March 29, 2012.
Foreign Affiliate Dumping
Following the recommendation of the Advisory Panel on Canada’s System of International Taxation, Budget 2012 proposes to implement measures to curtail the so-called foreign affiliate dumping transactions. These transactions have been characterized as potentially reducing the Canadian tax base without providing any significant economic benefit to Canadians.
Foreign affiliate dumping transactions would include any investment by a Canadian corporation in a foreign affiliate where the Canadian corporation is controlled by a foreign corporation and such investment may not reasonably be considered to have been made for bona fide business purposes (other than to obtain a Canadian tax benefit). For this purpose, an investment may include an acquisition of shares, a contribution to capital or certain other transactions. Budget 2012 specifically identifies a number of transactions that are targeted by this proposal, including a direct acquisition of shares of the foreign affiliate from the foreign parent with borrowed funds, certain acquisitions of such shares with internal funds and certain third-party acquisitions of such shares made at the request of the foreign parent.
Budget 2012 proposes that, under certain circumstances, a dividend will be deemed to be paid by a Canadian subsidiary to its foreign parent to the extent of any non-share consideration given by the Canadian subsidiary for the acquisition of the shares of a foreign affiliate or upon other investments that are subject to these measures. Such dividend would be subject to withholding tax at the applicable rate under the Act or any applicable tax treaty. Paid-up capital in respect of shares issued by the Canadian subsidiary on such transactions would also be disregarded and, in addition, contributed surplus arising on such transactions would be disregarded for the purposes of the debt-to-equity ratio in the thin capitalization rules.
The new measures will not apply to bona fide transactions that meet the business purpose test referred to above. The primary factors to be considered in relation to this test will be non-tax factors to be set out in the Act and explained in the accompanying explanatory notes. The Government has invited stakeholders to submit before June 1, 2012, comments concerning the details of this test.
The new measures will apply to transactions that occur on or after March 29, 2012, other than transactions that occur before 2013 between parties that deal at arm’s length and that are obligated to complete the transactions pursuant to an agreement in writing entered into before March 29, 2012.
E. PERSONAL TAX MEASURES
Group Sickness or Accident Insurance Plans
Where an employer contributes to a wage-loss replacement plan in respect of an employee, the employee is generally required to include an amount in his or her income for the year in which the employer contribution is made or for the year in which benefits under the plan are received. However, in circumstances where benefits under a plan are not payable on a periodic basis or benefits are payable in respect of a sickness or accident when there is no loss of employment, no amount is included in the employee’s income for the year in which employer contributions are made or for the year in which benefits are received.
In an effort to provide fairness and neutrality among wage-loss replacement plans, Budget 2012 proposes to include the amount of an employer’s contribution to a group sickness or accident insurance plan in an employee’s income for the year in which the contribution is made to the extent such contribution is not in respect of benefits payable on a periodic basis. This proposed amendment will not apply to employer contributions to private health services plans, employee life and health trusts, supplementary unemployment benefit plans, registered pension plans and other plans described in paragraph 6(1)(a).
This measure will apply to employer contributions made to a group sickness or accident insurance plan on or after March 29, 2012, that relate to coverage after 2012, except contributions made between March 29, 2012, and December 31, 2012, will not be included in the employee’s income until 2013.
Retirement Compensation Arrangements (RCAs)
Due to several tax-motivated schemes involving RCAs that have been identified as being inconsistent with the policy behind RCAs, Budget 2012 proposes to adopt “prohibited investment” and “advantage” rules for RCAs that are similar to those currently applicable to TFSAs, RRSPs and RRIFs.
Contributions to an RCA together with income and gains earned in an RCA are generally subject to a 50% tax that is refundable as taxable distributions are made from the RCA. In cases where property of an RCA has declined in value, Budget 2012 proposes to limit the refund of this tax to circumstances where the decline in value is not reasonably attributable to a prohibited investment or an advantage. In such a case, the refund may still be paid where, in the opinion of the Minister of National Revenue, it would be just and equitable to do so having regard to all the circumstances.
These proposed changes to the RCA rules will apply as follows:
(a) investments the prohibited investment rules will apply in respect of investments acquired on or after March 29, 2012, and held by an RCA that become prohibited investments on or after March 29, 2012;
(b) the advantage rules will apply to advantages received or receivable on or after March 29, 2012, subject to certain transitional rules in respect of advantages in respect of property acquired or transactions occurring before March 29, 2012;
(c) the restriction on refunds of RCA tax will apply in respect of RCA contributions made on or after March 29, 2012.
Employee Profit-sharing Plans (EPSP)
Budget 2012 proposes to introduce a new tax on excessive employer contributions to EPSPs in an effort to deter the use of EPSPs by certain business owners to “income split” with their families. Specified employees (generally an employee who has a significant interest in the employer or who does not deal at arm’s length with the employer) will be subject to tax at their top combined federal/provincial marginal rate (federal only for specified employees resident in Quebec) on any “excess EPSP amount,” subject to the minister’s discretion to waive the tax. An excess EPSP amount is, generally, the amount by which the employer’s contribution to an EPSP that is allocated by the EPSP to the specified employee exceeds 20% of the specified employee’s salary. To avoid double taxation, the specified employee will then be entitled to deduct the amount of EPSP tax paid in computing his or her income for the year.
This measure will apply in respect of EPSP contributions made by an employer on or after March 29, 2012, other than contributions made on or before December 31, 2012, pursuant to a legal obligation under a written agreement entered into before March 29, 2012.
Mineral Exploration Tax Credit for Flow-Through Share Investors
The 15% investment tax credit for "flow-through mining expenditures" has been extended for another year. The tax credit will be available for flow-through share agreements entered into on or before March 31, 2013, and in respect of expenditures incurred, or deemed under the "look-back rule" to have been incurred, by the end of 2013.
Life Insurance Policy Exemption Test
The income earned on the savings component of a life insurance policy that is an “exempt policy” is not subject to accrual taxation in the hands of the policyholder. The Government is of the view that the criteria for determining whether a policy is an exempt policy are outdated. As a result, Budget 2012 proposes to implement certain amendments that would improve and simplify the life insurance exemption test and to recalibrate the Investment Income Tax imposed on life insurers in light of these changes. The Government plans to consult with key stakeholders regarding these changes over the coming months and amendments arising from these consultations will apply to life insurance policies issued after 2013.
Overseas Employment Tax Credit
The overseas employment tax credit will be eliminated over a period of four years. A qualifying employee is generally entitled to a credit equal to the lesser of the income tax otherwise payable on $80,000 and 80% of the employee’s employment income in relation to the overseas employment. Budget 2012 proposes to reduce the amount of the credit as follows:
- 2013 – the lesser of the income tax otherwise payable on $60,000 and 60% of the overseas employment income;
- 2014 – the lesser of the income tax otherwise payable on $40,000 and 40% of the overseas employment income;
- 2015 – the lesser of the income tax otherwise payable on $20,000 and 20% of the overseas employment income; and
- 2016 and beyond – no credit.
The phase out will not apply if the employment income is earned by the employee in connection with a project or activity to which the employee’s employer has committed in writing before March 29, 2012.
F. OTHER MEASURES OR ANNOUNCEMENTS OF INTEREST
Gifts to Foreign Charitable Organizations
Charitable donations made to foreign charities are not eligible for the charities donation tax credit or charitable deduction unless the foreign charity registers as a “qualified donee” under the Act, which is permitted only if the Government of Canada has made a gift to the foreign charity in the year or the previous 12-month period.
Budget 2012 proposes to add additional criteria for registering foreign charities as qualified donees. Specifically, in addition to receiving a gift from the Government of Canada, only charities that pursue activities that are (i) related to disaster relief or urgent humanitarian aid or (ii) in the national interest of Canada, may apply for qualified donee status. Such a designation would last for a 24-month period, which would normally begin no later than the date of the gift from the Government. This measure will apply to applications made by foreign charities on or after the later of (i) January 1, 2013; and (ii) the date the proposed amendment receives Royal Assent.
Budget 2012 introduces new measures to encourage the registration and reporting compliance of tax shelters. These include:
(a) Modifying the calculation of penalties applicable to a “promoter” of an unregistered charitable donation tax shelter;
(b) Introducing a new penalty applicable to promoters who fail to file annual information returns in respect of the tax shelter; and
(c) Limiting the period for which a tax shelter registration is effective to one year.
Foreign Affiliate Rules – Canadian Banks
Budget 2012 proposes that the Department of Finance work with Canadian banks to develop adjustments to Canada’s foreign affiliate “tax base erosion” rules to provide relief where these rules may produce inappropriate limitations. Specifically, the Government will develop amendments to alleviate the tax cost of using excess foreign affiliate liquidity in Canadian operations, and to better accommodate securities trading business undertaken for arm’s length customers outside Canada.
Taxation of Corporate Groups
Budget 2012 restated the intention of the Government to explore whether new rules for corporate groups could improve the functioning of the Canadian tax system. As changes in respect to the taxation of corporate groups may be fundamental to the Canadian tax system, the Government will pursue its analysis as to the impacts that such changes may have on taxpayers and federal and provincial governments. If as a result of this exercise a new system of group taxation should be proposed, the Government will again consult stakeholders on the specific design of the new system.
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